Adjustments at the end of an accounting period are essential to ensure that financial statements reflect accurate and up-to-date information about a business’s financial position and performance. They help align revenues and expenses with the proper accounting period, adhering to the matching principle and accrual basis of accounting. Here’s a breakdown:
Key Reasons for Adjustments:
- Accrual of Revenues and Expenses:
- Some revenues may have been earned but not yet recorded (e.g., interest income or service provided but not invoiced).
- Certain expenses may have been incurred but not yet recorded (e.g., utility bills or salaries payable).
- Prepaid Items:
- Adjustments ensure that prepaid expenses like rent or insurance are recognized as expenses only for the period they apply to, not the entire prepayment duration.
- Depreciation and Amortization:
- Long-term assets like machinery lose value over time. Adjustments allocate a portion of this cost to each accounting period to reflect their usage.
- Unearned Revenue:
- When a business receives payment in advance, it needs to recognize revenue as it is earned over time, not when the cash is received.
- Errors and Omissions:
- Adjustments correct any mistakes or omissions discovered during the period-end review.
Example:
- A company pays $12,000 for a year’s insurance in January. At the end of March, an adjustment ensures that only $3,000 ($1,000/month) is recorded as an expense, leaving $9,000 as a prepaid asset.
By making these adjustments, businesses can provide stakeholders with a more accurate financial picture, ensuring compliance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).
