Adjustment Entries in Financial Statements¶
Financial statements aim to provide a true and fair view of a business's financial position and performance. This requires making adjustment entries, which are corrections or additions made at the end of an accounting period to ensure that revenues and expenses are recognized in the correct period.
Why Adjustment Entries are Necessary¶
Accountants typically record transactions based on supporting documents (e.g., invoices, receipts). However, some economic events occur without immediate documentation. Ignoring these events would lead to an inaccurate representation of the business's financial status, understating expenses and overstating profits.
Adjustment entries address this by recognizing revenues and expenses that haven't been recorded through normal accounting procedures. They are crucial for adhering to the accrual accounting principle, which dictates that revenues are recognized when earned and expenses are recognized when incurred, regardless of when cash changes hands.
Impact on Financial Statements¶
Due to the double-entry bookkeeping system, every adjustment entry affects at least one income statement account (revenue or expense) and one balance sheet account (asset, liability, or equity).
Types of Adjustment Entries¶
Adjustment entries can be broadly classified based on their impact:
- Income (Revenue) Related: Recognize revenue earned but not yet received or recorded.
- Expense Related: Recognize expenses incurred but not yet paid or recorded.
- Asset Related: Adjust asset values due to factors like depreciation or prepayments.
- Liability and Equity Related: Account for changes in liabilities or equity that haven't been captured through regular transactions.
Adjustment Entries Related to Income (Revenue)¶
1. Accrued Interest Income¶
When a company invests in interest-bearing instruments (bonds, fixed deposits), interest is often paid periodically (e.g., semi-annually). If the accounting period ends between payment dates, the company has earned interest that hasn't been received yet.
- Example: A company's accounting period is April to March. They have a fixed deposit that earns interest on September 30th and March 31st. At the end of December, they've earned three months of interest (January 1st to March 31st) that hasn't been paid.
Adjustment Entries Related to Expenses¶
1. Prepaid Expenses¶
Expenses paid in advance benefit future periods. Only the portion of the expense related to the current period should be recognized in the current income statement.
- Example: A company pays a one-year insurance premium in October. If the accounting period is January to December, only three months of the premium (October to December) are an expense for the current year.
2. Accrued Expenses¶
Expenses incurred but not yet paid or recorded require an adjustment.
- Example: A company receives an electricity bill on January 10th for December's consumption.
3. Estimated Expenses (Provisions)¶
Some expenses, like bad debts or warranty costs, are uncertain in amount but likely to occur. These are estimated and a provision is created.
- Example: A company estimates warranty expenses of $20,000.
- Adjustment Entry:
- Debit: Warranty Expense
- Credit: Provision for Warranty Expenses (Balance Sheet - Liability)
- Explanation: This adheres to the matching principle by recognizing the expense in the same period as the related revenue. When actual warranty claims occur:
- Debit: Provision for Warranty Expenses
- Credit: Inventory/Cash (depending on the nature of the claim)
4. Gratuity Payable¶
Gratuity is a lump-sum payment to employees upon retirement or resignation. The matching principle requires recognizing a portion of this expense each year the employee works.
Adjustment Entries Related to Assets¶
1. Material Consumption (Inventory Adjustment)¶
When materials are used in production, an adjustment entry is needed to reflect the consumption and reduce the inventory balance. This is because the initial purchase is recorded as inventory, but the actual use is not immediately tracked.
Calculation:
Material Consumed = Opening Stock + Purchases - Closing Stock
Example:
- Opening Stock: ₹10,00,000
- Purchases: ₹4,00,00,000
- Closing Stock: ₹30,00,000
Material Consumed = ₹10,00,000 + ₹4,00,00,000 - ₹30,00,000 = ₹3,80,00,000
Adjustment Entry:
This entry debits the "Material Consumed" account (which will eventually be part of the Cost of Goods Sold) and credits the "Materials Account" (inventory), reducing its balance.
2. Depreciation (Fixed Asset Adjustment)¶
When a business buys a fixed asset like a machine, its value decreases over time due to wear and tear. This decrease in value is called depreciation.
Initial Entry (Purchase of Machine):
Depreciation Calculation:
A common method is straight-line depreciation, where the asset's cost is evenly spread over its useful life.
