Adjustments to Financial Statements
Understanding Adjustments to Financial Statements
- Adjustments to financial statements are typically applied at the end of a financial period.
- This process can include profit and loss items and balance sheet items, such as stock valuations, accruals, and prepayments.
- Adjustments are necessary to reflect the true and correct financial position of a business and to ensure accounting standards are met.
Common Types of Adjustments
Accruals
- Accruals are expenses that a business has incurred but not yet paid for.
- When preparing financial statements, these expenses need to be added in the current period, increasing both the expenses and liabilities in the balance sheet.
Prepayments
- Prepayments refer to payments for services or goods which the business will receive in the future.
- Prepaid amounts are first recorded as an asset, but over time as the goods or services are received, the asset is reduced and the amount becomes an expense.
Depreciation
- Depreciation is used to spread the cost of a tangible fixed asset over its useful life.
- This is particular is a non-cash adjustment that involves increasing depreciation expense and reducing the balance of the asset account.
Bad debts and provision for doubtful debts
- Bad debts are accounts receivable that a firm is unlikely to collect, and thus becomes an expense.
- The provision for doubtful debts is a precautionary amount set aside for possible non-collection of receivables.
Adjustments process
- When making adjustments to financial statements, a business would first need to identify the nature of each transaction and determine if an adjustment is needed.
- Any adjustments should be documented in the journal entries, with a clear explanation of the reason for each change.
- These will then need to be posted to the ledger accounts, debiting and crediting appropriately.
- Finally, reflect the adjusted amounts in the finalised financial statements.
Importance of adjustments
- Ensures the business' financial position is accurately presented, aiding in decision-making.
- Adjustments align accounting records with actual business transactions and events.
- Helps to maintain compliance with accounting policies as per GAAP or IFRS.
- Presents a realistic picture of the business to potential investors and shareholders.
- Provides a basis for comparison across financial periods.