End-of-period adjustments

Understanding End-of-Period Adjustments

• End-of-period adjustments, also known as adjusting entries, are modifications made to the accounts at the end of an accounting period to accurately reflect the financial status of a business.
• These adjustments ensure that financial statements follow the accrual basis of accounting, where revenues are recognisable when earned and expenses are recognisable when incurred.

Types of End-of-Period Adjustments

• Accrued Expenses: These are costs incurred but not yet paid, such as wages or utility expenses. An adjusting entry for accrued expenses increases the relevant expense account and increases the relevant payable account.
• Prepaid Expenses: These are costs paid in advance and are recorded as assets. As the benefit of these costs is used, an adjusting entry is required to decrease the asset account and increase the relevant expense account.
• Deferred Revenue: These are payments received from customers for products or services yet to be delivered. They are initially recorded as a liability. When the product or service is delivered, an adjusting entry is needed to decrease the liability and increase the revenue.
• Accrued Revenues: These are revenues earned but not yet received. The adjusting entry will increase the relevant receivable account and increase the revenue account.

The Purpose of End-of-Period Adjustments

• End-of-period adjustments are vital to create accurate financial statements, ensuring that revenues and expenses are matched correctly. The matching principle states that a company’s revenues should be paired with the associated costs in the same accounting period.
• Without these adjustments, financial statements might misstate a business’s profitability and financial situation.
• Adjusting entries allow for the efficient tracking of revenues and expenses, providing a clear picture of a business’s financial health.

Impact on Financial Statements

• The adjustment of accrued expenses and revenues impacts both the income statement and balance sheet. The addition increases expenses and assets on the balance sheet and decreases net income on the income statement.
• The adjustment for prepaid expenses and deferred revenues modifies the balance sheet by decreasing assets and liabilities, respectively. Simultaneously, it impacts the income statement by increasing expenses or revenues.

End-of-Period Adjustments and Sole Traders

• Sole traders must perform end-of-period adjustments in their financial accounts, just like any other business organisation.
• They allow sole traders to accurately calculate their net profit, which is crucial since the net profit is directly transferred to the owner’s equity. If net profit is inaccurately calculated, it would inevitably lead to a distorted view of the financial health of the business.