Adjustments and Closing the Books

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Introduction

At the conclusion of each accounting period, an organization must meticulously prepare its financial statements to ensure they faithfully represent its economic performance and financial health. This process extends beyond merely compiling recorded transactions. It necessitates a deliberate review to capture all economic activities of the period, including those not yet finalized through cash exchanges or invoices.

This chapter provides a comprehensive examination of the period-end adjustment process, a cornerstone of accrual accounting. We will detail the identification and recording of accruals, prepayments, depreciation, and provisions, followed by the preparation of an adjusted trial balance. The process culminates in the closing of temporary accounts and the formal preparation of the Statement of Profit or Loss and Statement of Financial Position. Mastery of these steps is fundamental to adhering to the matching and revenue recognition principles, thereby ensuring financial statements are both accurate and compliant with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).

9.1 The Imperative for Accurate and Complete Financial Statements

Financial statements serve as the primary communication channel between a company and its stakeholders—including management, investors, creditors, and regulators. For these statements to be decision-useful, they must possess several key qualitative characteristics:

• Faithful Representation: Information must be complete, neutral, and free from material error.
• Comparability: Financial results should be consistent over time and comparable with other entities, enabled by uniform application of accounting policies.
• Timeliness & Relevance: Information must be available to decision-makers while it can still influence their economic choices.

The adjustment process is the mechanism that transforms a simple listing of transactions into statements that meet these criteria. It ensures:

• Revenue Recognition: Income is recorded in the period it is earned, regardless of when cash is received.
• Expense Matching: Expenses are recognized in the period in which they are incurred to help generate revenue, irrespective of the payment date.

This adherence to the accrual basis of accounting and the matching principle is what differentiates meaningful financial reporting from a basic cash summary.

9.2 Period-End Adjustments for Accruals and Prepayments

Adjustments are primarily needed to account for timing differences between when a transaction's economic effect occurs and when the related cash flow happens.

9.2.1 Accruals (Accrued Expenses / Liabilities)

An accrual recognizes an expense that has been incurred and a corresponding liability that has arisen during the accounting period, but for which an invoice has not been received or payment has not yet been made by the period end.

Conceptual Basis: Apply the matching principle. The expense belongs in the current period's income statement, and the obligation is a true liability at the reporting date.

Common Examples:

• Wages/Salaries owed for the last week of the period, paid in the next period.
• Utilities (electricity, water, gas) consumed but not yet billed.
• Interest on loans that has accumulated but is not yet due for payment.
• Services received from a supplier (e.g., legal, consulting) before an invoice arrives.

Accounting Treatment & Journal Entry:

The expense account is increased (debited), and a liability account is established (credited).

Journal Entry (to record an accrued expense):

DrExpense Account (e.g., UtilitiesExpense, Wages Expense)

    Cr Accrued Liabilities (ora specific account like Accrued Wages Payable)

Detailed Example:

At the financial year-end on December 31, a company owes its employees $5,000 for wages earned during the last week of December, to be paid on January 5.

• Effect: The $5,000 wage expense relates to the current year's operations, and the company has a legal obligation to pay it.
• Adjusting Entry (December 31):

  Dr Wages Expense          5,000

      Cr Accrued Wages Payable  5,000

  To accrue unpaid wages for the period.

• Subsequent Entry (January 5,when paid):

  Dr Accrued Wages Payable  5,000

      Cr Cash                        5,000

  To record the payment of the previously accrued wages.

9.2.2 Prepayments (Prepaid Expenses / Assets)

A prepayment arises when a payment for an expense is made in advance of the period(s) in which the economic benefit will be consumed. The portion relating to future periods is an asset, not an expense.

Conceptual Basis: Apply the expense recognition principle. Only the portion of the prepayment "used up" or expensed during the period is reported on the income statement. The remainder is a future economic benefit (an asset).

Common Examples:

• Insurance premiums paid annually upfront.
• Rent paid for office space in advance.
• Annual business licenses or software subscriptions.
• Bulk purchases of supplies not yet consumed.

