Adjusting entries are journal entries (which is why they are sometimes called adjusting journal entries) that are made at the end of the financial reporting period to correct the accounts for the preparation of financial statements. They are used to implement the matching principle, which is the concept to match the revenues and expenses to the “right” period. Show
The Accounting Cycle ExampleThroughout this series on the accounting cycle, we will look at an example business, Bob’s Donut Shoppe, Inc., to help understand the concepts of each part of the accounting cycle. Below is the complete list of accounting cycle tutorials:
We also have an accompanying spreadsheet which shows you an example of each step. