Question

Krystal had learned a lot in this first year with her firm. Now, it was year-end. Her accounting manager told her that “adjustments” had to be made. In particular, four adjustments needed to be made. Krystal knew a little about these entries. But, she decided to pull out her accounting books and brush up a little on this information.

What are the four adjustments? Why must these adjustments be made? What happens if these adjustments are ignored?

Answer 1

Answer

• The four kinds of account adjustments are:

#1 Accrued Expenses
#2 Accrued Revenues
#3 Deferred Expenses
#4 Deferred Revenue

• These account adjustments are made so that the financial statements adhere to ‘accrual’ concept of accounting in addition to other principal of accounting like matching principal, revenue recognition principles, etc.

These are also made so that the financial statements reflect a true, fair and correct financial position of the concerned organisation.

• Detailed analysis and what will happen if these adjustments are ignored:-

#1 Accrued Expenses
--These adjustment are regarding some expenses that have been incurred BUT are not yet paid in cash, hence, they are ‘accrued’ but not paid.
--Examples would include utilities bills received but not paid, salaries are wages due but not paid etc.
--While adjusting these, expense account is debited and respective ‘liability’ account is credited.
--Hence, If these adjustments are ignored the expenses would be under-stated. This means that Income Statement would show overstated Net Income, so would Retained earnings balance.
--Also, the liabilities on the Balance Sheet would be understated if these are ignored.

#2 Accrued Revenues
--These refers to revenue that has been earned BUT has not been received in cash.
--Example: Sales on account, interest on bonds due to be received, services performed on account.
--Ignoring these would lead to lower Net Income because the Revenues would be understated.
--In Balance Sheet, the Assets would be understated if these are ignored.

#3 Deferred Expenses
--These are those expense that are paid in cash BUT they do not belong to current period.
--In other words, these are “prepaid” expenses.
--Example: rent paid for 2 years.
--Ignoring adjustments of these would overstate the Net Income on Income Statement.
--Asset would be overstated on Balance sheet if these are ignored to be adjusted.

#4 Deferred Revenue
--These are revenues that have been received in cash BUT are not actually earned.
--These are “Unearned” revenue accounts where cash payment is received in advance.
--If these are not adjusted, the Income Statement would show under stated Revenues.
--Balance Sheet would show overstated Liabilities if adjustments of these are ignored.