Accounting Treatment & Journal Entry (Two Methods):

Method 1: Initial Entry to an Asset Account (Preferred)

1. Initial Payment: The entire amountisrecorded as a prepaid asset.

   Dr Prepaid Expense (e.g.,PrepaidInsurance, Prepaid Rent)

       Cr Cash

2. Adjusting Entry at Period End:The portionrelating to the period is expensed.

   Dr Expense Account (e.g., InsuranceExpense, Rent Expense)

      Cr Prepaid Expense

Method 2: Initial Entry to an Expense Account

1. Initial Payment: The entire amountis recordedas an expense.

   Dr Expense Account

       Cr Cash

2. Adjusting Entry at Period End:The portion relating to future periods is removed from expenseand set up as an asset.

   Dr Prepaid Expense

       Cr Expense Account

Detailed Example (Method 1):

On October 1, a company pays $2,400 for a one-year insurance policy. The accounting year ends on December 31.

• Initial Entry (October1):

  Dr Prepaid Insurance       2,400

      Cr Cash                        2,400

• Adjusting Entry (December 31): 3 months have expired (Oct, Nov, Dec).

  Expense for the year = $2,400 / 12 months * 3 months = $600

  Prepaid asset remaining = $2,400 - $600 = $1,800

  Dr Insurance Expense        600

      Cr Prepaid Insurance          600

  To recognize insurance expense for the period.

9.3 Systematic Allocations: Depreciation and Provisions

9.3.1 Depreciation of Non-Current Assets

Depreciation is the systematic and rational process of allocating the depreciable amount (cost minus residual value) of a tangible non-current asset over its useful economic life. It is a process of allocation, not valuation; the book value (cost minus accumulated depreciation) does not necessarily equal market value.

Purpose:

• Matching: Allocates the asset's cost to the periods that benefit from its use.
• Profit Measurement: Prevents profit from being overstated by recognizing the consumption of the asset.
• Asset Valuation: Reports the asset at its net book value in the Statement of Financial Position.

Key Methods:

• Straight-Line Method:Allocates an equal amount of depreciation expense each year.

  Annual Depreciation = (Cost -Residual Value) / Useful Life (in years)

• Reducing Balance (DiminishingBalance) Method: Applies a fixed percentage to the asset's carrying amount (book value) each year, resulting in higher charges in early years.

Accounting Treatment:

Depreciation is recorded via an adjusting entry that increases an expense and a contra-asset account.

Dr Depreciation Expense

    Cr AccumulatedDepreciation (contra-asset account)

Accumulated Depreciation is presented on the Statement of Financial Position as a deduction from the related asset's cost.

9.3.2 Provisions and Allowances

A provision is a liability of uncertain timing or amount that meets specific recognition criteria (present obligation from a past event, probable outflow of resources, reliable estimate). A common type is an allowance for doubtful accounts (provision for doubtful debts).

Purpose of Allowance for Doubtful Accounts: To adhere to the prudence concept by recognizing expected losses from credit sales (bad debts) in the same period the related revenue is recorded, even though the specific uncollectible accounts may be identified later.

Process:

1. Estimate: Based on past experience, aging of receivables, or industry norms, estimate the amount of the year-end receivables that may be uncollectible.
2. Adjust: Create or adjust the allowance to the required balance.

   Dr Bad Debts Expense (or DoubtfulDebts Expense)

       Cr Allowance for DoubtfulAccounts (contra-asset to Accounts Receivable)

   The Allowance for Doubtful Accounts is deducted from gross Accounts Receivable on the Statement of Financial Position to show Net Realizable Value.

9.4 Preparing an Adjusted Trial Balance

After recording all necessary period-end adjusting entries in the general journal and posting them to the general ledger, the next step is to prepare an Adjusted Trial Balance.

Purpose:

• To verify the arithmetical accuracy of the ledger after all adjustments. Total debits must equal total credits.
• To provide a complete and organized listing of all account balances (including new adjustment accounts like Accrued Expenses, Prepaid Assets, Accumulated Depreciation, and Allowances) that serves as the direct source for preparing the formal financial statements.

