Let us make in-depth study of the meaning of adjustment entries and need for adjustment.
Meaning of Adjustments:
Adjustment entries are those entries which need to be passed at the end of the accounting period so that the true profit or loss and fair financial position of the business can be shown. Trial Balance is the base for preparing final accounts of any business enterprise. To see the arithmetical accuracy we record all balances of debits and credits extracted from ledger accounts, including cash book in this statement. There are possibilities that some such items, as were not detected at the time of preparing trial balance, could hence not be shown in the trial balance.
For example, closing stock cannot be estimated during the accounting year and is usually valued after the accounting year is over. Similarly, depreciation is charged on fixed assets at the end of the accounting year. In the same parlance, there are innumerable important items that may not find a place in the trial balance.
As per Generally Accepted Accounting Principles (GAAP), all these items are very important and critical to calculate the actual earnings and thus show assets and liabilities at their true and fair values.
From the above it is clear that these items must be shown in the final accounts of business enterprise because without showing the impact of these items we cannot say that books of accounts show true and fair view of the business enterprise. It is also true that the ultimate impact of these items must show itself in trading and Profit & Loss Account and Balance Sheet.
Now question arises as to how these items can be shown when all the ledger accounts must have been closed. The only option available is to pass adjusting entry for each and every such item in such a manner that the true and ultimate impact on Trading and Profit & Loss Account and Balance Sheet can be shown. Following the double entry system, adjustment entries are to be posted to at least two accounts.
Need for Adjustments:
Adjustments are required to be passed for the following purposes:
(i) To show the true income of the business concern.
(ii) To show the assets and liabilities at their actual values.
(iii) To record omissions during the year.
(iv) To record all outstanding and prepaid expenses.
(v) To record all accrued and advance incomes.
(vi) to create reserves and provisions.
(vii) To overcome the limitations of Trial Balance.