Basic Adjustments in Final Accounts

In the previous chapter, "Arranging Items in a Balance Sheet", we learned how to neatly organize our assets and liabilities to show a clear picture of a business's financial health. But there is a catch. That beautiful, perfectly balanced Balance Sheet—and the Profit & Loss Account that feeds into it—relies entirely on the numbers in your Trial Balance.

What happens if the Trial Balance is incomplete?

In the real world, a Trial Balance drawn up on the last day of the financial year (March 31st) rarely tells the whole story. The electricity bill for March hasn't arrived in the mail yet. The warehouse manager is still counting the unsold inventory. The annual fire insurance premium was paid back in October and covers six months of the next financial year.

If we just blindly copy the Trial Balance figures into our Final Accounts, our profit will be wrong, and our Balance Sheet will be a lie. We have to adjust the numbers. This chapter is about how to make those basic adjustments—specifically for closing stock, outstanding expenses, and prepaid expenses—so that your Final Accounts reflect absolute reality.

The Accrual Concept: Why We Adjust

To understand why adjustments are necessary, you first have to understand the beating heart of modern accounting: the Accrual Concept.

Imagine you run a small printing press. Your financial year runs from April 1st to March 31st. You rent your workshop for ₹10,000 a month. By March 31st, you have paid rent for 11 months (₹1,10,000), but you haven't paid the rent for March yet because you were short on cash.

If you prepare your Profit & Loss Account based only on the cash you actually paid out, you will record your rent expense as ₹1,10,000. But wait—you used the workshop for 12 months to generate your sales. If you only record 11 months of rent, your expenses look artificially low, which means your profit will look artificially high. You are lying to yourself (and to the tax department).

Closely related to this is the Matching Principle. This principle says that if you record a certain amount of revenue in a year, you must "match" it against all the expenses incurred to generate that specific revenue. You cannot match 12 months of sales against 11 months of rent.

Adjustments exist to enforce the Accrual Concept and the Matching Principle. They are the accountant's way of saying: "I don't care what the cash book says. I only care what actually belongs to this 12-month period."

The Trial Balance vs. Adjustments

When you look at an exam question (or a real-world accounting problem) for Final Accounts, you will always see two distinct parts:

1. 1The Trial Balance: A big box of numbers containing all the ledger balances.
2. 2The Adjustments: A list of bullet points sitting outside and below the Trial Balance.

Why are some items inside the box and some outside?

Items inside the Trial Balance have already passed through the entire accounting cycle. A journal entry was passed, it was posted to a ledger account, the ledger was balanced, and that balance was carried to the Trial Balance. The double-entry bookkeeping for these items is complete.

Items outside the Trial Balance (the adjustments) are pieces of information that have not yet been recorded in the books. Because they haven't been journalized, their double-entry is incomplete.

This brings us to the most important rule in this entire chapter. If you remember nothing else, remember this:

Why two places? Because every transaction in accounting has a dual aspect (a debit and a credit). Since the adjustment was never recorded in the journal, you are effectively doing the double-entry directly inside the Final Accounts. Every adjustment will have one Debit effect and one Credit effect.

Let's look at the three most common adjustments you will face: Closing Stock, Outstanding Expenses, and Prepaid Expenses.

Adjustment 1: Closing Stock

Closing stock represents the goods that a business bought or manufactured during the year but could not sell by the last day of the financial year.

Why is it usually outside the Trial Balance?

Most businesses do not keep a continuous, real-time ledger of every single item they sell (this is called a periodic inventory system). Instead, on March 31st, they physically go into the warehouse, count the boxes, and calculate the value of the unsold goods. Because this physical count happens at the very end of the year, it doesn't make it into the regular ledger accounts, and therefore, it doesn't appear inside the Trial Balance.

The Logic of the Adjustment

Think about the Trading Account. On the debit side, you record your Opening Stock and all your Purchases for the year. Let's say you started with 100 shirts and bought 900 more. You have debited the cost of 1,000 shirts to the Trading Account. But what if you only sold 800 shirts? Your Sales (on the credit side) only reflect the revenue from 800 shirts. If you leave it like this, you are matching the cost of 1,000 shirts against the revenue of 800 shirts. Your gross profit will be completely wrong.

To fix this, we must remove the cost of the 200 unsold shirts from the debit side. In accounting, the easiest way to reduce a debit is to add a credit. So, we put the Closing Stock on the credit side of the Trading Account.

Furthermore, those 200 unsold shirts belong to the business. They have value. They will be sold next year. Therefore, they are an asset.

