Welcome to Your Guide on Period End Adjustments!
Hello there! If you’ve ever felt a bit overwhelmed when the "end of the month" or "year-end" approaches in accounting, you are not alone. In this chapter, we are going to learn how to tidy up our accounts so they tell the true story of what happened during the period. This process is like "fine-tuning" a musical instrument before a big performance—it ensures everything sounds exactly right for the financial statements.
By the end of these notes, you’ll understand how to handle things like unpaid bills, advance payments, and wear-and-tear on equipment. Let's dive in!
1. The "Why" Behind Adjustments: The Accrual Basis
Before we look at the numbers, we need to understand a very important rule in accounting: the Accrual Basis. Under this rule, we record transactions when they happen, not necessarily when the cash moves.
Analogy: Imagine you go to a restaurant in December, eat a delicious meal, but the restaurant lets you pay the bill in January. Even though you pay in January, the expense of that meal belongs to December because that's when you actually ate it! Period end adjustments make sure these "timing" issues are fixed.
Key Principle: The Matching Principle
We want to match our expenses against the income they helped generate in the same time period.
2. Accruals (Expenses and Income)
Accruals are for things that have happened, but the paperwork (or the cash) hasn't caught up yet.
A. Accrued Expenses
These are expenses that you have used/incurred during the period, but you haven't paid for them or received an invoice yet. Common examples include electricity, water, or wages.
The Journal Entry:
Dr Expense Account (increases the expense in the Profit or Loss)
Cr Accruals / Accrued Expenses (creates a current liability in the Statement of Financial Position)
Example: Your company uses \$500 worth of electricity in December, but the bill won't arrive until January. At year-end (31 December), you must record:
\nDr Electricity Expense \$500
Cr Accruals \$500
B. Accrued Income
\nThis is income you have earned (provided a service or sold goods), but you haven't been paid yet.
\nThe Journal Entry:
\nDr Accrued Income (creates a current asset)
\nCr Income Account (increases revenue/income)
Quick Review: Accruals mean "I owe it" (Expense) or "They owe me" (Income) for things already done. Accruals always increase the figures in your Profit or Loss account.
\n\n\n\n
3. Prepayments (Expenses and Income)
\nPrepayments are the opposite of accruals. This is where money has changed hands too early.
\n\nA. Prepaid Expenses
\nYou have paid for something in advance that relates to the next accounting period. A classic example is an annual insurance premium or rent paid in advance.
\n\nThe Journal Entry:
\nDr Prepayments (creates a current asset)
\nCr Expense Account (reduces the expense for this year)
Example: On 1 December, you pay \$1,200 for a 12-month insurance policy. Since only 1 month (December) belongs to this year, and 11 months belong to next year, you need to "remove" the 11 months from this year's expenses.
\( \text{Prepayment} = \$1,200 \times \frac{11}{12} = \$1,100 \)
Dr Prepayments \$1,100
\nCr Insurance Expense \$1,100
B. Deferred Income (Prepaid Income)
A customer pays you in advance for work you haven't done yet. You cannot call this "Profit" yet because you still owe the customer the service.
The Journal Entry:
Dr Income Account (reduces income)
Cr Deferred Income / Income in Advance (creates a current liability)
Memory Aid (The "TAP" Rule):
Time Advance = Prepayment. If you pay before the time is up, it's a prepayment!
4. Depreciation of Non-Current Assets
Assets like cars, computers, and machinery don't last forever. They wear out or become obsolete. Depreciation is the way we spread the cost of an asset over its useful life.
Important Note: Depreciation is not about the "market value" of the asset. It is about matching the cost of using the asset to the years it helps the business make money.
Method 1: Straight-Line Method
The asset loses the same amount of value every year.
\( \text{Annual Depreciation} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life}} \)
Method 2: Reducing Balance Method
The asset loses more value in the early years. You apply a fixed percentage to the Net Book Value (NBV).
\( \text{Depreciation Charge} = \text{NBV} \times \text{Percentage} \)
(Where NBV = Cost minus Accumulated Depreciation)
The Journal Entry:
Dr Depreciation Expense (Profit or Loss)
Cr Accumulated Depreciation (Statement of Financial Position—this reduces the asset's value)
Common Mistake to Avoid: Never credit the "Asset Account" (like the "Car Account") directly for depreciation. We keep the original cost in the Asset Account and keep the total wear-and-tear in the Accumulated Depreciation account.
5. Irrecoverable Debts and Allowances
Sometimes, customers who bought on credit simply cannot pay their bills. We need to handle this so our "Accounts Receivable" figure isn't lieing to us!
A. Irrecoverable Debts (Bad Debts)
When you are 100% sure a customer won't pay, you "write it off."
The Journal Entry:
Dr Irrecoverable Debts Expense
Cr Trade Receivables (removes the customer from your books)
B. Allowance for Doubtful Debts
This is for when you are worried a customer might not pay, but you aren't 100% sure yet. It follows the Prudence Concept: don't overstate your assets.
The Adjustment: We only record the change in the allowance.
- If you need to increase the allowance: Dr Expense, Cr Allowance.
- If you need to decrease the allowance: Dr Allowance, Cr Expense (Income).
Did you know? The "Allowance for Doubtful Debts" is called a Contra-Asset account. It sits right under "Trade Receivables" on the balance sheet to show the "net" amount we actually expect to collect.
6. Closing Inventory
At the end of the year, you count what’s left in the warehouse. This is Closing Inventory.
The Rule: Inventory must be valued at the lower of Cost or Net Realizable Value (NRV). NRV is basically the selling price minus any costs to finish or sell the item.
The Journal Entry:
Dr Inventory (Statement of Financial Position - Asset)
Cr Closing Inventory / Cost of Sales (Profit or Loss)
Key Takeaway: By recording closing inventory, we are essentially "removing" the cost of goods we didn't sell this year so they can be matched against sales next year!
Summary Checklist for Period End
Before you finish your adjustments, ask yourself these three questions:
- Have I included all expenses? (Check for Accruals)
- Have I removed expenses that belong to next year? (Check for Prepayments)
- Are my asset values realistic? (Check Depreciation and Doubtful Debts)
Don't worry if this seems like a lot to remember! With practice, these journal entries will become second nature. Just remember: we are just trying to make sure the Profit or Loss reflects what actually happened THIS year, and the Statement of Financial Position shows what we TRULY own and owe on the last day.