When $1,200 is paid, it is recorded as an asset called Prepaid Insurance. At year end, an adjustment is made to transfer $400 from the Prepaid Insurance to the Insurance Expense account. Although $1200 was paid only $400 is claimed as expense for the current year.
Adjustments for depreciation of various fixed assets are also made only at the year end. Depreciation represents the portion of a fixed asset used up in the current year.
Certain expenses like the Home Office and Vehicle are recorded normally as total for Business and Personal use. However, the Personal use portions must be separated out at the year end.
Many other adjustments are required for correctly representing the expenses and income for the year. If management decisions are to be right, they must be based on correct information. Returns to be filed several times a year, e.g. for HST, WSIB and Payroll, are prepared through the year from the journals. However year’s last return is prepared only after the account balances have been adjusted.
Thus the annual returns if prepared without year end adjustments are likely to be incorrect and if audited, may result in much additional tax, penalties and interest.