Paper: 02, Accounting & Financial Analysis

Module: 15, Adjustment Entries

Prof. S P Bansal
Principal Investigator Vice Chancellor
Maharaja Agrasen University, Baddi

Prof YoginderVerma
Co-Principal Investigator Pro–Vice Chancellor
Central University of Himachal Pradesh. Kangra. H.P.

Dr. O.P Verma

Paper Coordinator Department of Commerce
Himachal Pradesh University shimla

Prof. S.S. Narta

Content Writer Director UCBS Himachal Pradesh
University Shimla
 Items Description of Module
Subject Name Management
Paper Name Accounting & Financial Analysis
Module Title Adjustment Entries
Module Id Module No- 15
Pre- Requisites Journal entries passed/ prepared at the end of
accounting year,
Objectives To understand what is an adjustment entry and
main items that need to be adjusted in the
books of accounts..
Keywords Adjustment, P&L A/C, Entries

QUADRANT I

1. Module-15: Adjustment Entries

2. Learning Objectives
3. Introduction
4. Meaning of Adjustment Entries
5. Adjustments
6. Practical Example
7. Need for passing adjustment entries
8. Summary

LEARNING OBJECTIVES:

After studying the module students may be able to understand what is an adjustment entry and main
items that need to be adjusted in the books of accounts along with a hypothetical example. Also need
for passing adjustment entries is also highlighted.

INTRODUCTION:

The main objective behind preparing the final statements is to judge the financial strength of any
enterprise. An organisation maintains a proper record of the transactions being carried out throughout
the year not due to the compulsion of the law, but in order to get an overview of the entire working of
the business and find out the amount of profits earned and the amount of losses incurred. In order to
satisfy the above mentioned objectives a set of statements including the trading and profit and loss
account and the balance sheet are prepared, collectively known as final accounts. Preparing final
accounts is the last step in the entire accounting cycle, which gives a conclusive and important
overview of the working of the business throughout the accounting year.

The preparation of the accounts is not error free, but certainly includes some sort of error either due to
human mistakes or due to some technical fault in recording. The error may be in the form of either
partially omitting any entry or error in updating certain revenue and expense accounts. It is certainly
not possible to re-prepare the entire line of accounts right from the very beginning, so in order to
rectify the mistakes certain adjustment entries are passed at the end of the accounts to update certain
revenue and expense accounts.

MEANING OF ADJUSTMENT ENTRIES:

As the name suggest, adjustment entries (also known as correcting entries) means entries passed in
order to adjust some unadjusted accounts. These are the journal entries passed/ prepared at the end of
accounting year, in order to meet up the matching principle of accounting. The matching principle of
accounting states that there should be a match between the expenses and the revenues in one
accounting year. In simple terms it means that the expenses incurred need to be matched up to the
same accounting period in which the revenue was earned by paying those expenses.

Adjustment entries are an important part for every organisation, as passing the adjustment entries at
the end will ensure that the matching concept has been followed properly, and that the true and a fair
image of the organisation is being highlighted.

The main types of accounts that need to be adjusted are:

1. Prepaid expenses: these include the sum of expenses already paid for by the company and that the
benefit will be availed in the later stages to come. Example: an insurance amount paid at the
starting of accounting year, and the benefits will be availed in the later stages to come.
2. Unearned revenues: also known as income received in advance. It means that the said revenues
are not earned in the same accounting year, but still has been received. Simply it means that the
company have received the income in advance but they have not rendered the services for the
same. Example: a company has received the payment for delivering the goods at customer’s shop
but have still not delivered the goods.
3. Accrued/ Outstanding expenses: these are the expenses that have not been paid yet by the
company. These are due to be paid, but not yet paid. That means the payment has not been made
by the company. Example: a business firm pays Rs 60000 per annum to an employee. But during
the year only 58000 have been paid, this means that Rs 2000 (60000- 58000) are considered as
not paid/ outstanding on the part of the company.
4. Accrued Income: this is that portion of the net income that have been earned but not yet received
by the company. It means that the income was due to be received but still it has not been
received. Example: if the business has invested Rs 30000 @ 5%. The interest earned is Rs 1500.
And if only Rs 1000 has been receives, so the remaining amount of Rs 500 will be termed as
accrued income.

