A Guide to Adjusting Financial Statements (AS Level 9706)
Welcome to one of the most crucial topics in financial accounting! You’ve already mastered recording transactions and preparing a trial balance. But here’s the secret: a trial balance rarely provides the full, true picture of a business’s performance or position.
This chapter focuses on the necessary final steps—the Adjustments to Draft Financial Statements. These adjustments ensure that we comply with the fundamental Matching Concept (Accruals Concept) and the Prudence Concept, giving users a much more accurate view of the business.
Don't worry if this seems tricky at first; adjustments follow standard rules. Mastering the double entry for these six key areas will transform your accounts from a draft into a final, reliable set of financial statements!
1. Accruals and Prepayments (Applying the Matching Concept)
The Matching Concept states that expenses incurred and income earned during the specific accounting period must be matched against each other, regardless of when the cash was paid or received. This leads to two main types of timing adjustments: accruals and prepayments.
Accruals: Expenses Incurred or Income Earned, But Not Yet Paid/Received
Analogy: Think of an electricity bill you received in January but which covers December's usage. The expense relates to the previous year, even though you paid the cash later.
A. Accrued Expenses (Expense Outstanding)
These are expenses relating to the current financial period but for which cash has not yet been paid.
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Double Entry:
Debit (Increase) the Expense Account (Statement of Profit or Loss impact).
Credit (Increase) the Accrual Account (Statement of Financial Position: Current Liability).
B. Accrued Income (Income Earned but Not Received)
This is income that the business has earned during the period but has not yet received cash for.
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Double Entry:
Debit (Increase) the Accrued Income Account (Statement of Financial Position: Current Asset).
Credit (Increase) the Income Account (Statement of Profit or Loss impact).
Quick Review: Accruals
Accruals increase the expense or income in the Statement of Profit or Loss for the current year.
Prepayments: Expenses Paid or Income Received, But Not Yet Incurred/Earned
Analogy: Paying your annual insurance premium in December for the year starting January 1st. The expense paid in December is actually a benefit for the next year.
A. Prepaid Expenses (Expense Paid in Advance)
The portion of an expense paid during the current period that relates to the next financial period. We need to remove this portion from the current year's Statement of Profit or Loss.
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Double Entry:
Debit (Increase) the Prepayment Account (Statement of Financial Position: Current Asset).
Credit (Decrease) the Expense Account (Statement of Profit or Loss impact).
B. Deferred Income (Income Received in Advance)
Cash received in the current period for services or goods that will be delivered in the next period. This is a liability because the business owes the service/goods.
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Double Entry:
Debit (Decrease) the Income Account (Statement of Profit or Loss impact).
Credit (Increase) the Deferred Income Account (Statement of Financial Position: Current Liability).
2. Irrecoverable Debts and Allowances (Prudence Concept)
This adjustment deals with the risk that customers who owe the business money (Trade Receivables) might fail to pay. This links directly to the Prudence Concept, which requires us to anticipate losses.
A. Irrecoverable Debts (Writing Off Bad Debts)
An irrecoverable debt is a specific amount owed by a customer that is now confirmed as uncollectible (e.g., the customer went bankrupt). This debt must be removed from the trade receivables balance and treated as an expense.
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Double Entry for Write-off:
Debit (Increase) Irrecoverable Debts Expense (Statement of Profit or Loss).
Credit (Decrease) Trade Receivables Control Account (Statement of Financial Position).
B. Irrecoverable Debts Recovered
Occasionally, a debt previously written off might be paid later.
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Double Entry for Recovery:
Debit Cash/Bank (Increase Asset).
Credit Irrecoverable Debts Recovered Account (Treated as income in the Statement of Profit or Loss).
C. Allowance for Irrecoverable Debts (The Provision)
The Allowance for Irrecoverable Debts is an estimated amount set aside for potential future losses on current trade receivables. It is an application of the Prudence Concept. It is not an actual expense, but an estimate.
The calculation required in the Statement of Profit or Loss is the change in the allowance, not the total allowance itself.
Step 1: Calculate the required allowance.
Allowance = (Percentage) \(\times\) (Total Trade Receivables after any specific write-offs)
Step 2: Determine the adjustment (Change).
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If the allowance increases: The increase is an additional expense in the Statement of Profit or Loss.
Debit Irrecoverable Debts Expense (P/L).
Credit Allowance for Irrecoverable Debts (SOPFP). -
If the allowance decreases: The decrease is treated as a reduction in expense (or income).
Debit Allowance for Irrecoverable Debts (SOPFP).