The Dual Effect

When Closing Stock is given as an adjustment outside the Trial Balance, you must record it in two places:

Note on Valuation: Accounting conservatism dictates that closing stock should always be valued at Cost Price or Net Realizable Value (Market Price), whichever is lower. If an exam question gives you two values for closing stock (e.g., "Cost ₹50,000; Market Value ₹45,000"), always pick the lower number (₹45,000) for both your Trading Account and Balance Sheet.

Adjustment 2: Outstanding Expenses

Outstanding expenses are expenses that have been incurred during the current financial year, but the payment has not been made by the end of the year. They are also known as unpaid expenses or accrued expenses.

The Logic of the Adjustment

Let's go back to our printing press example. You owe ₹10,000 for March rent, but you haven't paid it. Inside your Trial Balance, the Rent Account shows a debit balance of ₹1,10,000 (the 11 months you actually paid).

According to the Accrual Concept, your true rent expense for the year is ₹1,20,000. To fix your Profit & Loss Account, you must add the unpaid ₹10,000 to the rent expense.

But wait, you still owe this money to your landlord. It is a debt. Any money a business owes to an outsider is a liability. Therefore, this unpaid amount must also be shown on the Balance Sheet.

The Dual Effect

When an Outstanding Expense (like unpaid wages, unpaid salaries, or unpaid rent) is given as an adjustment outside the Trial Balance:

Worked Example: Outstanding Wages

Given in Trial Balance:

• Wages: ₹45,000

Given in Adjustments:

• Wages outstanding for the month of March: ₹5,000

How to record it:

1. 1In the Trading Account: On the debit side, write "To Wages: ₹45,000". Right below it, write "Add: Outstanding Wages: ₹5,000". Draw a line and put the total, ₹50,000, in the outer amount column.
2. 2In the Balance Sheet: On the Liabilities side, write "Outstanding Wages: ₹5,000".

Notice the dual effect? We increased a debit (expense) by ₹5,000, and we created a credit (liability) of ₹5,000. The accounting equation remains perfectly balanced.

Adjustment 3: Prepaid Expenses

Prepaid expenses are exactly the opposite of outstanding expenses. These are expenses that have been paid in advance during the current year, but the benefit of that payment will be received in the next financial year. They are also known as unexpired expenses or expenses paid in advance.

The Logic of the Adjustment

The most common example is insurance. Insurance companies usually charge annual premiums. Suppose your financial year ends on March 31st. On October 1st, you paid an annual fire insurance premium of ₹12,000. This payment covers you from October 1st of this year to September 30th of the next year.

Inside your Trial Balance, the Insurance Account shows a debit balance of ₹12,000. But wait! Only 6 months of that insurance (October to March) belongs to the current financial year. The remaining 6 months (April to September) belong to next year.

According to the Matching Principle, we cannot charge next year's expenses against this year's profits. The true insurance expense for this year is only ₹6,000. To fix your Profit & Loss Account, you must subtract the prepaid ₹6,000 from the insurance expense.

Furthermore, because you have paid for a service you haven't received yet, the insurance company owes you coverage. A right to receive a future benefit is an asset. Therefore, the prepaid amount must be shown on the Balance Sheet.

The Dual Effect

When a Prepaid Expense (like advance insurance or advance rent) is given as an adjustment outside the Trial Balance:

Worked Example: Prepaid Insurance

Given in Trial Balance:

• Insurance Premium: ₹18,000

Given in Adjustments:

• Insurance premium includes ₹4,000 paid for the next financial year.

How to record it:

1. 1In the P&L Account: On the debit side, write "To Insurance Premium: ₹18,000". Right below it, write "Less: Prepaid Insurance: ₹4,000". Draw a line and put the true expense for the year, ₹14,000, in the outer amount column.
2. 2In the Balance Sheet: On the Assets side, write "Prepaid Insurance: ₹4,000".

Again, observe the dual effect. We reduced a debit (expense) by ₹4,000, and we created a new debit (asset) of ₹4,000. The net effect keeps the books balanced.

The "Inside the Trial Balance" Trap

Examiners love to test if you truly understand the difference between an unrecorded adjustment and an already-recorded ledger balance. They do this by putting these adjustment items inside the Trial Balance.

What happens if "Outstanding Wages" or "Prepaid Insurance" or "Closing Stock" appears inside the Trial Balance box, rather than as a bullet point at the bottom?

Apply the Golden Rule: If it is inside the Trial Balance, it goes to only ONE place.

Why? Because if it is inside the Trial Balance, the accountant has already passed the journal entry during the year.

