Final Accounts with Adjustments: Types, Adjustments & Preparation

TAKEAWAYS:

• Adjustments are necessary to match revenues and expenses to the correct accounting period.
• Common adjustments include outstanding expenses, prepaid expenses, accrued income, and depreciation.
• Adjustments affect either the Income Statement (revenue/expense) or the Balance Sheet (asset/liability).
• The adjustment process involves journal entries, ledger updates, and trial balance adjustments.
• Final accounts are prepared after adjustments to show the true financial position and performance.
• NEB exams often test identifying adjustments and preparing final accounts from incomplete data.

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Why Adjustments Are Needed

Final accounts (Income Statement and Balance Sheet) must show the true financial position of a business. However, the trial balance prepared from the ledger may not reflect this because:

• Some expenses or incomes are not yet recorded (e.g., rent paid in advance, salary owed but not paid).
• Some transactions span multiple accounting periods (e.g., insurance paid for 2 years, but only 1 year’s expense is recorded).
• Depreciation on assets is not yet recorded.

Example: If a business pays Rs. 12,000 rent for 2 years on 1st January 2023, but the accounting year ends on 31st December 2023, only Rs. 6,000 should be treated as an expense for 2023. The remaining Rs. 6,000 is a prepaid expense (an asset) for 2024.

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Types of Adjustments

Adjustments can be classified into four main types:

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Step-by-Step Adjustment Process

To prepare final accounts with adjustments, follow these steps:

1. Prepare the Trial Balance (from ledger accounts).
2. Identify Adjustments Needed (check for outstanding, prepaid, accrued, and depreciation).
3. Pass Adjusting Journal Entries (to correct the trial balance).
4. Prepare Adjusted Trial Balance (to ensure totals match).
5. Prepare Final Accounts (Income Statement and Balance Sheet).

Example: Adjusting Journal Entries

Given:

• Rent Outstanding (for December): Rs. 5,000 (not yet paid).
• Insurance Prepaid (for next year): Rs. 3,000 (paid in advance).
• Salary Accrued (for December): Rs. 2,000 (owed but not paid).
• Depreciation on Machinery (10% per year): Rs. 10,000 (original cost).

Journal Entries:

Explanation:

• Rent Outstanding: Since rent is owed but not paid, it increases Rent Expense (Income Statement) and Rent Payable (Balance Sheet).
• Insurance Prepaid: Since insurance was paid in advance, we reduce Insurance Expense (Income Statement) and increase Prepaid Insurance (Balance Sheet).
• Salary Accrued: Since salary is earned but not paid, it increases Salary Expense (Income Statement) and Salary Payable (Balance Sheet).
• Depreciation: Reduces the value of machinery (Balance Sheet) and increases Depreciation Expense (Income Statement).

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Preparing Adjusted Trial Balance

After passing adjusting journal entries, update the ledger and prepare a new trial balance (Adjusted Trial Balance).

Example of Adjusted Trial Balance:

(Note: Adjustments are shown in bold.)

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Preparing Final Accounts (Income Statement & Balance Sheet)

After adjusting the trial balance, prepare:

1. Income Statement (Profit & Loss Account)

   • Shows revenue, expenses, and net profit/loss.
   • Includes adjusted expenses and incomes.

2. Balance Sheet

   • Shows assets, liabilities, and capital after adjustments.
   • Includes prepaid expenses, accrued incomes, and depreciation.

Example: Income Statement (Extract)

Example: Balance Sheet (Extract)

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Common Adjustments in NEB Exams

NEB often tests adjustments related to:

1. Outstanding Expenses (e.g., salary, rent, interest).
2. Prepaid Expenses (e.g., insurance, rent, taxes).
3. Accrued Income (e.g., rent received in advance, interest earned).
4. Depreciation (on machinery, furniture, vehicles).
5. Closing Stock (if not already recorded).

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Exam Tip: How to Score Full Marks

✅ Identify Adjustments Correctly – Always check if an expense/income is outstanding, prepaid, or accrued. ✅ Pass Correct Journal Entries – Use the debit-credit rule properly (e.g., outstanding expenses = debit expense, credit liability). ✅ Update Trial Balance – Show adjusted figures in the trial balance. ✅ Prepare Final Accounts Properly –

• Income Statement should show net profit/loss.
• Balance Sheet should show correct assets, liabilities, and capital. ✅ Show Workings Clearly – If depreciation is calculated, show the formula (e.g., Straight-line method: Cost × Rate). ✅ Use NEB Format – Follow the standard layout for Income Statement and Balance Sheet.

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NEB Board-Style Questions (Practice)

Question 1 (Short Answer)

"What is the difference between outstanding expenses and prepaid expenses?" Answer:

Question 2 (Journal Entry)

"On 31st December 2023, the following adjustments are needed:

• Rent outstanding: Rs. 2,000
• Insurance prepaid: Rs. 1,500
• Salary accrued: Rs. 1,000 Pass the necessary journal entries."

Solution:

Question 3 (Final Accounts Preparation)

"From the following trial balance and adjustments, prepare the Income Statement and Balance Sheet of Mr. Ram for the year ending 31st December 2023."

Solution:

1. Journal Entries:

   • Rent Expense (2,000) → Rent Payable (2,000)
   • Prepaid Insurance (1,000) → Insurance Expense (1,000)
   • Salary Expense (1,500) → Salary Payable (1,500)
   • Depreciation Expense (5,000) → Accumulated Depreciation (5,000)

2. Adjusted Trial Balance: (Prepare similarly to the earlier example.)

3. Income Statement:

   • Gross Profit = Sales (400,000) - Purchases (250,000) = 150,000
   • Total Expenses = Rent (12,000) + Salary (21,500) + Insurance (5,000) + Depreciation (5,000) = 43,500
   • Net Profit = 150,000 - 43,500 = 106,500

4. Balance Sheet:

   • Assets: Machinery (50,000 - 5,000) = 45,000; Prepaid Insurance = 1,000; Debtors (if any), etc.
   • Liabilities: Rent Payable (2,000), Salary Payable (1,500), Capital (150,000 + 106,500) = 256,500

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Summary

• Adjustments ensure accurate financial statements.
• Outstanding expenses and accrued incomes are recorded as liabilities/assets.
• Prepaid expenses reduce current period expenses.
• Depreciation reduces the value of fixed assets.
• Final accounts are prepared after adjustments to show the true financial position.

Practice Tip: Always cross-check your adjustments with the trial balance before preparing final accounts. NEB exams often give incomplete data, so identifying missing adjustments is key!

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