Welcome to the World of Accounting Adjustments!
Hello there! If you’ve ever looked at a Trial Balance and thought it was the final word on a business's health, think again. Before we can prepare the final Financial Statements, we need to do some "housekeeping." These are called Adjustments.
Think of it like editing a photo before posting it online. You want the photo to represent reality accurately. In accounting, adjustments ensure our profit and our assets follow the Matching/Accruals Concept—which basically says: "Record expenses and income in the period they actually happen, not just when the cash moves."
Don't worry if this seems a bit "fiddly" at first. Once you master these five common adjustments, you'll be able to tackle any financial statement question with confidence!
1. Accruals and Prepayments
In a perfect world, we would pay for everything exactly when we use it. In the real world, we often pay for things in advance (like a mobile phone plan) or pay for them later (like an electricity bill).
Accrued Expenses (Accruals)
An Accrual is an expense that you have used during the year but haven't paid for yet.
Example: You used \$500 of electricity in December, but the bill doesn't arrive until January.
The Rule: We must ADD the amount to the expense in the Statement of Profit or Loss and record it as a Current Liability in the Statement of Financial Position.
Prepaid Expenses (Prepayments)
A Prepayment is when you pay for something in advance for the next year.
Example: You pay \$1,200 for insurance in October, but it covers you for a whole year. Part of that belongs to next year!
The Rule: We must SUBTRACT the amount from the expense in the Statement of Profit or Loss and record it as a Current Asset in the Statement of Financial Position.
Quick Memory Aid: The "PANA" Rule
Prepaid = Asset
New (Accrued) = Add
Summary Table:
1. Accrued Expense: Add to Expense (P&L) | Current Liability (SOFP)
2. Prepaid Expense: Less from Expense (P&L) | Current Asset (SOFP)
3. Accrued Income: Add to Income (P&L) | Current Asset (SOFP)
4. Prepaid Income: Less from Income (P&L) | Current Liability (SOFP)
2. Irrecoverable Debts and Allowances
Sometimes, customers who bought goods on credit simply cannot pay us back. This is a sad reality of business!
Irrecoverable Debts (Bad Debts)
When we are certain a customer won't pay, we "write it off."
Treatment: Deduct the amount from Trade Receivables and record it as an Expense in the Statement of Profit or Loss.
Allowance for Irrecoverable Debts
This is where we estimate that some customers might not pay. We do this to follow the Prudence Concept (don't overstate your assets!).
How to calculate the adjustment:
We only look at the CHANGE in the allowance from the previous year.
\( \text{Adjustment} = \text{New Allowance} - \text{Old Allowance} \)
- If the allowance increases: It’s an Expense (P&L).
- If the allowance decreases: It’s Other Income (P&L).
Important Note: In the Statement of Financial Position, always subtract the full New Allowance from your Trade Receivables.
Quick Review: Irrecoverable debts are 100% gone. Allowances are just us being careful!
3. Depreciation
Non-current assets (like vans or machinery) wear out over time. Depreciation is how we spread the cost of that asset over its useful life.
The Two Main Methods:
1. Straight Line: The same amount every year.
\( \text{Annual Depreciation} = \frac{\text{Cost} - \text{Residual Value}}{\text{Expected Life}} \)
2. Reducing Balance: A percentage of the "Net Book Value" (Cost minus existing depreciation). It's higher in the early years.
\( \text{Annual Depreciation} = \text{Rate \%} \times (\text{Cost} - \text{Accumulated Depreciation}) \)
Effect on Financial Statements:
Statement of Profit or Loss: Record the "Depreciation Charge for the Year" as an Expense.
Statement of Financial Position: Add this year's charge to the Accumulated Depreciation and subtract it from the Cost of the asset.
4. Inventory Valuation
At the end of the year, we must value the goods we haven't sold yet. This is a very common area where students lose easy marks!
The Golden Rule:
Inventory must be valued at the LOWER of Cost or Net Realisable Value (NRV).
What is NRV?
NRV is what you can actually sell the item for, minus any costs needed to get it ready for sale.
\( \text{NRV} = \text{Selling Price} - \text{Selling Costs/Repair Costs} \)
Analogy: You bought a phone for \$500 (Cost). It’s now slightly scratched. You can sell it for \$400, but you have to spend \$20 on a new screen first. The NRV is \$380 (\$400 - \$20). Since \$380 is lower than \$500, you must value the phone at \$380 in your accounts.
Key Takeaway: Never value inventory at what you hoped to sell it for if that price has dropped below what you paid for it!
5. Correction of Errors
We are all human, and sometimes bookkeepers make mistakes. Before finalizing the accounts, we must fix them using the General Journal.
Common Errors:
- Omission: You completely forgot to record a transaction.
- Principle: You put an item in the wrong type of account (e.g., treating a repair to a van as a new van).
- Commission: You put it in the right type of account but for the wrong person (e.g., Sales to Mr. A recorded in Mr. B's account).
The Impact: If an error involves a Profit or Loss item (like Sales or Rent), it will change your Draft Profit. If it involves an asset or liability, it will change your Statement of Financial Position.
Step-by-Step Fix:
1. Ask: What did happen?
2. Ask: What should have happened?
3. Create a journal entry to move the money from where it is to where it should be.
Final Checklist for Success
- Double Entry: Remember that every adjustment usually affects two places (one in the Profit or Loss, one in the SOFP).
- Prudence: Always choose the figure that is most "cautious" (higher expenses/lower assets) when uncertain.
- Matching: Always ask: "Does this amount belong to this year?"
Don't worry if this seems tricky at first! Accounting is a practical skill. The more you practice these adjustments in full questions, the more they will become second nature. You've got this!