What are adjusting entries? Why are they necessary for preparing final accounts?
Adjusting entries are those entries that are recorded at the end of an accounting period to give effect to the various adjustments arising out of the accrual basis of accounting. These entries are essential to update the accounts before preparing the final statements.
The necessity for these entries arises because the process of determining income is based on the accrual basis of accounting. This basis emphasises that while ascertaining profitability, revenues must be considered on an earned basis rather than on a receipt basis, and expenses must be considered on an incurred basis rather than on a paid basis.
Furthermore, adjustments are necessary for items that are not recorded on a day-to-day basis, such as depreciation on fixed assets, interest on capital, and closing stock. We also need to adjust for outstanding expenses, prepaid expenses, accrued income, and income received in advance to account for the correct amounts applicable to the current accounting period.
Ultimately, the purpose of recording adjusting entries is to ensure that the final accounts reveal the true profit or loss of the business for the year. It is also necessary to present a correct and true financial position of the business through the Balance Sheet, ensuring a proper distinction between capital and revenue items.
Explanation
The answer is derived from the 'Summary with Reference to Learning Objectives' and the introductory paragraphs of Chapter 9 in the provided context. It defines adjusting entries based on the summary's explicit definition. It explains the necessity by citing the text's emphasis on the 'accrual basis of accounting' (matching revenues earned vs. received and expenses incurred vs. paid). It includes the specific examples listed in the text (depreciation, outstanding expenses, etc.) and concludes with the text's stated purpose: to reveal the 'true profit or loss' and 'true financial position'.