QUICK REVISION:
▪ The main objective behind preparing the final statements is to judge the financial strength of any
enterprise.
▪ In order to rectify the mistakes certain adjustment entries are passed at the end of the accounting
year to update certain revenue and expense accounts.
▪ Adjustment entries means entries passed in order to adjust some unadjusted accounts.
▪ Prepaid expenses are already paid in advance.
▪ Accrued income means the income earned but not received.
▪ Unearned revenue is the revenue received but not earned.

ADJUSTMENTS:
Adjustments are made in the accounts at the end so as to satisfy the matching concept and passing
adjustment entries is an important part for every organisation. Organisations while preparing trading
and profit and loss account pass adjustment entries for some of the items, and ensure that the expenses
actually paid and the income actually earned are recorded in the accounts. And that the entries in
order to adjust the unearned revenue or prepaid expenses are passed well in advance.

Trading account is prepared in order to find out the gross margin/ profit or loss earned or incurred
while trading in the market. The net result of the trading account is the gross profit or gross loss.
Profit and loss account is prepared in order to find out the net profit/ loss of the business. The result is
either net profit or net loss.

Following are some of the important items, explained in detail which needs to be adjusted:

1) CLOSING STOCK:
Closing stock means the stock that is not sold during the year and remains as a left over portion
with the business after the end of the accounting year. Stock is always valued at realisable value
or cost, whichever is less.
Adjustment Entry: Stock A/C….Dr.
To Trading A/C
Effect: closing stock will be recorded on the credit side of trading account and on the asset side of
balance sheet.

2) PREPAID EXPENSES:
These are the expenses paid in advance before they become due to be paid. It means that the
benefit of the services for whom payment have been made, will be availed in future. Example:
XYZ Ltd had paid the insurance premium on Dec 31, 2014 which will expire on 30 April, 2015.
Adjustment Entry: Prepaid Insurance premium A/C….Dr.
To Insurance Premium A/C
Effect: will be deducted from the expenses, and shown in the profit and loss account. And will be
recorded on the asset side of balance sheet.
3) ACCRUED INCOME:
Is the amount which have been already earned but not received by the yet. Example: amount of
rent not yet received by the business which was expected to be received earlier is termed as
accrued income.
Adjustment Entry: Accrued Interest A/C….Dr.
To Interest A/C
Effect: accrued interest will be added to the income and shown on the credit side of the profit and
loss A/C, and on the asset side of the balance sheet.

4) DEPRECIATION:
It refers to the reduction in the value of asset (fixed) with time due to normal wear and tear or
obsolescence. Depreciation is charged at some percent on the value of asset and is charged on the
profit of that year. This helps in showing true financial position and depicting its true value in the
balance sheet.
Adjustment Entry: Depreciation A/C…..Dr.
To Machinery A/C
 Effect: depreciation is recorded on the debit side of P&L A/C. The asset side of balance sheet will
hold the depreciation amount after being deducted from the amount of machinery.

5) BAD DEBTS:
The amount of debt which is not repaid by the debtors or which remain unrecovered in spite of the
collection efforts are termed as bad debts. They are important to be adjusted in order to find the
exact amount of sundry debtors.
Adjustment Entry: Bad Debts A/C……Dr.
To Sundry Debtors
Effect: bad debts will be written on the debit side of profit and loss account and on the asset side
of balance sheet.

6) PROVISION FOR DOUBTFUL DEBTS:

Doubtful debts are those on which the company is doubtful, that whether the amount due will be
paid or not. For such types of debts, a provision is created on the basis of conservatism approach
i.e. one must anticipate the losses and not the profits. Provision for doubtful debts is created in
terms of percentage keeping in mind the past experience.
Adjustment Entry: Profit and Loss A/C….Dr.
To Provision for Doubtful Debts A/C
Effect: it will be added in the amount of bad debts on the debit side of Profit and Loss Account
and will be deducted from sundry debtors, on the asset side of balance sheet.

7) OUTSTANDING EXPENSES:
An expense is considered as outstanding if the amount of expense is not paid before the date it
was supposed to be paid. So in order to highlight the fact, adjustment entry is supposed to be
passed at the year end.
Adjustment Entry: Expense A/C…..Dr.
To Outstanding Expense A/C
Effect: it will be shown on the liability side of the balance sheet and debit side of trading or profit
and loss account.

