1. Need for Adjustments
According to the Accrual Concept and Matching Concept, the true profit or loss of a business can only be calculated when all expenses relating to the current year are recorded (whether paid or not), and all incomes relating to the current year are recorded (whether received or not).
Transactions omitted or incomplete at the time of making the Trial Balance are given outside it as Adjustments.
Golden Rule for Adjustments: Every adjustment given outside the Trial Balance will have a dual effect (it will appear in two places in the final accounts) to satisfy the double-entry principle.
2. Common Adjustments & Their Treatment
1. Closing Stock
- Entry: Closing Stock A/c Dr. To Trading A/c
- Treatment:
- Credit side of Trading A/c.
- Asset side of the Balance Sheet.
- (Note: Valued at Cost or Net Realizable Value, whichever is lower).
2. Outstanding Expenses (Expenses incurred but not paid)
- Entry: Expense A/c Dr. To Outstanding Expense A/c
- Treatment:
- Add to the respective expense on the Debit side of Trading/P&L A/c.
- Show on the Liabilities side of the Balance Sheet.
3. Prepaid Expenses / Expenses Paid in Advance
- Entry: Prepaid Expense A/c Dr. To Expense A/c
- Treatment:
- Deduct from the respective expense on the Debit side of Trading/P&L A/c.
- Show on the Asset side of the Balance Sheet.
4. Accrued Income (Income earned but not yet received)
- Entry: Accrued Income A/c Dr. To Income A/c
- Treatment:
- Add to the respective income on the Credit side of P&L A/c.
- Show on the Asset side of the Balance Sheet.
5. Unearned Income / Income Received in Advance
- Entry: Income A/c Dr. To Unearned Income A/c
- Treatment:
- Deduct from the respective income on the Credit side of P&L A/c.
- Show on the Liabilities side of the Balance Sheet.
6. Depreciation
- Entry: Depreciation A/c Dr. To Asset A/c
- Treatment:
- Debit side of P&L A/c.
- Deduct from the respective Asset in the Balance Sheet.
7. Bad Debts (Further Bad Debts outside Trial Balance)
- Entry: Bad Debts A/c Dr. To Sundry Debtors A/c
- Treatment:
- Add to existing Bad Debts on the Debit side of P&L A/c.
- Deduct from Sundry Debtors on the Asset side of the Balance Sheet.
8. Provision for Doubtful Debts
A provision created to cover expected future losses from current debtors.
- Calculation: Calculated on Debtors after deducting further bad debts.
- Treatment:
1. Debit side of P&L A/c (Formula: Old Bad Debts + New Bad Debts + New Provision - Old Provision).
2. Deduct from Sundry Debtors in the Balance Sheet.
9. Manager's Commission
Sometimes the manager is entitled to a commission on the Net Profit.
- On Net Profit before charging such commission: Commission = Net Profit $\times \frac{\text{Rate}}{100}$
- On Net Profit after charging such commission: Commission = Net Profit $\times \frac{\text{Rate}}{100 + \text{Rate}}$
- Treatment: Debit in P&L A/c, and show as Outstanding Commission (Liability) in Balance Sheet.
10. Goods Distributed as Free Samples / Goods taken for Personal Use / Loss by Fire
- Treatment 1: Deduct from Purchases on the Debit side of the Trading A/c.
- Treatment 2:
- Free Samples $\rightarrow$ Debit side of P&L (as Advertisement).
- Personal Use $\rightarrow$ Deduct from Capital (as Drawings).
- Fire Loss $\rightarrow$ Debit side of P&L (net of insurance claim); Claim amount shown as Asset.