Process:

1. List all general ledger account titles and their adjusted balances (original balance +/- effects of adjustments).
2. Total the debit and credit columns.
3. A balanced adjusted trial balance is a positive control point, indicating readiness to proceed to statement preparation, though it does not guarantee the absence of logical or classification errors.

9.5 Closing Entries: Resetting Temporary (Nominal) Accounts

Temporary (or nominal) accounts—specifically all revenue, expense, gain, and loss accounts—accumulate activity for a single accounting period. Permanent (or real) accounts—asset, liability, and equity accounts—carry their ending balances forward into the next period.

9.5.1 Purpose of Closing Entries

• To clear the balances of all temporary accounts to zero, readying them for the next period's transactions.
• To transfer the net result of the period's operations (net profit or net loss) to the owner's capital or retained earnings, thereby updating the equity section.
• To clearly delineate one accounting period from the next.

9.5.2 The Four-Step Closing Process

The closing process typically utilizes a temporary clearing account called Income Summary.

1. Close Revenue Accounts: Debit each individual revenue account for its balance and credit the total to Income Summary.

   Dr Service Revenue, SalesRevenue, etc.

       Cr Income Summary

2. Close Expense Accounts: Credit each individual expense account for its balance and debit the total to Income Summary.

   Dr IncomeSummary

       Cr Rent Expense, Wages Expense,Depreciation Expense, etc.

3. Close Income Summary: Transfer the balance of Income Summary (which now equals Net Profit or Net Loss) to the owner's equity account (Capital or Retained Earnings).

   For Net Profit:

   Dr Income Summary

       Cr Capital / Retained Earnings  

   For Net Loss (the opposite):

   Dr Capital / Retained Earnings

       Cr Income Summary

4. Close Withdrawals/Dividends Account (if applicable): Transfer the balance of the owner's drawing account or dividends declared account to capital (directly reduces equity).

   Dr Capital / Retained Earnings

       Cr Owner's Drawings / DividendsDeclared

Post-Closing Trial Balance: Prepared after closing entries are posted. It contains only permanent accounts (assets, liabilities, equity) and confirms the ledger is in balance for the start of the new period.

9.6 Preparing the Final Financial Statements

The final accounts are prepared directly from the balances listed in the Adjusted Trial Balance.

9.6.1 Statement of Profit or Loss (Income Statement)

This statement summarizes financial performance.

• Structure: Begins with Revenue, subtracts Cost of Goods Sold (for merchandising/manufacturing firms) to arrive at Gross Profit, then subtracts all other Operating Expenses (including depreciation, bad debts, accrued expenses, and adjusted prepaid expenses) to arrive at Net Profit or Loss.
• Source: All revenue and expense account balances from the adjusted trial balance.

9.6.2 Statement of Financial Position (Balance Sheet)

This statement presents financial position at a point in time.

• Structure: Assets = Liabilities + Equity. Assets include adjusted figures for Prepaid Expenses (as current assets) and are reported net of Accumulated Depreciation and Allowance for Doubtful Accounts. Liabilities include all Accrued Expenses. Equity reflects the opening balance plus current period net profit (from the Statement of Profit or Loss) minus any drawings/dividends.
• Source: All asset, liability, and equity account balances from the adjusted trial balance, incorporating the period's net result.

Exam-Style Questions and Answers

Question 1

Explain the fundamental accounting principle that necessitates making accrual and prepaymentadjustments, anddistinguish between the balance sheet classification of an accrual versus a prepayment.

Answer:

The matching principle (or expense recognition principle) necessitates theseadjustments. It requires that expenses be recorded in the same accountingperiod as the revenues they helped to generate, regardless of cash flow timing.

An accrual represents an incurred expense not yet paid, resulting in a current liability (e.g.,Accrued Wages Payable) on the balance sheet. Aprepayment represents an advance payment for a future benefit, resulting in a current asset (e.g., Prepaid Rent) on the balance sheet.

Question 2

A company purchases machinery for $50,000 on January 1. It estimates a useful life of 10 years and a residual value of $5,000. Calculate the annual depreciationexpense using the straight-line method and prepare the required annual adjusting journal entry.

