Adjusting the financial statements

Understanding Adjustments

Adjustments to financial statements are modifications made to the original accounting records of a business.
They ensure that the financial statements comply with the Accrual Accounting principle.
This principle requires revenues and expenses to be recognized when they are incurred not when cash is received or paid.
Regular adjustments help in maintaining accuracy and reliability of the financial statements.

Types of Adjustments

Accrued expenses: These are expenses incurred in a period but not yet paid.
Prepaid expenses: These are payments made in advance for services or goods to be received in future.
Accruall of income: This represents income earned but not yet received in cash or kind.
Income received in advance: This is where the business receives payment for services that are yet to be rendered.

Justification for Adjustments

Adjustments rectify mistakes and discrepancies.
Income and outcomes must match each financial year, as stated by the matching principle.
Regular adjustments ensure compliance to GAAP (Generally Accepted Accounting Principles).

Process of Adjusting Financial Statements

Adjustment entries are dated at the end of the accounting period.
They impact one balance sheet account (asset, liability, or equity) and one income statement account (revenue or expenditure).
All adjustments are recorded in the general journal, then posted to the ledger, and finally reflected in the final accounts.

Impact of Adjustments on Financial Statements

Adjustments can increase or decrease net income on the income statement.
They may also raise or lower assets, liabilities, or owner’s equity on the balance sheet.

Significance of Adjustments

They assist in providing an accurate snapshot of a business’s health for the required period.
Adjustments allow for firm and correct calculations of net income, key to assessing business performance.
Potential and current investors rely on adjusted financial statements for informed financial investment decisions.

Pitfalls and Limitations of Adjustments

Frequent and substantial adjustments may point to mismanagement and could discourage potential investors.
Some adjustments are based on estimates and assumptions, which may not always prove accurate, impacting the balance sheet’s reliability.