Credit Irrecoverable Debts Expense (P/L).
Statement of Financial Position Treatment: The full required allowance is subtracted from the Trade Receivables balance to find the Net Realisable Value of Trade Receivables.
3. Depreciation (Accounting for Non-Current Assets)
Depreciation is the process of allocating the cost of a non-current asset over its useful economic life (Syllabus 1.3.2). When preparing final accounts, we must ensure the depreciation charge for the current year is included.
Recording the Year’s Depreciation Charge
This adjustment allocates the current year's wear and tear to the profit calculation.
- Calculation: Use either the Straight-Line or Reducing Balance method (as specified in the question).
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Double Entry:
Debit (Increase) Depreciation Expense (Statement of Profit or Loss).
Credit (Increase) Accumulated Depreciation Account (Statement of Financial Position contra-asset).
Key Takeaway: In the Statement of Profit or Loss, the depreciation charge for the year is shown as an operating expense. In the Statement of Financial Position, the accumulated depreciation figure is subtracted from the cost of the asset to show the Net Book Value.
4. Inventory Valuation
At the end of the year, the value of Closing Inventory (unsold goods) must be determined accurately, as it directly affects the Cost of Sales figure and the Profit for the year.
The Rule: Lower of Cost and Net Realisable Value (LCNRV)
The Prudence Concept requires inventory to be valued at the lower of cost and net realisable value (NRV).
Cost: The actual amount paid to acquire the goods (using FIFO or AVCO).
Net Realisable Value (NRV): The estimated selling price in the ordinary course of business, less all estimated costs of completion and costs necessary to make the sale.
NRV = Estimated Selling Price – Estimated Selling Costs
We use the lower figure because recognizing potential losses (NRV < Cost) is prudent, while recognizing potential profits (NRV > Cost) before the sale actually happens is not allowed.
Recording Closing Inventory
- Statement of Profit or Loss: Closing Inventory is deducted when calculating Cost of Sales (i.e., Opening Inventory + Purchases – Closing Inventory).
- Statement of Financial Position: Closing Inventory is shown as a Current Asset.
Did you know? If inventory is damaged or obsolete, its NRV is often lower than its original cost, resulting in a write-down that reduces profit immediately.
5. Correction of Errors
Even after a trial balance is extracted, errors may be discovered. Correcting these errors (Syllabus 1.4.2) is a final adjustment process. The key here is not just fixing the ledger accounts, but understanding the ultimate impact on the published financial statements.
Errors may have been corrected using a Suspense Account, but the ultimate requirement is ensuring the Statement of Profit or Loss and Statement of Financial Position reflect the true figures.
Impact on Financial Statements
When correcting an error, ask yourself: "Which financial statement elements (Asset, Liability, Income, or Expense) are affected?"
Example: Incorrect Treatment of Capital Expenditure
If the purchase of new machinery (\( \$ 10,000 \)) was incorrectly treated as a Revenue Expense (Maintenance):
Correction Needed:
- The Maintenance Expense was overstated (reduce expense, increase profit).
- The Non-Current Asset was understated (increase asset).
- Depreciation was probably not charged (add depreciation expense, reduce profit).
Steps for Correction:
- Use the General Journal to correct the accounts (e.g., Dr Machinery, Cr Maintenance/Suspense).
- Adjust the Statement of Profit or Loss (for the change in expense/income).
- Adjust the Statement of Financial Position (for the change in assets/liabilities).
Common Mistake to Avoid: When correcting an error involving a suspense account, remember that the suspense account entry merely balances the ledger. The *other side* of the entry is what impacts the P/L or SFP figures.
Summary: Flow of Adjustments into Final Statements
The adjustments we’ve covered ensure that the draft figures from the Trial Balance are converted into accurate final statements.
Statement of Profit or Loss (Income Statement) Adjustments:
- Add/Deduct Accrued/Prepaid Income and Expenses.
- Include Irrecoverable Debts Expense and the Change in Allowance.
- Include the year’s Depreciation Charge.
- Use the correctly valued Closing Inventory to calculate Cost of Sales.
- Ensure all figures reflect corrected errors.
Statement of Financial Position (Balance Sheet) Adjustments:
- Include Accruals (Current Liabilities) and Prepayments (Current Assets).
- Show Trade Receivables net of the final Allowance for Irrecoverable Debts.
- Show Non-Current Assets net of Accumulated Depreciation.
- Include the correctly valued Closing Inventory (Current Asset).
Keep practising these adjustments! They are the heart of financial statement preparation, ensuring the final accounts are true and fair. You've got this!