Answer:

• Calculation:

  Depreciable Amount = Cost - Residual Value = $50,000 - $5,000 = $45,000

 Annual Depreciation Expense = $45,000 / 10 years = $4,500

• Adjusting Journal Entry (December31):

  Dr Depreciation Expense - Machinery    4,500

      Cr Accumulated Depreciation -Machinery  4,500

  To record annual depreciation on machinery.

Question 3

At year-end, a review of the $100,000 Accounts Receivable balance indicates that $3,000 is estimatedto be uncollectible. The existing Allowance for Doubtful Accounts has a credit balanceof $500. Prepare the necessary adjusting journal entry.

Answer:

The required ending balance in the allowance account is $3,000. Since a $500 creditbalance alreadyexists, an adjustment of $2,500 is needed to increase it to $3,000.

Dr Bad Debts Expense (or DoubtfulDebtsExpense)     2,500

    Cr Allowance for DoubtfulAccounts                     2,500

To adjust the allowance for doubtful accounts to the estimated required balance.

Question 4

Describe the purpose and content of a Post-Closing Trial Balance. How does it differfrom anAdjusted Trial Balance?

Answer:

The Post-Closing Trial Balance is preparedafter all closing entries have been posted to the ledger. Its purpose is to verify that total debitsstill equal total credits and that all temporary accounts (revenues, expenses, dividends/drawings, Income Summary) have been closed to a zero balance. It contains only permanent accounts: assets, liabilities, and equity (including the updated retained earnings/capital balance).

This differs from the Adjusted Trial Balance, which is prepared before closing entries and contains all accounts—both permanent and temporary—with their adjusted balances, used as the direct source for preparing the financial statements.

Question 5 (Comprehensive)

The following information is extracted from the unadjusted trial balance of XYZ Co. on December 31:

• Rent Expense: $12,000 (Debit)
• Salaries Expense: $0
• Supplies Expense: $0
• Prepaid Rent: $0
• Supplies on Hand: $0

Additional Information:

a) The $12,000 in Rent Expense represents a payment made on October 1 for a one-year lease.

b) Salaries owed but unpaid at December 31 amount to $4,200.

c) A physical count of supplies reveals $850 of unused supplies remaining.

Required: For each item of additional information (a, b, c):

1. Identify the type of adjustment needed (Accrual or Prepayment/Deferral).
2. Prepare the necessary adjusting journal entry as of December 31.

Answer:

a) Rent Adjustment:

1. Type: Prepayment/Deferral. Three months (Oct, Nov, Dec) of the 12-month prepayment have expired.
2. Adjusting Entry:

   Monthly Rent = $12,000 /12 = $1,000

   Rent Expense for the year = $1,000 *3 = $3,000

   Prepaid Rent (Asset) remaining = $12,000 - $3,000 = $9,000

   Dr Prepaid Rent             9,000

       Cr Rent Expense               9,000

   (After this entry, Rent Expense will have a $3,000 debit balance, and Prepaid Rent a $9,000 debit balance).

b) Salaries Adjustment:

1. Type: Accrual.
2. Adjusting Entry:

   Dr Salaries Expense        4,200

       Cr Salaries Payable (or AccruedSalaries)  4,200

   To accrue unpaid salaries at year-end.

c) Supplies Adjustment:

1. Type: Prepayment/Deferral (of supplies expense).
2. Adjusting Entry: Assuming all supplies were initially recorded as an expense when purchased (a common practice), we need to recognize the unused portion as an asset.

   The $850 of unused supplies is an asset.

   Supplies used (expense) = Amount originally debited to Supplies Expense (unknown from given data) - $850. Since the original expense balance was $0, this implies the purchase was likely debited to an asset. However, based on the standard adjustment approach from an unadjusted "Supplies Expense" of $0, we assume the purchase was in assets. A more complete problem would give a Supplies asset balance. For this framework, a standard entry recognizing the asset is:

   Dr Supplies on Hand         850

       Cr Supplies Expense           850

   (This assumes some supplies expense was previously recorded; the credit reduces the expense to the amount actually consumed).

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