Financial statements refer to those Accounts and Statements which are prepared at the end of an accounting period (which is generally a year) to know about the business activities and financial performance of a company. It is a summary of all the accounting activities of a business enterprise where the income statement shows the profit or loss during the year, and the balance sheet reflects the assets, liabilities and capital, which tells about the financial position of the company. After determining the accuracy of the books of accounts with the help of trial balance, a business concern proceeds to prepare a financial statement (or final accounts). Thus, Financial Statement consists of the following:
- Trading Account
- Profit & Loss Account
- Balance Sheet
Adjustments in Financial Statement:
The main objective of preparing a financial statement is to know about the financial position of a company and find out the profit earned or loss suffered during the accounting period. The former objective is achieved by preparing a Trading A/c and a Profit & Loss A/c, which are also known as ‘Income Statement’ and the latter by preparing a Balance Sheet, also known as ‘Position Statement’. The reason why Trading and Profit & Loss A/c is called Income Statement is that it gives information about the Income of the Company i.e., Gross Profit and Net Profit, while the Balance sheet of any enterprise tells about the position of the company related to its Assets and Liabilities.
While the objective clearly states the purpose of preparing a Financial Statement, the major hindrance that follows is the accuracy of the figures. Actual or accurate profit or loss can only be calculated after considering all the incomes, expenses, assets, liabilities, etc., of the related financial year. For example, if we want to prepare profit and loss a/c for the year ending 31st March 2022, then it becomes mandatory to record all the income and expenditure of that year starting from 1st April 2021 in the profit and loss a/c. But some of the incomes which are a part of this financial year, have not been actually received (Accrued Income) ,along with some expenses which are a part of this financial year have not actually been paid (Outstanding Expenses). So in such cases, it becomes essential to add all the Accrued Income in the current year’s profit and deduct all the Outstanding Expenses. A greater emphasis is made on finding all the accounting items and information that are related to the current financial year and passing entries accordingly.
So, all the accounting items which are related to the current financial year but not recorded in the books due to any reason should be taken into consideration to find out the actual profit or loss and accurate financial position of the organization, and accounting entries for such transactions are called adjustment entries or simple adjustments.
Objectives and Needs of Adjustments
The major objectives and need for adjustments are as follows:
- To get information about actual Profit or Loss: Through adjustments in the financial statement, we consider all the accounting items which are relevant to the current financial year, but not recorded in the books due to any reason. This helps us in getting the actual profit or loss for the year.
- To know about the real financial position of the business: Adjustments bring many accounting information related to assets and liabilities, which need attention while preparing the Balance Sheet. We can only get the accurate financial position of the company if adjustment entries are passed in the Balance Sheet.
- To rectify the errors found in the books of accounts: Adjustment plays an important part in rectifying any error which was previously recorded in the books of accounts. As we all know that we cannot change any previous entry but can only pass a different entry to register the same effect.
- To complete the incomplete transactions: With the help of adjustment, a rectifying entry can be passed for any partial or total omission of any accounting item.
- To make provision for depreciation and other such provisions: Often, provisions are made at the end of the financial year and sometimes even after preparing a financial statement. With the help of adjustments, we make provisions for depreciation and other provisions so that any assets or liabilities will not remain undervalued or overvalued.
- To include all incomes, whether received or about to be received: Without including all the accrued income in the Profit & Loss A/c, it will not show the actual profit or loss for the year. With the help of adjustments, we try to include all the income of the financial year, whether it has been received or still accrued. This helps in ascertaining the actual income of the enterprise.
- To include all the expenses, whether paid or about to be paid: Like Accrued Income, we also have to include all the expenses of the current financial year, which have been paid or are still outstanding. This also helps us in ascertaining the actual profit or loss of the year.
- To record all such incomes, which have been received in advance: Income received in advance are those incomes which are unearned but yet received in a financial year. It shows the profit overvalued for the year because Unearned Income does not belong to the current year. With the help of adjustments, we cancel those effects by recording all the incomes, which are received in advance.
- To record all such expenses, which have been paid in advance: Like Income received in Advance, there are some expenses which are paid in advance. Such expenses are called prepaid expenses and because of them, the profits for the year go undervalued. By recording all such expenses which are paid in advance, we aim to get the actual profit or loss for the year.
Effect of Adjustment
Some points must be considered at the time of adjustment:
- Accounting for items mentioned in the trial balance will be carried out only once i.e., in one account only, whether in the Trading A/c, Profit and Loss A/c, or Balance Sheet.
- Accounting for items given outside the trial balance in adjustments will be carried out twice or at two places or in two accounts.