Inventory adjustments in accounting: concept, importance

Inventory adjustments are one of the main pillars of the accounting system, as they aim to portray the real financial position of the entity at the end of each financial period. These adjustments are accounting procedures performed to amend or correct the balances recorded in the books, so that they reflect the actual results of the financial performance and financial position of the entity, in accordance with generally accepted accounting principles.
In this article, we'll address the importance and basic principles of inventory adjustments, simplifying examples that illustrate how to deal with expenses and revenues due or paid/received in advance.

First: What is meant by inventory settlements?

Inventory adjustments are accounting procedures that are usually performed at the end of a monthly, quarterly, or annual financial period in order to ensure that revenues and expenses are correctly recorded in periods that actually concern them. These reconciliations assist in the preparation of financial statements in a manner that reflects the true financial performance of the entity.

Second: What is the importance of inventory settlements?

The importance of inventory adjustments stems from their role in applying basic accounting principles, the most prominent of which are:

  1. Accrual basis 
    According to this basis, financial operations record income or expenses in the same period in which they occurred, regardless of the timing of payment or receipt. For example, if a service is provided in December and is not received for it until January, revenue is recorded in December. 

  2. Cash basis
    Unlike accrual basis, cash basis is based on recording transactions only when cash is received or paid. This basis is used in specific cases, but it is not approved in the preparation of official financial statements because it does not give an accurate picture of the financial performance of the entity. 

  3. The principle of matching revenues with expenses
    This principle requires that the financial period be charged with all expenses that contributed to the revenue, even if they were not actually paid during that period. The goal is to compare returns with associated costs to get an accurate picture of profits or losses. 

  4. Revenue realization principle
    Under this principle, revenue is recorded only when it is actually realized, i.e. when the service is provided or the product is delivered, and not upon receipt of the payment. This sometimes requires the recording of accrued income or the postponement of recognition of income received in advance.

Third: Types of inventory adjustments

  1. Expense adjustment
    Expense adjustment aims to ensure that all expenses related to the financial period are recognized in the same period, whether paid or not. They include two types: 

  2. Accrued expenses
    are expenses for the current financial period but not yet paid, and not recorded in the books. Such as salaries or rent that has not been paid at the end of the month.

Fourth: When are inventory adjustments made?

Inventory adjustments are usually made at the end of each financial period, and the period may be monthly, quarterly, or annual, depending on the nature of the business and the requirements of financial reporting. This procedure is a necessary step before preparing the financial statements to ensure their accuracy and comprehensiveness.

Inventory adjustments are not just a formality, but rather the essence of accurate accounting work that aims to provide a true and comprehensive picture of the financial performance of the entity. By applying accounting principles such as accrual basis and revenue generation, organizations ensure reliable financial reports that reflect reality and help decision-makers make informed decisions.