8) PROVISION FOR DISCOUNT ON DEBTORS:

If the sales are made on credit basis, then in order to get the early payments from the debtors,
merchants declare of giving discounts to the debtors. This is known as provision for discount on
debtors.
Adjustment Entry: Profit & Loss A/C…..Dr.
To provision for discount on debtors A/C
Effect: It will be presented on the debit side of profit and loss account. It will also be shown on
the asset side of balance sheet by deducting it from the sundry debtors.

9) RESERVE FOR DISCOUNT ON CREDITORS:

Creditors arise when the transaction is done on credit basis, i.e. when the business purchases the
goods and does not pay right away, instead promise to pay in the later date. And the creditors in
order to speed up the collection from the business declares a discount if the payment is done
within specific period. Such a discount on creditors in anticipated profits for the business and
adjustment entry need to be passed for the same.
Adjustment Entry: Reserve for discount on creditors A/C……Dr.
To Profit & Loss A/C
 Effect: in the profit and loss account, it is shown on the credit side and in the balance sheet it is
subtracted from sundry debtors on the liabilities side.

QUICK REVISION:
▪ The adjustment entries in order to adjust the unearned revenue or prepaid expenses are passed
well in advance.
▪ Adjustments are made in the accounts at the end so as to satisfy the matching concept of
accountancy.
▪ Closing stock is recorded on the credit side of trading account and on the asset side of balance
sheet.
▪ Depreciation on any fixed asset is shown on the debit side of profit and loss account and asset
side of the balance sheet.
▪ Prepaid expenses will be deducted from the expenses, and shown in the profit and loss account.
And will be recorded on the asset side of balance sheet.
▪ Closing stock will be recorded on the credit side of trading account and on the asset side of
balance sheet.

PRACTICLE EXAMPLE:

A hypothetical trial balance of ABC Ltd as on April 30, 2014 is given under. With the help of
which, trading and profit and loss account will be prepared, followed by the balance sheet.

TRIAL BALANCE

PARTICULARS DEBIT CREDIT

(Rs) (Rs)
Capital Account 108190
Stock on 31st March 2013 46900
Sales and Sales Return 8700 289700
Purchases and Purchases Return 243200 5900
Freight and Carriage 18700
Rent and Taxes 5800
Salaries and Wages 9400
Sundry Debtors 24100
Bank Loan @ 6% 20100
Bank Interest 1000
Printing & Advertisement 14700
Income from Investments 1750
Discounts Receivables 3790
Sundry Creditors 14900
Cash at Bank 8300
Investments 5100
Furniture 1900
Discount Payable 7440
General Expenses 3260
Audit Fee 600
Insurance 900
Travelling Expenses 2230
Postage 970
Cash in Hand 930
Deposit with Mr X at 10% 30100
Drawings 10100
TOTAL 444330 444330

Additional Information:
Stock on April 30 2014: Rs 78700
50% printing is to be carried forward as a charge
Rate of depreciation on furniture @ 10%
5% provision on doubtful debts
2% for discount on debtors and creditors
Prepaid insurance Rs 300
Salaries outstanding Rs 600
Carriage outstanding Rs 200
Full year interest on deposit is charged on deposit with Mr X

SOLUTION:
Trading and Profit & Loss Account for the year ended April 30, 2014

Particulars Amount Particulars Amount

To Opening Stock 46900 By sales 289700
To purchases 243200 Less: Sales return 8700 281000
Less: Purchase Return 5900 237300 By Closing stock 78700
To freight and carriage 18900
To Gross Profit c/d 56600
359700 359700
To rent & taxes 5800 By gross profit 56600
To salaries & wages By income from investments 1750
9400 10000 By discounts receivables 3790
Add: outstanding By reserve for discount on creditors 298
600 1206 (@ 2%)
To bank interest By accrued interest on deposit with 3010
1000 7350 Mr X
Add: outstanding 7440
206 3260
To printing & adver. 600
14700
Less: carried forward 7350 600
To discount 2230
To general expenses 970
To audit fees 190
To insurance 900 1205
 Less: prepaid insurance 300
To travelling expense 458
To postage 24139
To depreciation on furniture 65448 65448
To provision for doubtful debts
To provision on discount on
debtors (@ 2%)
To net profit transferred to capital
A/C

