The purpose of accounting is to provide useful information to various parties who need it. To be most useful, the information must be accurate and up to date. In accounting, some transactions take place, which need to be recorded in the normal way but have not yet been properly finalized during the period involved, such outstanding events that have not been noted and recorded in the normal way, and so the information in the ledger will not be completed. The entries required at the end of an accounting period to record outstanding internal transactions are called corrections in the accounts. But bringing the ledger up to date is planned part of the accounting procedure and is not necessitated merely by errors. The term 'adjusting entries' is therefore more appropriate than 'correcting entries'.
Adjusting entries bring the accounts to their proper balance before, financial statements are prepared. The adjusting entries change the amounts originally in the accounts to the amounts that should be in the accounts for proper financial reporting.
One might ask, why to worry about adjustments? Doesn't everything come out all right in the end? The main reason for making adjustments is that they help accountants to give accounting information that is useful for decision making.
Importance and Example of Adjusting Entries:
For example, adjusting entries are necessary to measure income and financial position in a relevant and useful way. The management of a company wants to know how much it has earned during the last month, quarter or year and what are its liabilities and assets at a certain date. This need is an important reason for making the adjusting entries, to show the actual and realistic position to the users.
For example, suppose accounts have to be prepared up to 31 December of the year. The salaries of the staff amounting to $150,000 are payable by 5th of the next month i.e. by the 5th January. Thus at the last day of the month of December, the recorded expenditure of salaries will not be inclusive of salaries for the month because these have not yet been paid but the amount of $150,000 actually relates to the month of December. If accounts are prepared only on the basis of amounts recorded up to 31 December without taking unpaid December salaries into accounts, the profits would naturally be overstated and the financial statements would not reveal true position of the business.
Another important reason for the use of adjusting entries is that they allow financial statements to be compared from one period to the next. This is known as matching rule. Management can see that the company is making progress toward earning a profit or the company has improved its financial position. To return to our example, if the accrued salary expense for December is not recorded, not only the income of that month will be overstated but the net income for the month in which the payment has to be made (next month) will be understated by the same amount. Similar is the necessity of adjustment for prepaid rent and insurance, office supplies, depreciation of equipment and machinery, un-earned fees, accrued wages and unpaid electricity bills and accrued advertising fees. These are all normal and usual adjustments; the combined effect of all of them on net income is significant.
The adjusting procedures and entries must be complete and consistent at the end of every accounting period. Accountants make these adjustments by analyzing the accounts and determining which ones need adjustment. For example, assume a three year insurance policy costing $60000 was purchased at the beginning of the year and debited to prepaid insurance. At year-end, it is obvious that $20000 of the cost should be removed from the asset and recorded as an expense for the year. Failure to do so will result in overstated assets and understated net income in the financial statements.
Events such as the using up of insurance coverage that has been prepaid are known as continuous events. Most adjusting entries are the result of continuous events. The need for adjusting entries is based on the matching principle, which requires that expenses incurred in producing revenues be deducted from the revenues they generated during the accounting period. This mailing of expenses and revenues is necessary for the income statement to present an accurate picture of the profitability of a business for a particular period. Benefits from many assets such as prepaid expenses (e.g., prepaid insurance and prepaid rent) are being derived continuously by a company.
Thus, the expense relating to these items could also be recognized properly as time elapses. An entry could be made when the expense has been incurred. But typically, the entry is not made until financial statements are prepared. Monthly adjusting entries are required by custom. However as required by law, business report are required to be furnished to the shareholders at least annually. Accordingly, adjusting entries will be required al least once a year. However, one point must be kept in mind that the entry transferring an amount from an asset account to an expense account should transfer only the cost of the portion of tile asset that has expired during the period.
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