Question

Why do some accounts need to be adjusted before the Financial Statements are prepared?

Answer 1

Need for Adjusting entries before the Financial statements are prepared :-

While preparing the Financial statements, enterprise must follow the Accrual concept and the Matching concept in order to reflect the True and fair view. Therfore, the preparation of adjusting entries is an application of the accrual concept of accounting and the matching principle.

As pre the accrual concept, the Income is recognised when it was earned irrespective of its collection status and expense is also recognised when it was incurred irrespective of payment status.

As per the matching principle, always match the expenses with revenues. It means expenses which are incurred to generate the revenue for the given period, those expenses can be charged to that period. Matching concept is  important because net profit or loss and financial position can be recognized in same accounting period.

Necessity of Adjusting Entries :-

Adjusting entries is required to update the accounts to conform with the accrual concept. At the end of the accounting period, some income and expenses may have not been recorded, taken up or updated; hence, there is a need to update the accounts.

If adjusting entries are not prepared, some income, expense, asset, and liability accounts may not reflect their true values when reported in the financial statements. For this reason, adjusting entries are necessary.

Types of Adjusting Entries :-

Generally, there are Four types of adjusting entries. Adjusting entries are prepared for the following:

1. Prepaid Expense – These are the Expenses which are paid but not incurred yet.
2. Deferred Income – These are the Income which is received in advance but not earned yet.
3. Accrued Income – Income which is earned but not received yet.
4. Accrued Expense – Expenses which are incurred but not paid yet.

Adjusting entries are also made for:

1. Depreciation.
2. Warranties, Doubtful Accounts or Bad Debts, and other allowances

Composition of an Adjusting Entry

Adjusting entries affect at least one nominal account and one real account.

A nominal account is an account whose balance is measured from period to period. Nominal accounts include all accounts in the Income Statement, plus owner's withdrawal. They are also called temporary accounts or income statement accounts.

Examples of nominal accounts are: Service Revenue, Salaries Expenses, Administrative Expense, Rent Expense, Wages, Drawings, Depreciation etc.

A real account has a balance that is measured cumulatively, rather than from period to period. Real accounts include all accounts in the balance sheet. They are also called permanent accounts or balance sheet accounts.

Real accounts include: Cash,Cash at bank, Accounts Receivable, Rent Receivable, Accounts Payable, Capital, and others.

All adjusting entries include at least a nominal account and a real account.