Adjustment Entries

Prerequisites: Module 4 — Accounting Principles

Learning Objectives

By the end of this module, you will be able to:

• Explain why adjustment entries are necessary
• Identify and record all 7 types of adjusting entries
• Calculate depreciation using both SLM and WDV methods
• Prepare adjustment entries for Sunrise Retail's April 2025 close

Why Adjustments Are Needed

When the financial year (or month) ends, your trial balance reflects only what has been recorded — not necessarily what has been earned or incurred. The Matching Principle and Accrual Principle require that:

• Income earned but not yet collected must be shown as income
• Expenses incurred but not yet paid must be shown as expenses
• Cash received in advance must NOT yet be shown as income
• Cash paid in advance must NOT yet be shown as expenses

Adjusting entries bridge this gap. They are made at the end of a period before preparing the final accounts.

Raw Trial Balance
      │
      ▼
  + Prepaid adjustments
  + Accrued expense adjustments
  + Accrued income adjustments
  + Unearned income adjustments
  + Depreciation entries
  + Bad debt provisions
  + Closing stock entries
      │
      ▼
Adjusted Trial Balance  ──→  Final Accounts (P&L + Balance Sheet)

Type 1 — Prepaid Expenses

A prepaid expense is cash paid in advance for a future benefit. You've paid the money, but the benefit belongs to the next period — so it's an asset right now.

Rule: Reduce the expense this period, create a Prepaid (asset) account.

Entry at period end:

Dr  Prepaid Expense A/c     ₹X
    Cr  Expense A/c              ₹X

Sunrise Retail: Suppose Sunrise Retail pays ₹60,000 on April 30 for 2 months rent (May + June). April's books should NOT show ₹60,000 as April rent — it is a May-June expense.

Account	Dr (₹)	Cr (₹)
Prepaid Rent A/c	60,000
To Rent A/c		60,000

At year end, when May and June pass: ₹30,000/month is transferred from Prepaid Rent to Rent Expense each month.

Type 2 — Accrued Expenses (Outstanding Expenses)

An accrued expense is a cost that has been incurred this period but not yet paid. It's a real liability — you owe it, it just hasn't been paid yet.

Rule: Record the expense in the current period, create a liability (Outstanding/Payable account).

Entry at period end:

Dr  Expense A/c             ₹X
    Cr  Outstanding Expense A/c  ₹X

When eventually paid:

Dr  Outstanding Expense A/c  ₹X
    Cr  Bank/Cash A/c            ₹X

Sunrise Retail: The electricity bill for April is ₹8,500. Sunrise Retail received the bill on April 30 but will pay in May. This ₹8,500 must be an April expense.

Account	Dr (₹)	Cr (₹)
Electricity A/c	8,500
To Outstanding Electricity Payable		8,500

(If Sunrise Retail actually paid this in cash on April 15, then no adjustment is needed — it was already recorded as an expense.)

Type 3 — Accrued Income (Income Receivable)

Income earned this period but not yet received in cash. It's a real asset — someone owes you money for services already rendered.

Entry:

Dr  Accrued Income A/c      ₹X
    Cr  Income A/c               ₹X

Sunrise Retail: If Sunrise Retail charges a ₹5,000 monthly service retainer to a client (e.g., AMC for installed systems), and April's retainer hasn't been billed yet, the entry is:

Account	Dr (₹)	Cr (₹)
Accrued Service Fee A/c	5,000
To Service Fee Income A/c		5,000

Type 4 — Unearned Income (Advance Received)

Cash received in advance for goods/services to be delivered in a future period. Currently a liability — you owe the customer the delivery.

Entry when advance received:

Dr  Bank/Cash A/c           ₹X
    Cr  Advance from Customer A/c  ₹X

When delivery happens (in future period), it becomes revenue:

Dr  Advance from Customer A/c  ₹X
    Cr  Sales A/c                   ₹X

Sunrise Retail: On April 28, Tech Park Retail Store pays ₹1,00,000 advance for phones to be delivered in May. This is NOT April sales revenue.

Account	Dr (₹)	Cr (₹)
SBI Current Account	1,00,000
To Advance from Tech Park Retail		1,00,000

Type 5 — Depreciation

Depreciation is the allocation of an asset's cost over its useful life. A computer worth ₹80,000 doesn't last forever — its cost should be spread across the years it benefits the business.

Method A: Straight Line Method (SLM)

A fixed amount is charged every year — the same rupee amount regardless of the asset's current book value.

Formula:

Annual Depreciation = (Original Cost − Salvage Value) / Useful Life in Years

If no salvage value is given, assume zero.

Example with Sunrise Retail's Computer (SLM):

• Cost: ₹80,000 | Useful life: 5 years | Salvage: ₹0
• Annual depreciation = ₹80,000 / 5 = ₹16,000/year = ₹1,333/month

Method B: Written Down Value (WDV)

A fixed percentage is applied to the current book value each year. Early years have higher depreciation, later years have lower. This better matches how assets actually lose value — rapidly at first, then slowly.

Formula:

Annual Depreciation = Opening Book Value × Rate%

Sunrise Retail uses WDV for all assets:

Furniture: ₹1,50,000 @ 10% WDV

Computer: ₹80,000 @ 40% WDV

April 30 Depreciation Journal Entry:

Type 6 — Bad Debts and Provision for Bad Debts

When a debtor cannot pay, the amount is written off as a bad debt (loss).

