Question

What is the purpose of adjusting entries? If we failed to make the proper adjustments at year end, how will our expenses be effected? How will our liabilities be affected? Will our assets be affected. Provide an example of when the liabilities would be affected if we fail to post an adjusting entry. Why is the matching principle important here?

Answer 1

Adjusting Entries are journal entries that are made at the end of the accounting period, to adjust expenses and revenues to the accounting period where they actually occurred. Generally speaking, they are adjustments based on reality, not on a source document.Preparing adjusting entries is a key step in the ongoing accounting cycle, coming right after you’ve completed preparing a trial balance.You can use these adjustment entries during preparation of final accounts in your company or firm.

Few Examples of Adjusting Entries:

1- Adjustment of Closing Stock,

2- Depreciation,

3- Appreciation on revaluation,

4- Investment Revaluation,

5- Advance/Outstanding Expenses, etc.

The Effect of not making proper adjustments:

If the proper adjustments aren't made it will not only effect the Profit and loss statement but will effect Balance Sheet too.

1- The Effect on Expenses :-

It can be of two type:

• If you recognize an expense earlier than is appropriate, this results in higher expense turning to be a lower net income.
• If you recognize an expense later than is appropriate, this results in in lower expense turning to be a higher net income.

2- The Effect on liabilities :-

If an expense is due and it is not adjusted in accounts the liability will be understated hence resulting in lower expenses and more profit. Like agents commission based on sales he generated is usually calculated and paid after year end sales figure has been established. This Expense relates to current year sales and has to be provided for. This will increase the liability. Same goes with unpaid rent, bonus, Interest on loans, Bank Overdraft, Sales Tax/VAT/GST or TDS due etc.

On the other side if any expense which does not relate to current year is been booked as due, it will result in inappropriate increase in liability and false expenses resulting in lower profits.

3- The Effect on Assets :-

If an expense is due and it is not adjusted in accounts the assets will be overstated hence resulting in lower expenses and more profit. Like depreciation based on yearly wear and tear of assets is usually calculated and provided at year end. This Expense relates to current year use of fixed assets and has to be provided for. This will reduce the assets. Like with advance rent, expenses are not effected because it is recorded as an advance in asset, but if it is not provided correctly it will increase the expenses, same is with prepaid insurance, prepaid phone charges etc. In the other case with Interest on investments which is accrued but not received, proper adjustment will be to book the income and asset as accrued interest.

On the other side if any expense which relates to current year is not been adjusted, it will result in inappropriate increase in assets and false expenses resulting in higher profits.

Adjusting entries are necessary to achieve a true financial position at the year end. For this we have to understand the matching principle.

Matching Principle : The matching principle is one of the basic underlying guidelines in accounting. The matching principle directs a company to record and report "revenues," that is, along with the "expenses" that brought them. The matching principle is associated with the accrual basis of accounting and adjusting entries. It is not used in cash accounting, wherein revenues and expenses are only recorded when cash actually flows.

Importance: If expenses are recognized at the wrong time, the financial statements may be greatly distorted: in turn jeopardizing the quality of the statements and providing an inaccurate representation of the financial position of the business.