Adjustments to draft financial statements

Draft financial statements are the initial versions of the Statement of Profit or Loss and Statement of Financial Position, prepared from the trial balance. They are a 'first draft' and almost always need changes. These changes, called adjustments, are made at the end of an accounting period to ensure the final accounts present a 'true and fair view' of the business's performance and position. Adjustments are necessary to apply key accounting principles, like the matching principle, and to correct any errors discovered after the trial balance was prepared.

Errors in bookkeeping can occur. Some errors, like an error of principle (e.g., treating a capital expense as revenue expense), won't cause the trial balance to disagree. However, other errors, such as posting to only one account, will create a difference between the debit and credit totals. To make the trial balance 'balance' temporarily, the difference is placed in a suspense account. This account is then cleared by posting correcting journal entries once the errors are found. The final balance on the suspense account should be zero.

The matching principle dictates that expenses should be recognised in the period they are incurred, not when they are paid. This leads to two key adjustments:

1. Accruals (or Accrued Expenses): These are expenses the business has used up but has not yet paid for by the year-end (e.g., an electricity bill for December that arrives in January). We must record this expense and a corresponding liability (Accruals). The double entry is Dr Expense, Cr Accruals.
2. Prepayments (or Prepaid Expenses): These are expenses paid for in advance, where the benefit extends into the next accounting period (e.g., paying a full year's insurance premium six months before the year-end). The portion that relates to the next period is not an expense of this year; it is an asset (Prepayments). The double entry is Dr Prepayments, Cr Expense.

Non-current assets (like vehicles, machinery, and buildings) lose value over time due to wear and tear, obsolescence, or usage. Depreciation is the process of allocating the cost of a non-current asset over its useful economic life. It is an application of the matching principle, matching the asset's cost to the revenues it helps generate. The two main methods are:

• Straight-Line Method: A fixed amount or percentage of the asset's cost is charged as depreciation each year. This results in the same depreciation charge annually.
• Reducing (or Diminishing) Balance Method: A fixed percentage is applied to the asset's Net Book Value (NBV) each year. This results in a higher depreciation charge in the early years and a lower charge in later years.

Businesses that sell on credit face the risk that some customers (trade receivables) will not pay what they owe. An 'irrecoverable debt' (or bad debt) is a specific debt that is known to be uncollectible, for example, because the customer has gone bankrupt. It must be written off as an expense. A 'doubtful debt' is a debt where there is uncertainty about its collection. Due to the prudence concept, businesses should not overstate their assets. Therefore, they create a 'provision for doubtful debts', which is an estimate of future irrecoverable debts from the current list of receivables. This provision is usually a percentage of total trade receivables. The movement (increase or decrease) in the provision is recorded as an expense or income in the Statement of Profit or Loss.

IAS 10 deals with how to handle events that occur between the date of the Statement of Financial Position (the 'reporting date') and the date the financial statements are officially authorised for issue. It splits these events into two types:

1. Adjusting Events: These provide evidence of conditions that *existed at* the reporting date. The financial statements must be adjusted to reflect these events. Examples include a major customer going bankrupt shortly after year-end (confirming their debt was already doubtful at year-end) or the discovery of a significant error or fraud that occurred during the year.
2. Non-Adjusting Events: These indicate conditions that *arose after* the reporting date. The financial statements are not adjusted for these events. However, if they are material (significant enough to influence users' decisions), they must be disclosed in the notes to the accounts. Examples include a fire destroying assets after the year-end or a major business acquisition.

The ultimate goal of making adjustments is to arrive at the correct profit (or loss) for the period and a true and fair Statement of Financial Position. Each adjustment must be carefully considered for its impact. A useful technique is to prepare a 'Statement of Adjusted Profit'. You start with the draft profit and then systematically add or subtract the effect of each adjustment. Remember that any adjustment to an income or expense account will affect profit. Any adjustment to an asset or liability account will affect the Statement of Financial Position. Many adjustments affect both.