Question

Explain to the business owner the need and purpose of adjusting entries, and why the adjusted trial balance should be the source for the financial statements.

Answer 1

1. A business running on accrual basis of accounting recognises expenses and revenues in the period in which they occur rather than when they are actually expensed/received
2. Adjusting entries ensure that companies recognise revenues in the period in which the performance obligation is satisfied and recognise expenses in the period in which they are incurred.
3. The major types of adjusting entries are
   • deferrals (prepaid expenses and unearned revenues) and
   • accruals (accrued revenues and accrued expenses)
4. Deferrals are either prepaid expenses or unearned revenues. Companies make adjusting entries for deferrals to record the portion of the prepayment that represents the expense incurred or the revenue for services performed in the current accounting period
5. Accruals are accrued revenues or accrued expenses. Companies make adjusting entries for accruals to record revenues for services performed and expenses incurred in the current accounting period that have not been recognised through regular entries.
6. An adjusted trial balance shows the balances of all accounts, including those that have been adjusted, at the end of an accounting period. Its purpose is to prove the equality of the total debit balances and total credit balances in the ledger after all adjustments

Thus to arrive at correct picture of a business over an accounting period it is must that all the expenses and revenues are correctly and chronologically recognised in the books of accounts and special emphasis should be made for year end entries , that is why it is important that adjustment are done to book of accounts through adjusting entries so that an adjusted trial balance is made which is a source for preparation for rest of the statements like income statement and balance sheet . that is why it becomes important to follow the whole cycle properly