Adjustments

Adjustments

Introduction

Adjustments are necessary to ensure that financial statements accurately reflect an entity's financial position and performance for a specific financial period. Adjustments correct the balances in accounts before final accounts and financial statements are prepared. This process involves identifying accounts that require adjustments, determining their correct balances, calculating the necessary amounts, recording the adjustments, and ensuring the new balances are accurate.

Steps for Making Adjustments

The adjustment process can be broken down into five steps:

1. Identify the accounts that must be adjusted.
2. Determine how the accounts would be affected and what the balances of these accounts should be.
3. Calculate the amount(s) involved in the adjustment.
4. Record the necessary adjustments in the general journal and post the entries to the ledger(s).
5. Ensure that the new balances of the accounts are now correct.

Short-term Adjustments

Short-term adjustments relate to the allocation of income and expenses to the appropriate financial periods. These adjustments ensure that income received in one period is matched with the expenses incurred in the same period.

Prepaid Expenses

A prepaid expense is an expense that has been paid in advance for a service that will be received in a future period. For example, if an insurance premium is paid for the year, only the portion that relates to the current financial period should be recorded as an expense.

Example:

On 2 January 20.1, Xa-Xa Dealers paid an annual insurance premium of R2 400. The financial year ends on 28 February 20.1. The portion of the insurance expense that relates to January and February is:

Amount spent on insurance for January and February = R2 400 × (2/12) = R400.

The prepaid amount (R2 000) should be recorded as a current asset. The accounting entries are as follows:

ADJUSTMENT ENTRY: 28 FEBRUARY 20.1 J1
Prepaid expenses GL55 2 000
Insurance expenses GL40 2 000
Adjustment of insurance expenses account

CLOSING TRANSFER: 28 FEBRUARY 20.1 J2
Profit or loss GL60 400
Insurance expenses GL40 400
Transfer of insurance expenses to profit or loss account

Accrued Expenses

An accrued expense is an expense that relates to the current financial period but has not yet been paid. For example, if the water and electricity account shows expenses of R2 880, but the February account of R360 has not been accounted for, an adjustment is necessary.

Example:

Actual expenditure on water and electricity = R2 880 + R360 = R3 240.

The accounting entries are:

ADJUSTMENT ENTRY: 28 FEBRUARY 20.1 J5
Water and electricity GL41 360
Accrued expenses GL56 360
Adjustment of water and electricity account

CLOSING TRANSFER: 28 FEBRUARY 20.1 J6
Profit or loss GL60 3 240
Water and electricity GL41 3 240
Closing of water and electricity account to profit or loss account

Consumable Inventory Adjustments

Consumable inventory adjustments relate to the stock of items that are used up in the course of business, such as stationery. An adjustment is made to record the actual expenditure on consumables.

Example:

On 28 February 20.1, stationery worth R500 was purchased, but a physical count shows R150 worth of stationery is still on hand. The actual expenditure on stationery is:

Expenditure = R500 - R150 = R350.

The accounting entries are:

ADJUSTMENT JOURNAL: 28 FEBRUARY 20.1 J3
Inventory: Stationery GL57 150
Stationery GL42 150
Adjustment of stationery account

CLOSING TRANSFER: 28 FEBRUARY 20.1 J4
Profit or loss GL60 350
Stationery GL42 350
Closing of stationery account

Income Received in Advance

Income received in advance is income that has been received but relates to a future period. Only the portion that relates to the current period should be recorded as income.

Example:

On 28 February 20.1, R10 400 was received as rental income, but R800 for March has already been received. The actual income for the year is:

Income = R10 400 - R800 = R9 600.

The accounting entries are:

ADJUSTMENT JOURNAL: 28 FEBRUARY 20.1 J9
Rental income GL44 800
Income received in advance GL59 800
Adjustment of rental income account

CLOSING TRANSFER: 28 FEBRUARY 20.1 J10
Rental income GL44 9 600
Profit or loss GL60 9 600
Closing of rental income to profit or loss account

Accrued Income

Accrued income is income that has been earned but not yet received. This adjustment ensures that all income earned in the current period is recorded.

Example:

On 28 February 20.1, commission income of R2 200 has been earned, but R200 has not yet been received. The actual income is:

Income = R2 200 + R200 = R2 400.

The accounting entries are:

ADJUSTMENT JOURNAL: 28 FEBRUARY 20.1 J11
Accrued income GL61 200
Commission income GL45 200
Adjustment of commission income account

CLOSING TRANSFER: 28 FEBRUARY 20.1 J12
Commission income GL45 2 400
Profit or loss GL60 2 400
Closing of commission income to profit or loss account

Credit Losses (Bad Debts)

Credit losses occur when a debtor is unable to pay their debt. This adjustment removes the bad debt from the accounts and reflects it as an expense.

Example:

A debtor, A Boeka, is insolvent and owes R230. The accounting entries to write off this amount are:

GENERAL JOURNAL: 25 JANUARY 20.1 J13
Credit losses (Bad debts) GL62 230
A Boeka/Trade receivables control DL2/GL6 230
Write off debtor’s account as irrecoverable

CLOSING TRANSFER: 28 FEBRUARY 20.1 J14
Profit or loss GL60 230
Credit losses GL62 230
Closing of credit losses to profit or loss account

Long-term Adjustments

Long-term adjustments relate to the depreciation of tangible assets. Depreciation is the allocation of the cost of an asset over its useful life.

Example:

On 28 February 20.1, machinery worth R80 000 has a depreciation expense of R12 000. The accounting entries are:

ADJUSTMENT JOURNAL: 28 FEBRUARY 20.1 J15
Depreciation GL46 12 000
Accumulated depreciation: machinery GL63 12 000
Adjustment to make provision for depreciation

CLOSING TRANSFER: 28 FEBRUARY 20.1 J16
Profit or loss GL60 12 000
Depreciation GL46 12 000
Closing of depreciation to the profit or loss account

Preparation of the Trial Balance

A trial balance is prepared to test the correctness of entries in the ledger. It is compiled at various stages, including pre-adjustment, post-adjustment, and post-closing.

Pre-adjustment Trial Balance

This trial balance checks the accuracy of entries before adjustments are made.

Post-adjustment Trial Balance

This trial balance is prepared after all adjustments have been recorded.

Post-closing Trial Balance

This trial balance is prepared after closing entries have been made, showing only asset, liability, and equity accounts.

Summary

• Adjustments are necessary for accurate financial reporting.
• Short-term adjustments include prepaid expenses, accrued expenses, consumable inventory adjustments, income received in advance, and accrued income.
• Long-term adjustments primarily involve depreciation.
• The trial balance is prepared at different stages to ensure accuracy.

Check your understanding

• What is the purpose of making adjustments in accounting?
• How do you record an adjustment for prepaid expenses?
• What are the steps involved in making adjustments?
• Explain the difference between accrued income and income received in advance.