Accounting Basics : Adjustment Entries

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Accounting Basics and Adjustment EntriesFirst we need to know few important terms

Adjustments are transactions relating to business which have not yet been journalized.

Therefore, to make the adjustments one should have an idea of the journal entry related to the transaction indicated by the adjustment.

If we know the Journal entry, we can identify the effect of the same on the ledger accounts and thus be able to identify the adjustments to be made.

The adjustments are made at the time of making up the final accounts within the three parts that make up the final accounting, i.e. the “Trading a/c”, “Profit & Loss a/c” and the “Balance Sheet”.

Each item from the adjustments should be dealt with at least twice in Final Accounting.


Bad Debt:

A person or company who is not expected to pay his debt; for example, because the company has gone into liquidation. Bad debts must be written-off and therefore they will reduce profit.

This type of transaction would affect both the profit and loss, and the balance sheet. The profit and loss would show the bad debt as an expense as this is money owed by a customer that cannot be collected.

The transaction has previously processed as a debit to the Debtors Control account. As it is money that can no longer be collected, you would reverse this by making a credit to the Debtors Control account.

Discount:


The amount by which a bill is reduced. Discounts can be given for a variety of reasons, e.g. buying in bulk, spending large amounts, being a preferred customer (trade discounts) or settlement discount.

Discount Allowed:


A deduction from the amount due, given to the customers, who pay their accounts within the time allowed.  It appears as an expense in the profit and loss account.

Discount Received:


A deduction from the amount due, given to a business, by a supplier, when their account is paid before the time allowed has elapsed.  It appears as income in the profit and loss part of the trading and the profit and loss account.

Depreciation:


A figure representing the reduction in value of a fixed asset, due to use, obsolescence etc., in the calculation of Net profit.

This involves splitting the monetary value of the asset into instalments to each accounting period of its useful life.

Depreciation involves estimates of life and residual values.  It is common that an asset will be worth less at the end of its life expectancy than when the business first started using it, so in affect, it has cost the business money.  If it has cost the business money, then it must be an expense and will therefore affect the profit and loss.  The asset is also expected to be worth less, and thus also affect the balance sheet.

There are various methods of depreciation, Straight Line and Reducing Balance:

Preliminary Expenses:


All the costs that are incurred when a company is formed.

Prepayments:


A payment for goods or services before they are received.  e.g. Insurance paid 1 year in advance and accounted for over 12 months.

Most businesses would pay for their insurance 1-year in advance.  You would account for this transaction by making a credit entry to the bank account and a debit entry to the Insurance account.  This transaction is quite correct from a bookkeeping point of view.  However, every business is expected to present accurate accounts showing all expenses in the accounting period that the costs/expenses relate to.  If the insurance transaction were left, as it is, the cost for a whole year would be shown in one accounting period – this would give a misinterpretation of the accounts.  To account for this transaction correctly the business would have a Prepayments Account.

A Prepayment Account is an asset account because something has been paid for but not yet used in the business.  To correctly account for the insurance that has been paid in advance you would debit the full amount to the Prepayment Account and credit the full amount to the Insurance Account.

When the accounts are processed at the end of each accounting period you would credit 1/12th of the of the annual amount from the Prepayment Account and debit 1/12th of the annual amount to the Insurance Account.  This would enable the business to correctly account for the insurance in each accounting period i.e. 1/12th of the annual amount would be shown in the Insurance Account each month, making the profit & loss report more accurate.

The outstanding balance of the prepayment for each accounting period would be shown in the balance sheet as a current asset.  This would reduce each month until the year has been fully expensed.

Provision for Bad Debt:


An amount put by for those debts which may not be paid. It appears as an expense on the profit and loss account and is deducted from the debtors control account.

Suspense Account:


A temporary account that is used when you are unsure as to what you should do with a certain value. The Suspense Account can be used as a holding account until it is decided what should be done with the value. The balance on the Suspense Account should ultimately be zero. It is most commonly used in Sage when the Opening Balances are being put onto the system.

Accounting students and those using manual accounting systems should see our comprehensive guide on Preparing A Trial Balance (Creation Of A Suspense Account) using the manual system and some potential errors.

Now we will take a look at adjustments and how to adjust them in P & L account and balance sheet.

There are many adjustment because earlier we have not passed any journal entry , so at the time of making final account we have to adjust them .
Name of items
Adjustment entry
Effect on trading and profit and loss account
Effect on balance sheet
1. Closing stock
Closing stock account dr. xxx
To trading account xxx
Closing stock will write in the credit side of trading account
It will show as asset in the final account
2. outstanding expenses or expenses payable or expenses due but not paid
Expenses account dr. xxx
To outstanding exp. xxx
Outstanding expenses will add in expenses . if it is direct it will go to trading account’s debit side , if it is indirect nature then it will go to the debit side of profit and loss account
It will be the current liability so it will go to the liability side of balance sheet.
3. advance expenses
Advance expenses a/c dr. xxx
To expenses account xxx
It will deduct from respective expenses paid .
It will be the current asset so it will go to assets side of balance sheet
4. income receivable
Outstanding income account dr. xxx
To income account xxx
It will add in the income and go to credit side of profit and loss account
It will show as asset in the assets side of balance sheet
5. income received in advance
Income account dr. xxx
To advance income account xxx
It will deduct from the income received
It will shown as liability in the liabilities side of balance sheet
6 Goods use for personal use
Drawing account dr. xxx
To purchase account
It will deduct from purchase in the debit side of trading account
= purchase –drawing in goods
It will deduct from capital in the liabilities side of balance sheet
=capital- drawing in goods
7. Destroyed of goods
loss by fire or accident account Dr. xxx
To trading
If there is no insurance
It will also go to profit and loss account
Profit and loss account dr. xxx
To loss by fire / accident
It will shown in credit side of trading account
And also in profit and loss account’s debit side
It will not go to balance sheet
8. Depreciation
Depreciation account dr. xxx
To respective asset account xxxx
It will go to the debit side of profit and loss account
It will deduct from fixed asset . Because it decrease the value of asset
=fixed asset – depreciation
9. provisional for doubtful debts
If you have make any provision for doubt ful debts the its journal entry will passed
Provision for doubtful debt account dr. xxx
To Bad debts account xxx
( New bad debts which is not shown in trial balance will transfer to provision for doubtful debt account )
Net value of provision for doubtful debt account transfer to profit and loss account’s debit side
=total bad debt + closing balance or provision of doubtful debt or this year provision – opening balance of provision for doubtful debts
Deduct from debtor
= debtor – new bad debts – this year provision or closing balance of provision for bad debts
10. Commission to manager
Commission account dr. xxx
To outstanding commission
It will shown in the debit side of profit and loss account as o/s commission to manager
If it charge on the amount after charging such commission then we will calculate
= profit before commission X Rate/ 100+rate
It will shown as liability
Wait for few more adjustments in future …

Useful resources:


1. http://www.accountingissue.info/accounting-glossary.html
2. http://ezinearticles.com/?Adjustments-of-Final-Accounts&id=616011
3. http://www.svtuition.org/2008/09/adjustments-of-final-accounts-full.html
4. http://www.futureaccountant.com/

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