Adjustments, Trial Balance and Statements
An adjustment connects what the ledger currently records with what should be reported at the period end. To understand it, separate the amount already entered, the balance required and the difference still to record. That distinction explains both the journal entry and its effect on the statements.
The worked example follows Harbour Cycle Supplies, a fictional sole trader, for the year ended 31 December 20X2. All amounts are in pounds. This original case is independent of Northstar and the other practice datasets. Ignore VAT, income tax and interest; assume no other transactions or adjustments. The £20,000 loan falls due more than twelve months after the reporting date.
Follow the workings into the trial balance and then into profit, capital and financial position. If the debit and credit directions are unfamiliar, first review double-entry.
The relationship behind the entries
Prepaid insurance, inventory and equipment all illustrate how a cost can remain in an asset before being recognised as an expense. Their routes into expense differ: insurance follows the coverage period, inventory becomes cost of sales when sold, and depreciation allocates equipment's depreciable cost over its useful life. The accounting method and the business facts determine the route.
An unpaid wage works from the other direction: the employee's work belongs to this period even though payment comes later. Recording the expense and liability together keeps the period's performance connected to the closing financial position. The example below shows why neither an adjustment nor an expense necessarily means a current cash payment.
1. Unadjusted trial balance
This business uses periodic inventory: the inventory account still contains opening inventory, and purchases/returns have separate accounts. No cost-of-sales entry has yet been made. A physical count supplies closing inventory. Do not mix this method with the perpetual-inventory entries in other chapters.
| Account | Debit £ | Credit £ |
|---|---|---|
| Cash | 12,000 | 0 |
| Trade receivables | 18,000 | 0 |
| Opening inventory | 10,000 | 0 |
| Equipment at cost | 40,000 | 0 |
| Purchases | 36,000 | 0 |
| Sales returns | 2,000 | 0 |
| Insurance expense | 6,000 | 0 |
| Wages expense | 14,000 | 0 |
| Utilities expense | 3,000 | 0 |
| Drawings | 4,000 | 0 |
| Opening capital | 0 | 40,000 |
| Bank loan | 0 | 20,000 |
| Trade payables | 0 | 15,000 |
| Sales | 0 | 64,000 |
| Accumulated depreciation | 0 | 4,000 |
| Purchase returns | 0 | 2,000 |
| Total | 145,000 | 145,000 |
Additional information:
- The £6,000 insurance payment covers September 20X2 to February 20X3, six months equally. It was all recorded as expense.
- Wages of £1,000 earned in December will be paid in January and have not been recorded.
- Equipment was available for use throughout this year. Its cost is £40,000, residual value £4,000 and useful life six years. Use straight-line depreciation; the opening accumulated depreciation is already in the trial balance.
- An additional £1,200 of this year's credit purchases was returned before year-end. Neither the return nor the reduction of the outstanding payable has been recorded.
- The inventory count values goods on hand at £12,000 at cost, after the return. Assume no write-down is needed.
2. Reading the worked example
Work through W1–W5 in order, opening the explanations as needed. For each entry, identify the amount already recorded and the required closing balance. Then follow the revised balances into the statements. When revising, close the workings and try to reconstruct them. If totals disagree, trace the difference rather than inserting an unexplained cash or capital balance.
3. Workings and entries
W1–W4: timing, depreciation and returns
| Working | Calculation | Debit | Credit |
|---|---|---|---|
| W1 Insurance | £6,000 × 2/6 = £2,000 belongs to next year; this year's expense is £4,000 | Prepaid insurance £2,000 | Insurance expense £2,000 |
| W2 Wages | £14,000 + £1,000 = £15,000 expense | Wages expense £1,000 | Accrued wages £1,000 |
| W3 Depreciation | (£40,000 − £4,000) / 6 = £6,000; accumulated depreciation becomes £10,000 | Depreciation expense £6,000 | Accumulated depreciation £6,000 |
| W4 Purchase return | Returns become £3,200; payables become £13,800 | Trade payables £1,200 | Purchase returns £1,200 |
None of these four adjustments changes cash at the adjustment date. The insurance has already been paid and the wages will be paid later. Depreciation allocates the equipment's cost, while the purchase return reduces the amount owed on an unpaid invoice.
Depreciation is an allocation of depreciable cost, not a forecast of market value. Do not infer a tax deduction from this simplified accounting calculation. See the IAS 16 overview for the wider recognition and measurement context.
