Lesson 1, Topic 1
In Progress

5.1. Adjust claim and update amounts

ryanrori January 23, 2021

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Adjusting Entries

Before financial statements are prepared, additional journal entries, called adjusting entries, are made to ensure that the company’s financial records adhere to the revenue recognition and matching principles. Adjusting entries are necessary because a single transaction may affect revenues or expenses in more than one accounting period and also because all transactions have not necessarily been documented during the period.

Each adjusting entry usually affects one income statement account (a revenue or expense account) and one balance sheet account (an asset or liability account). For example, suppose a company has a R1,000 debit balance in its supplies account at the end of a month, but a count of supplies on hand finds only R300 of them remaining. Since supplies worth R700 have been used up, the supplies account requires a R700 adjustment so assets are not overstated, and the supplies expense account requires a R700 adjustment so expenses are not understated.

Adjustments fall into one of five categories: accrued revenues, accrued expenses, unearned revenues, prepaid expenses, and depreciation.

How are Financial Statements Adjusted for a Business Valuation?

In order to review financial statements for a business valuation, the financial statements must be adjusted to remove items that are unique to the current business or which do not accurately represent the business value on a continuing basis. These adjustments typically include the following:

  • Assets which are not part of operations are removed from the balance sheet. For example, assets like a corporate jet are not intrinsic to the continuing operations of a business, or these assets may be taken out of the deal by the owner.
  • Excess cash is removed from the balance sheet, if the cash will not be part of the deal. In many cases, the buyer wants the cash and will ask that it be retained. This is a negotiating point.
  • Non-recurring income items and expenses are removed from the Income Statement (P&L). For example, a one-time sale of assets, close down of a location, costs for a lawsuit, and a one-time gain on a sale of a building might be taken out of the Income Statement.
  • Wages, salaries, benefits, and rental income are adjusted for current levels.
  • Owner salaries are often taken out, since these are discretionary and may not be continued by a new owner.

Taking out discretionary, non-recurring, and non-operating items from the balance sheet and income statement make the company’s financial statements much more realistic, for a potential owner to review.