Every company prepares an income statement (or Profit & Loss Account) and a Balance Sheet at the end of each financial year. The income statement reflects a company’s net profit or loss, while the balance sheet provides insights into its financial position.

These financial statements are based on the trial balance, which records all transactions. However, certain entries may be (i) omitted, (ii) recorded incorrectly, or (iii) partially entered. To rectify these, adjustment entries are necessary.

Why Are Accounting Adjustments Needed? Accounting adjustments ensure that the financial statements accurately reflect the company’s financial performance and position. Adjustments are made to:

• Accurately determine the net profit or loss.
• Reflect the true financial status of the business.
• Record transactions that were omitted from the books.
• Correct errors made in the initial entries.
• Recognize income that has been earned but not yet received.
• Account for depreciation and other provisions.

Types of Adjustments and Their Accounting Treatment in Financial Statements Several types of adjustments impact financial statements. Each adjustment is recorded in specific accounts and reflected accordingly. Key types include:

1. Closing Stock

• Definition: Closing stock represents the inventory that remains unsold at the end of the accounting year. This amount does not appear in the trial balance and must be added to the financial statements.
• Adjustment Entry:
  
  
  Closing Stock A/c Dr.
To Trading A/c Cr.


• Explanation: This entry brings the closing stock into the books, appearing as a credit in the Trading Account and as an asset in the Balance Sheet.

1. Outstanding Balance

• Definition: These are expenses incurred during the year but remain unpaid at the time of preparing the final accounts.
• Adjustment Entry:
  
  Expense A/c Dr.
  

  To Outstanding Expense A/c Cr.

• Example: If November’s salary is unpaid, it is recorded as follows:
  
  Salary A/c Dr.
  

  To Outstanding Salary A/c Cr.


Dr.	Balance Sheet		Cr.
Assets	₹	Liabilities	₹
		Salary Outstanding

• Explanation: This adjustment increases expenses in the income statement and lists the outstanding amount as a liability on the Balance Sheet.

1. Prepaid Expenses

• Definition: Prepaid expenses are payments made in advance for future services, such as insurance premiums paid this year for coverage extending into the next.
• Adjustment Entry:
  
  Prepaid Expense A/c Dr.
  

  To Expense A/c Cr.


• Example: For prepaid insurance:
  
  Prepaid Insurance A/c Dr.
  

  To Insurance Premium A/c Cr.


• Explanation: The adjustment reduces expenses in the income statement and lists prepaid amounts as assets on the Balance Sheet.

1. Accrued Income

• Definition: Accrued income is revenue earned but not yet received by the end of the accounting period. Common examples include interest on securities or dividends.
• Adjustment Entry:
  
  Accrued Income A/c Dr.
  

  To Income A/c Cr.


• Example: For rent that has been earned but not yet received:
  
  Rent Receivable (Accrued) A/c Dr.
  

  To Rent Receivable A/c Cr.


• Explanation: This adjustment adds to the income in the income statement and lists accrued income as an asset on the Balance Sheet.

1. Unearned Income

• Definition: Unearned income represents payments received in advance for services not yet provided. An example is rent received this year for occupancy in the next.
• Adjustment Entry:
  
  Income A/c Dr.
  

  To Unearned Income A/c Cr.


• Example: If rent is received in advance for the following month:
  
  Rent Received A/c Dr.
  

  To Rent Received in Advance A/c Cr.


• Explanation: The adjustment reduces income in the income statement and shows unearned income as a liability on the Balance Sheet.

Accounting adjustments play a vital role in ensuring that financial statements accurately represent a company’s financial activities and position. They are especially relevant for students studying financial accounting, providing insights into handling various transactions.

For more detailed explanations on financial statement adjustments, stay tuned to Eduacademy