• If "Outstanding Wages" is inside the TB, it means the accountant already added it to the Wages account. The expense is already correct. You only need to record the liability.
• If "Prepaid Insurance" is inside the TB, it means the accountant already deducted it from the Insurance account. The expense is already correct. You only need to record the asset.
• If "Closing Stock" is inside the TB (usually under the name "Adjusted Purchases"), it means the accountant has already adjusted it against the Purchases account. You only need to record the asset.

Here is exactly how to handle them if they appear INSIDE the Trial Balance:

1. 1Closing Stock (inside TB): Goes ONLY to the Assets side of the Balance Sheet. (Do not put it in the Trading Account).
2. 2Outstanding Expenses (inside TB): Goes ONLY to the Liabilities side of the Balance Sheet. (Do not add it to the expense in Trading/P&L).
3. 3Prepaid Expenses (inside TB): Goes ONLY to the Assets side of the Balance Sheet. (Do not deduct it from the expense in Trading/P&L).

This distinction separates the amateurs from the experts. Always check where the item is located before deciding how to treat it.

Comprehensive Worked Example

Let’s put everything together in a single, concrete scenario. Imagine you are preparing the Final Accounts for Sharma Traders for the year ending March 31, 2025.

You are given the following extract from their Trial Balance:

Trial Balance (Extract) as on 31st March 2025

• Opening Stock: ₹20,000 (Dr)
• Purchases: ₹1,00,000 (Dr)
• Sales: ₹2,50,000 (Cr)
• Wages: ₹15,000 (Dr)
• Rent: ₹22,000 (Dr)

Adjustments (Outside the Trial Balance):

1. 1Closing Stock on 31st March 2025 was valued at ₹35,000.
2. 2Wages amounting to ₹3,000 are outstanding.
3. 3Rent includes ₹2,000 paid in advance for the month of April 2025.

Let's process this step-by-step.

Step 1: Trading Account (Extract)

• Opening Stock: ₹20,000 goes to the Debit side. (Inside TB = 1 place).
• Purchases: ₹1,00,000 goes to the Debit side. (Inside TB = 1 place).
• Sales: ₹2,50,000 goes to the Credit side. (Inside TB = 1 place).
• Wages: We have ₹15,000 inside the TB, but an adjustment of ₹3,000 outside.
• Action: Debit side: To Wages ₹15,000 + Add Outstanding ₹3,000 = ₹18,000.
• Closing Stock: ₹35,000 is an adjustment outside the TB.
• Action 1: Credit side: By Closing Stock ₹35,000.

Step 2: Profit & Loss Account (Extract)

• Rent: We have ₹22,000 inside the TB, but an adjustment of ₹2,000 prepaid outside.
• Action: Debit side: To Rent ₹22,000 - Less Prepaid ₹2,000 = ₹20,000.

Step 3: Balance Sheet (Extract) Now we must complete the "dual effect" for all three adjustments.

• Closing Stock: It was outside the TB. We put it in Trading. Now, it goes to Assets as ₹35,000.
• Outstanding Wages: It was outside the TB. We added it to Wages. Now, it goes to Liabilities as ₹3,000.
• Prepaid Rent: It was outside the TB. We deducted it from Rent. Now, it goes to Assets as ₹2,000.

If you trace every number, you will see that the Trial Balance items moved exactly once, and the Adjustment items moved exactly twice. The books are perfectly clean, the Accrual Concept is satisfied, and the profit calculated will be 100% accurate for the 12 months ending March 31, 2025.

Quick Revision

Scan these points the night before your exam to lock in the mechanics:

• The Accrual Concept: Income and expenses must be recorded in the year they occur, regardless of when cash is paid or received.
• The Golden Rule: Items inside the Trial Balance go to ONE place. Items outside the Trial Balance (Adjustments) go to TWO places.
• Closing Stock (Adjustment): Credit to Trading A/c AND show as an Asset in the Balance Sheet.
• Valuation of Stock: Always value closing stock at Cost Price or Market Price, whichever is lower.
• Outstanding Expenses (Adjustment): ADD to the respective expense on the Debit side of Trading/P&L AND show as a Liability in the Balance Sheet.
• Prepaid Expenses (Adjustment): DEDUCT from the respective expense on the Debit side of Trading/P&L AND show as an Asset in the Balance Sheet.
• The Trap: If Closing Stock, Outstanding Expenses, or Prepaid Expenses are given inside the Trial Balance, they skip the Trading/P&L entirely and go straight to the Balance Sheet (Stock/Prepaid as Assets, Outstanding as Liabilities).