Example:
- Machine Cost: ₹1,00,00,000
- Useful Life: 10 years
Annual Depreciation = ₹1,00,00,000 / 10 = ₹10,00,000
Adjustment Entry (Using Accumulated Depreciation):
Instead of directly reducing the "Machine Account," a contra-asset account called "Accumulated Depreciation" is used.
Balance Sheet Presentation:
The balance sheet shows the machine's original cost and the accumulated depreciation separately:
- Machine: ₹1,00,00,000
- Less: Accumulated Depreciation: ₹10,00,000
- Net Book Value: ₹90,00,000
In subsequent years, the depreciation entry is repeated, increasing the accumulated depreciation. For example, after two years:
- Machine: ₹1,00,00,000
- Less: Accumulated Depreciation: ₹20,00,000
- Net Book Value: ₹80,00,000
This method keeps the original cost of the asset visible while showing the accumulated depreciation.
3. Amortization (Intangible Asset Adjustment)¶
Intangible assets, like spectrum licenses, are also subject to value reduction over their useful life. This is called amortization.
Example:
- License Fee: Paid for 20 years.
Annual Amortization = (Total License Fee) / 20
Adjustment Entry:
Similar to depreciation, an adjustment entry is made:
Adjustment Entries Related to Liabilities¶
1. Foreign Currency Fluctuations¶
When a company has liabilities denominated in a foreign currency, fluctuations in exchange rates can impact the value of those liabilities in the company's reporting currency.
Example:
A company borrows $1,000,000 from a US bank.
- Initial Exchange Rate: ₹80/$1
- Initial Liability (in ₹): ₹80,000,000
After a few months, the exchange rate changes to ₹90/$1.
- New Liability (in ₹): ₹90,000,000
Adjustment Entry:
The increase in liability due to the exchange rate change needs to be recorded.
This entry debits a "Foreign Currency Exchange Loss" account (which impacts the income statement) and credits the "Foreign Currency Loan" account, increasing the recorded liability.
Explanation of "Depreciation" of ₹:
When the exchange rate changes from ₹80/\(1 to ₹90/\)1, it means the Indian Rupee has depreciated against the US Dollar. It now takes more Rupees to buy one Dollar.
2. Dividends Payable¶
When a company declares dividends, an adjustment entry is needed to recognize the liability to shareholders.
Process:
- Board Declaration: The board of directors declares a dividend.
- Shareholder Approval: Shareholders approve the dividend at the annual general meeting.
- Payment: The dividend is paid to shareholders.
Adjustment Entry (at the time of board declaration):
Where 'X' represents the total dividend amount.
Entry at the time of Payment:
3. Fair Value Adjustments for Financial Assets¶
New accounting standards require companies to revalue certain financial assets to their fair market value at the end of each reporting period.
Types of Investments and Accounting Treatment:
- Short-Term Investments (Trading Securities): Changes in fair value are recognized in the income statement (Profit and Loss). This uses the account Fair Value Through Profit and Loss (FVTPL).
- Long-Term Investments (Available-for-Sale or some Equity Investments): Changes in fair value are recognized in Other Comprehensive Income (OCI), which is a component of equity. This uses the account Fair Value Through Other Comprehensive Income (FVTOCI).
Example (Long-Term Investment):
A company invests ₹10,000,000 in SBI shares. At the end of the reporting period, the market value is ₹10,800,000.
Initial Entry (Investment):
Adjustment Entry (Fair Value Adjustment):
Example (Short-Term Investment):
If the same investment was short-term, the credit would be to "Fair Value Through Profit and Loss (FVTPL)."
Key Differences between FVTOCI and FVTPL:
- FVTOCI: Changes in fair value go directly to equity (OCI).
- FVTPL: Changes in fair value are recognized in the income statement (Profit and Loss).
Summary of Adjustment Entries on the Liability Side:
- Foreign Currency Fluctuations: Adjust liabilities for changes in exchange rates.
- Dividends Payable: Recognize the liability to shareholders when dividends are declared.
- Fair Value Adjustments: Adjust the carrying value of financial assets to reflect market values.
These adjustments are essential for providing a true and fair view of a company's financial position.
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