Bad Debt Written Off:

Dr  Bad Debts A/c           ₹X
    Cr  Debtor's A/c             ₹X

Since we don't always know which debts will go bad, we create a Provision for Doubtful Debts based on a percentage of debtors:

Or if creating the provision initially:

Dr  Bad Debts (Provision) A/c   ₹X
    Cr  Provision for Doubtful Debts  ₹X

Sunrise Retail: CloudStore Online has an outstanding balance of ₹3,89,400 from April 12. If Sunrise Retail learns CloudStore is in financial difficulty and estimates 5% may not be recoverable:

Provision = 5% × ₹3,89,400 = ₹19,470

Account	Dr (₹)	Cr (₹)
Bad Debts Provision A/c	19,470
To Provision for Doubtful Debts		19,470

Type 7 — Closing Stock Adjustment

At the end of a period, unsold stock is physically counted and valued. This closing stock must be:

1. Removed from the Trading Account (as it reduces Cost of Goods Sold)
2. Added to the Balance Sheet (as a current asset)

Entry:

Dr  Closing Stock A/c        ₹X
    Cr  Trading A/c               ₹X

Sunrise Retail: After April transactions, remaining phones: 50 (opening) + 100 (purchased) − 30 (sold to Digital Hub) − 20 (sold to CloudStore) = 100 phones.

Valued at cost: 100 × ₹12,000 = ₹12,00,000

Account	Dr (₹)	Cr (₹)
Closing Stock A/c	12,00,000
To Trading A/c		12,00,000

Note: In Tally with inventory, closing stock is automatically calculated — no manual entry needed.

SLM vs WDV — Side-by-Side on Sunrise Retail's Computer

The same ₹80,000 computer under both methods over 5 years — notice how depreciation behaves:

━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━
  COMPUTER — ₹80,000 | SLM Rate 20%/year | WDV Rate 40%/year
━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━
                     SLM (20% on cost)        WDV (40% on BV)
              ─────────────────────── ───────────────────────────
Year    BV         Dep      BV after    BV         Dep      BV after
─────  ────────  ───────  ────────   ────────  ───────  ────────
  1    ₹80,000  ₹16,000  ₹64,000    ₹80,000  ₹32,000  ₹48,000
  2    ₹64,000  ₹16,000  ₹48,000    ₹48,000  ₹19,200  ₹28,800
  3    ₹48,000  ₹16,000  ₹32,000    ₹28,800  ₹11,520  ₹17,280
  4    ₹32,000  ₹16,000  ₹16,000    ₹17,280  ₹ 6,912  ₹10,368
  5    ₹16,000  ₹16,000  ₹     0    ₹10,368  ₹ 4,147  ₹ 6,221
━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━
Total dep        ₹80,000                      ₹73,779 (never ₹0)

SLM: Equal depreciation every year → asset reaches ₹0 exactly at end
WDV: Higher early, lower later → asset never fully reaches ₹0 (just keeps shrinking)

Which method does Sunrise Retail use? WDV — more conservative, matches how electronics actually lose value (fast in year 1, slower later). Also the default under Indian Income Tax Act (Section 32) for computers and electronics.

April 2025 monthly depreciation:

• Furniture: ₹1,50,000 × 10% / 12 = ₹1,250/month
• Computer: ₹80,000 × 40% / 12 = ₹2,667/month (rounded from ₹2,666.67)
• Total: ₹3,917/month

The 7-Adjustment Decision Tree

Use this to identify which adjustment type applies to any transaction:

Is cash already received or paid?
│
├── YES → Does the cash belong to THIS period?
│         │
│         ├── YES → No adjustment needed (normal transaction)
│         │
│         └── NO → Cash paid for future period?
│                   ├── YES → Prepaid Expense (Type 1) — Dr Prepaid, Cr Expense
│                   └── NO  → Cash received for future service?
│                             └── YES → Unearned Income (Type 4) — Dr Bank, Cr Advance
│
└── NO → Is the income/expense real (incurred this period)?
          │
          ├── Income earned but not received?
          │   └── YES → Accrued Income (Type 3) — Dr Accrued Income, Cr Income
          │
          ├── Expense incurred but not paid?
          │   └── YES → Accrued Expense (Type 2) — Dr Expense, Cr Outstanding
          │
          ├── Asset losing value over time?
          │   └── YES → Depreciation (Type 5) — Dr Depreciation, Cr Fixed Asset
          │
          ├── Debtor cannot pay?
          │   └── YES → Bad Debt (Type 6) — Dr Bad Debts, Cr Debtor
          │
          └── Period ending — count unsold stock?
              └── YES → Closing Stock (Type 7) — Dr Closing Stock, Cr Trading A/c

All Adjustments: Sunrise Retail April 30 Summary

Practice Exercise

Exercise 1: Sunrise Retail pays ₹1,20,000 on May 1 for a one-year insurance policy (May 2025 to April 2026). By March 31, 2026 (year end), how much is a prepaid expense, and what is the adjustment entry?

Exercise 2: Calculate depreciation for Sunrise Retail's Furniture (₹1,50,000 @ 10% WDV) for the first 3 years. Show a complete depreciation schedule.

Adjustment Impact Matrix

A one-glance lookup of every adjustment Sunrise Retail (or any business) will face during final accounts. For each adjustment, the matrix shows the journal entry, the Trading/P&L effect, and the Balance Sheet effect — read across each row to see the full impact.

How to read this matrix in practice:

• Every adjustment hits two statements — the P&L (or Trading A/c) AND the Balance Sheet. This is double-entry in action.
• If an adjustment only seems to hit one side, you've missed something. Re-check.
• Items 7 and 8 (stock loss) are the most error-prone — trainees frequently forget to split insured vs uninsured.
• Items 14 and 15 work in mirror — provisions on debtors are conservative (expected loss), provisions on creditors are anticipatory (expected gain).

Key Terms

Next: Module 6 — Computerised Accounts — Moving from manual accounting to Tally Prime. We create Sunrise Retail as a company in Tally, step by step.