Tuesday, October 14, 2014

Adjusting Entries : Accounting Basics Day 8

Introduction 

Adjusting Entries are journal entries made at the end of the accounting period to allocate revenue and expenses to the period in which they actually are applicable. The Adjusting entries emphasize that while ascertaining the profitability, the revenues be considered as they are earned and not based on receipts, and the expenses be considered as they are incurred and not when they are paid Hence, many items need some adjustment while preparing the financial statements. In this chapter we’ll discuss all items which require adjustments and the way these are brought into the books of account and incorporated in the final accounts

What are adjusting entries?

Adjusting entries are accounting journal entries that convert a company's accounting records to the accrual basis of accounting(we have learnt about the accrual basis of accounting in the previous chapters) .An adjusting journal entry is typically made just prior to issuing a company's financial statements.
There are two scenarios where adjusting journal entries are needed before the financial statements are issued:


  • Nothing has been entered in the accounting records for certain expenses or revenues, but those expenses and/or revenues did occur and must be included in the current period's income statement and balance sheet.
  • Something has already been entered in the accounting records, but the amount needs to be divided up between two or more accounting periods.

Adjusting entries almost always involve a

  • Balance sheet account (Interest Payable, Prepaid Insurance, Accounts Receivable, etc.) and an Income statement account (Interest Expense, Insurance Expense, Service Revenues, etc.)

Types of Adjusting Entries

Some important and common items, which need to be adjusted at the time of preparing the final accounts, are discussed below.

  1. Closing stock
  2. Outstanding expenses
  3. Prepaid Expenses
  4. Accrued incomes
  5. Incomes received in advance
  6. Interest on capital
  7. Interest on drawings
  8. Interest on loan
  9. Interest on investment
  10. Depreciation
  11. Bad Debts
  12. Provision for bad and doubtful debts
  13. Provision for discount on debtors
  14. Provision for discount on creditors.

Note: All adjustments will be given outside the trial balance.

Closing Stock

The unsold goods in stock at the end of the accounting period is called as closing stock. This is to be valued at cost or market price whichever is lower.

Outstanding Expenses

Expenses which have been incurred but not yet paid during the accounting period for which the final accounts are being prepared are called as outstanding expenses.

Prepaid Expenses

Expenses which have been paid in advance are called as prepaid (Unexpired) expenses

Accrued Incomes or Outstanding Incomes

Income which has been earned but not received during the accounting period is called as accrued income.

Incomes Received in Advance

Income received during a particular accounting period for the work to be done in future period is called as income received in advance.

Interest on Capital

In order to see whether the business is really earning profit or not, it is desirable to charge interest on capital at a certain rate.

Interest on Drawings

Amount withdrawn by the owner for his personal use is called as drawings. When interest on capital is allowed, then interest on drawings is charged from the owner. Interest on drawings is an income for the business and will reduce the capital of the owner

Interest on Loan (Outstanding)

Borrowings from banks, financial institutions and outsiders for business are called loans. Amount payable towards interest on loan is an expense for the business

Interest on Investment:

Interest receivable on investments is an income for the business

Depreciation

Depreciation is the reduction in the value of fixed assets due to its use or obsolescence. Generally depreciation is charged at some percentage on the value of fixed asset.

Bad Debts

Debts which cannot be recovered are called bad debts. It is a loss for the business.

Provision for Bad and Doubtful Debts 

Every business suffers a percentage of bad debts over and above the debts definitely known as irrecoverable and written off as Bad (Bad debts written off). If Sundry debtors figure is to be shown correctly in the Balance sheet provision for bad and doubtful debts must be adjusted.
This Provision for bad and doubtful debts is generally provided at a certain percentage on Debtors, based on past experience. While preparing final accounts, the bad debts written off given in adjustment is first deducted from the Sundry debtors then on the balance amount (Sundry debtors – Bad debt written off) provision for bad and doubtful debts calculated
Provision for Discount on Debtors
To motivate the debtors to make prompt payments, cash discount may be allowed to them. After providing provision for bad and doubtful debts, the remaining debtors are called as good debtors. They may pay their dues in time and avail themselves of the cash discount Permissible. So a provision for discount on good debtors at a certain percentage may have to be created.
Provision for Discount on Creditors
Similar to cash discount allowed to debtors, the firm may have a chance to receive the cash discount from the creditors for prompt payment. Provision for discount on Creditors is calculated at a certain percentage on Sundry Creditors.

Treatment Given to Adjusting Entries



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