The revenue recognition principle is the basis for making adjusting entries at the year end. These are necessary to better match the revenues and expenses that occurred during the accounting year. Adjusting entries are used to record the economic events. Examples of adjusting entries are:
A prepaid expense is an economic benefit paid for in advance of its use. We pay insurance premium for a year. If this period does not coincide with the accounting period then at the year end an advance part of the premium is for the next year. We have to adjust this amount of advance payment as Prepayments (or sundry debtors) Account to reflect that the amount is not yet utilised to the benefit of the company but an asset with future benefit yet to be utilise. Unless similar expenditures are adjusted at the year end, the profit for the year is not accurate.
Similarly, expenses incurred during the year but not yet paid must be accounted for by adjusting by charging to the respective expenditure account and temporarily held in credits on the sundry creditors account as if the amount is owed to the external party.
Another kind of year end adjustment is where there is no financial activity to prompt the record of such transactions. Under this category are apportion of depreciations, provision of directors fees, provision for proposed dividends etc.
Notice all these actions of adjusting is just to reflect on the true and fair situation so that the profits, assets and liabilities of the company is fully stated and recorded completely according to the economic and financial effects.