Balance Sheet as on April 30, 2014

Liabilities Amount Assets Amount

Sundry creditors 14900 Cash in hand 930
Less: reserve for discount 298 14602 Cash at bank 8300
Bank loan Sundry debtors 24100
20100 20306 Less: provision for d/d 1205
Add: outstanding 600
206 200 22895 22437
Outstanding salaries Less: provision for discount 458 78700
Outstanding carriage Closing stock 300
Capital 108190 Prepaid insurance 7350
Less: Drawings 10100 122229 Printing & advertisement 5100
Investments
98090 Deposit with Mr X 30100 33110
Add: Net profit 24139 Add: accrued interest 3010
Furniture 1900 1710
157937 Less: Depreciation 190 157937

The above example explains the adjustments made on some of the important items such as bad
debts, outstanding expenses etc. These are not the only items to be adjusted. The rest of the items
that need adjustment are discussed below:

1) DEFERRED REVENUE EXPENDITURE:

It is that type of expenditure which is incurred only during the starting period, for some time
and whose benefit is availed in the longer period. The entire amount cannot be written off all
together, therefore it is written off in each year. Example: expenditure on radio expenditure is
Rs 20000, which is spread over a period of 5 years. So the amount to be written off each year
would be Rs 4000.
Adjustment Entry: Profit and Loss A/C……Dr. 4000
To advertisement A/C 4000
Effect: it is shown on the debit side of profit and loss account and on the asset side of balance
sheet after deducting from capitalised expenditure.
 2) RESERVE FUND:
It is the fund created out of the profit and is set aside for meeting any kind of future
contingencies. A portion of the profit is set aside every year to be transferred to the reserve
fund account.
Adjustment Entry: Profit and Loss A/C…..Dr.
To Reserve fund A/C
Effect: reserve fund is shown on the debit side of profit and loss account and on the liabilities
side of balance sheet. In case reserve fund already exists in the balance sheet, then the amount
will be added to the already existing amount.

3) HIDDEN ADJUSTMENTS:
Sometimes there are items present in the trial balance and need to be adjusted although there
is no additional given. Example: In trial balance there are following balances:
Dr Cr
6% loan 20000
Interest on loan 800

The interest on loan @ 6% is Rs 1200 (20000*6%). But only Rs 800 have been paid, it is
clear that Rs 400 (1200- 800) is considered as an outstanding loan.
Adjustment Entry: Interest on loan A/C……Dr. 400
To loan A/C 400
Effect: outstanding interest will be shown on the debit side of P&L A/C, whereas on the
liabilities side of the balance sheet.

QUICK REVISION:
▪ Deferred revenue expenditure is written off on yearly basis.
▪ Reserve fund is shown on the debit side of profit and loss account and on the liabilities side of
balance sheet.
▪ Hidden adjustments are those which need to be adjusted even though nothing is mentioned in
the additional information.

NEED FOR PASSING ADJUSTMENT ENTRIES:

1) These entries are passed so as to depict the correct net profit and net loss in the profit and loss
account.
2) To depict the true financial position of the business.
3) To match up the expenses paid with the revenue earned by paying such expenses in the same
accounting period.
4) To find out the actual amount payable to the outsider as well as the correct expenses incurred.

SUMMARY:

Final accounts are prepared at the end of accounting period with the main aim of presenting a true and
a fair picture of the business. And this true and fair picture will be depicted only when the business
maintains the accounts fairly by passing the entries accordingly. Business tries to keep a balance
between the revenues and the expenses and ensures that the matching principle is met properly. For
this certain adjustment entries need to be passed at the end of the accounting period to depict a correct
picture of the business.

Adjustment entries means entries passed in order to adjust some unadjusted items. Adjustment entries
are essential to be passed by the business so as to find out the correct amount of expenses incurred
against the amount of revenue generated falling under the same accounting period. Mainly
adjustments are made for adjusting the prepaid expenses, accrued incomes, unearned revenues and
outstanding expenses. Apart from these there are many more items which need to be adjusted by the
business house such as reserve fund, deferred revenue expenditure, bad debts, depreciation, provision
for discount on debtors and creditors, interest on drawings and capital etc.

Passing adjusting entries is a vital part in the entire accounting cycle and cannot be ignored by the
business, as by ignoring the process of passing adjustment entries the true and fair image of the
business will not be presented and also the matching concept of accounting will be violated.