Adjustment Entries: In Search of the Accrual Year

If juggling the different accounting entries is not easy, properly performing all the steps for each financial year is almost impossible... unless you have proper guidelines.

Are you wondering what adjusting entries are, what information they contain and what they are used for? You will find detailed information in this article.

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What are adjusting entries?

Adjustment entries are part of the adjustment entries, i.e. the entries that are made following the balance sheet valuations, just before the end of the financial year. They are essential entries in the preparation of financial statements as they allow the true accrual period of each expense and revenue to be determined.

Adjustment Entries

We have referred to the adjustment entries. This term is used to refer to a set of entries, such as:

• Completion entries , which record economic transactions not previously recorded;
• Supplementary entries , which integrate into the financial statements elements relating to financial events that will take place in future years;
• Adjustment entries , which defer to a future financial year certain costs and revenues that have already manifested themselves financially in the financial year just ended;
• Amortisation entries , which provide for the allocation of deferred costs according to their presumed contribution to the company's production

Adjustment entries: what information do they provide?

Adjustment entries express account values that have manifested themselves financially during a financial year, but which have not actually been realised and which therefore result in the next financial year . In other words, adjusting entries correspond to a set of information regarding costs that are to be deferred to a later financial year.

They are an application of the accrual principle , i.e. one of the pivotal principles in guiding the preparation of financial statements. It is expressed in Article 2423-bis of the Civil Code. The latter decrees that costs and revenues must be accounted for in accordance with the accrual principle regardless of whether they have had a financial manifestation or not.

Adjustment entries contain information on:

• Prepayments ;
• Inventories ;
• Capitalisation of costs , to which all costs incurred for the internal construction of assets are subject;
• Depreciation and revaluation of fixed assets ;

Inventories

Inventories , or inventories , refer to operating costs deferred to a future year . They can be considered as suspended costs that will only be taken into account in the final result of the financial year once the goods are sold.

Inventories may be of: raw materials, finished products, goods and may consist of two categories of goods :

1. Goods for sale;
2. Goods that contribute to the production of goods for sale.

Inventories may also include: acquisition and operating costs of goods, packaging and other consumables.

In order to make adjustments to inventories, it is necessary to perform the following operations:

• Recognition of inventories, i.e. the recognition of certain income components that are linked to elements of operating assets;
• Measurement of inventories, to be carried out on the purchase cost, i.e. the invoice cost charged to the supplier and directly related ancillary costs. There are various alternative methods for performing the valuation, such as:
  • Weighted average cost method , whereby the weighted average of purchase costs, integrated costs and ancillary costs are taken as cost;
  • FIFO method , whereby it is assumed that the goods will be sold according to the purchase order and, therefore, the inventories will correspond to the quantities purchased most recently;
  • LIFO method , where it is assumed that goods will be sold in reverse order of purchase (goods sold first will be those purchased last). In this case, the inventories will correspond to the quantities purchased in the most distant times (valuation on the actual cost of the most distant purchases).

Prepayments

Deferrals can be defined as the portions of cost or revenue not yet accrued , but already financially manifested by the end of the financial year. Deferrals are subdivided into:

• Prepayments , which correspond to suspended costs that are deferred to subsequent years (in other words, advance payments ), in relation to the following costs:
  • Rent payable;
  • Interest expenses;
  • Discount charges on trade bills;
  • Insurance charges;
• Deferred income (= suspended revenues that are deferred to subsequent years = prepaid collections), in relation to the following revenues:
  • Rental income;
  • Interest income.

Depreciation and revaluation of fixed assets

If a fixed asset is found to be of a lower value than its net book value, it must be revalued to that lower value. This operation consists of a write-down of the fixed asset .

If the reasons for the depreciation no longer apply, the depreciation can be reversed, thus restoring the original (previous) value of the fixed asset ( revaluation of fixed assets ).

What are adjustment entries used for?

The purpose of adjusting entries is to defer income components to subsequent years . In fact, by means of this accounting procedure, income components already financially recognised, but not pertaining to the financial year just ended, are deferred to one of the following accounting periods.

Ultimately, adjusting entries create an accounting link between several financial years , keeping the accounting process both smooth and reliable.

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Overview: let's take stock

The structuring and meaning of adjusting entries may appear, perhaps, to be quite complex concepts, albeit of great interest, if they are not put into proper context.

What follows is a summary of the accounting and balance sheet cycle , broken down into its various stages. In this way, it will be possible to identify the positioning of accounting entries in it and, consequently, to clarify its raison d'être.

1. Opening of the financial year;
2. Recording of the financial year (collection, classification and systematic recording of values);
3. Balance sheet valuations;
4. Year-end adjustments (supplementing, reversing, summarising and summarising values). They take the form of adjustment entries , which are divided, as seen, into:
   1. Integration entries, which involve the entry of new values ex novo during the financial year. The most frequent integration entries are:
      1. Accrued income and accrued expenses;
      2. Invoices to be issued and received;
      3. Depreciation and amortisation;
      4. Provisions to funds: future expenses;
      5. Provisions to funds: risks;
      6. SEVERANCE PAY;
      7. Taxes;
   2. Reversal or adjustment entries , which involve the variation (or adjustment, precisely) of values already entered . The most frequent adjustment entries are:
      1. Prepayments and deferrals;
      2. Inventories ;
      3. Capitalisation of costs;
      4. Devaluation and revaluation of fixed assets;
5. Closure of the financial year;
6. Summaries of the financial year (balance sheet and profit and loss account);
7. Preparation of the financial statements .