W5: periodic inventory and cost of sales
For this case, one combined adjustment transfers net purchases and updates the inventory balance:
| Account | Debit £ | Credit £ |
|---|---|---|
| Cost of sales | 30,800 | 0 |
| Inventory: increase from £10,000 to £12,000 | 2,000 | 0 |
| Purchase returns: clear the credit balance | 3,200 | 0 |
| Purchases: clear the debit balance | 0 | 36,000 |
| Total | 36,000 | 36,000 |
After this entry, the inventory account shows closing inventory and the adjusted trial balance includes cost of sales. Closing inventory has already been allowed for in that cost-of-sales figure, so deducting it again would misstate profit.
4. Adjusted trial balance
Check all balances after W1–W5
| Account | Debit £ | Credit £ |
|---|---|---|
| Cash | 12,000 | 0 |
| Trade receivables | 18,000 | 0 |
| Closing inventory | 12,000 | 0 |
| Equipment at cost | 40,000 | 0 |
| Prepaid insurance | 2,000 | 0 |
| Cost of sales | 30,800 | 0 |
| Sales returns | 2,000 | 0 |
| Insurance expense | 4,000 | 0 |
| Wages expense | 15,000 | 0 |
| Utilities expense | 3,000 | 0 |
| Depreciation expense | 6,000 | 0 |
| Drawings | 4,000 | 0 |
| Opening capital | 0 | 40,000 |
| Bank loan | 0 | 20,000 |
| Trade payables | 0 | 13,800 |
| Sales | 0 | 64,000 |
| Accumulated depreciation | 0 | 10,000 |
| Accrued wages | 0 | 1,000 |
| Total | 148,800 | 148,800 |
Purchases and purchase returns now have zero balances. Income, expenses and drawings have not yet been closed into capital.
5. Profit, capital and financial position
Reconciled statements
Income statement for the year ended 31 December 20X2
| Item | £ |
|---|---|
| Sales less sales returns: £64,000 − £2,000 | 62,000 |
| Cost of sales | (30,800) |
| Gross profit | 31,200 |
| Insurance | (4,000) |
| Wages | (15,000) |
| Utilities | (3,000) |
| Depreciation | (6,000) |
| Profit for the year | 3,200 |
Capital reconciliation: £40,000 opening capital + £3,200 profit − £4,000 drawings = £39,200 closing capital. Drawings reduce the sole trader's capital; they are not wages or another business expense. A company's dividends and equity presentation require their own treatment.
Statement of financial position at 31 December 20X2
| Item | £ |
|---|---|
| Equipment: £40,000 cost − £10,000 accumulated depreciation | 30,000 |
| Inventory | 12,000 |
| Trade receivables | 18,000 |
| Prepaid insurance | 2,000 |
| Cash | 12,000 |
| Total assets | 74,000 |
| Trade payables, current | 13,800 |
| Accrued wages, current | 1,000 |
| Bank loan, non-current | 20,000 |
| Total liabilities | 34,800 |
| Closing capital | 39,200 |
| Liabilities plus capital | 74,000 |
Profit of £3,200, closing cash of £12,000 and drawings of £4,000 measure different things. To prepare a historical cash-flow statement, you would also need opening cash and the full cash movements. Those details are not supplied and cannot be inferred from profit alone.
6. Independent checks
- If the £1,000 wage accrual were omitted, would the trial balance still agree? State the errors in profit, liabilities and capital.
- Instead of two months, suppose three of the six insurance months belong to next year. Recalculate insurance expense, profit, assets and closing capital; keep every other fact unchanged.
- In a separate mini-case, equipment costs £18,000, residual value is £3,000 and life is five years. Calculate annual straight-line depreciation. Separately, calculate the first two years at 25% reducing balance, assuming the residual-value floor is not reached.
Feedback
- It would still agree. Wages expense and liabilities would be £1,000 too low; profit and closing capital would be £1,000 too high. Cash would be unchanged.
- Prepayment and expense are each £3,000. Profit becomes £4,200; assets £75,000; closing capital £40,200. Liabilities remain £34,800, so the statement still reconciles.
- Straight-line: (£18,000 − £3,000) / 5 = £3,000 per year. Reducing balance: £4,500 in year 1, then £13,500 × 25% = £3,375 in year 2; closing carrying amount is £10,125. Do not subtract both methods from the same asset.
What to retain and where to go next
The trial balance checks equality of debits and credits; the statements organise those balances by purpose. Neither check proves that every event has been recorded in the correct period. The omitted-wages example remains balanced precisely because both sides of the adjustment are missing.
Take that distinction into financial-statement analysis: a ratio inherits the recognition and measurement choices in its inputs. To understand why an asset's reported amount can change for reasons beyond cost allocation, continue with measurement and adjustments.