Before the financial statements for an accounting period can be prepared, it is necessary to make some year-end adjustments to the trial balance. Year-end adjustments are transactions or modifications to the account entries on the trial balance. These are necessary to ensure that the accruals concept is applied to the preparation of the financial statements.
The accruals concept requires that:
- all income and expenditure must be ‘matched’ to the relevant accounting period; and
- all current obligations must be anticipated as liabilities and all asset values must be assessed to make sure they can be recovered through future profits in conditions of uncertainty.
For example, if a business’s accounting period matches the calendar year and it pays a year’s rent in advance on 1 September, only part of this payment will correspond to the current accounting period (1 Sept. – 31 Dec.). The remaining portion(1 Jan – 30 Aug.) will relate to the subsequent accounting period. According to the unadjusted trial balance, it will seem that the business has spent a lot more on rent for the current accounting period than it really has. The adjustments made effectively ‘correct’ this imbalance.
So if the rental payment made on 1 September was £12,000, only one-third of that figure (i.e. £4,000) will actually need to be shown in the financial statements for this year. The other £8,000 will be accounted for next year. This would be an example of a prepayment, as we will discuss later.
There are five year-end adjustments that you need to know, which you may need to carry out during the BLP exam:
I will go into each of the five adjustments in depth over the next few posts.