Let's look once again at a Trial balance at the end of an accounting year.
Even though, in reality, an accounting cycle would have thousands of transactions, and hundreds of accounts would appear in the TB, the 15 common accounts plus 6 adjustments accounts of the TB below are sufficient to illustrate the ideas we want to explain.
The accounts shown is blue correspond to the adjustments we have already studied:
Now we turn to the last two types of adjustment we shall learn in this course:
Prepayments: suppose that in the 1500€ of Shop expenses, recorded during the year by the accounting process and which appear in the TB above (because we received invoices and treated them), a part really concerns consumptions which we shall make next year.
Suppose 1000€ are the actual consumptions of this year, and 500€ will be consumed only next year (for instance if we buy at the end of October fuel for 3 months).
Since one of the objectives of accounting is to compute as precisely as possible the charges to be put against the sales in the Income Statement, in order to know exactly the net profit or loss of the year, the charge of 1500€ which appears in the IS below is not correct.
A part of it is a charge of next year.
Accounting mechanics of the adjustment. If the prepayment is 500€, whether we paid it in cash or not, we will make the following double-entry:
we credit the Shop expenses account, with the effect of reducing its balance to 1000€
and we debit a new account called "Prepayments account" which belongs to the Capital accounts (I could have added "BS" next to its name to stress this point). That is, it will be an account recording an asset in the firm (even if it is a short lived asset)
The Trial balance changes then. The Shop expenses (of the year) decrease to 1000€, and a new account "Prepayments" appeared with 500€ in debit.
The IS has evolved too:
Accruals: conversely, suppose that during the accounting cycle we purchased and consumed some things for which we haven't received an invoice from the supplier yet. Then this consumption is not in the accounting system (because the accounting system works only with formal documents – invoices, bills and such like –, from clients and suppliers, accompanying the recording of transactions).
But we know that it should be counted as a charge of the year.
Suppose it is an amount of 100€ of, say, shop expenses again.
Then we shall make an adjustment for this.
Posting accruals. We debit the shop expenses account, and we credit a new account "Accruals" which will belong to the Capital accounts. It will record money we owe a supplier, and we haven't paid yet (not even with an IOU).
The final TB and IS, with all the adjustments, are now these:
We are finished with the study of the various adjustments to be made to the Trial balance in order to have an exact view and record of the consumptions of the accounting cycle.
The next step is to compute the IS (well, it's already quite advanced...). More precisely we shall see a bit of technique to "extract" the IS from the adjusted TB.
And then we shall see how we reach the Balance Sheet, which is a snapshot, at the end of the year, of what the firm owns and what the firm owes.