Question

When using accrual accounting, why are adjustments necessary at the end of the period before preparing the financial statements?

Answer 1

Under the Accrual accounting system, all the business transactions are recorded at the time of occurrence, it does not matter whether cash is paid or received for them or not. Incomes are recorded when they are earned or accrued irrespective of the fact whether cash is received or not. Similarly, expenses are recorded when they are incurred or become due and not when cash is paid for them. Hence profit or loss of a particular period is the result of matching of revenues earned and expenses incurred during that period.

Adjustments for following items is required in the accrual accounting to calculate the profit or loss of the current year:

(i) Accrued incomes

(ii) Incomes received in advance

(iii) Prepaid expenses

(iv) Outstanding expenses

If before preparing financial statements, adjustment is not made for the above mentioned items, correct profit or loss of the current period cannot be calculated.

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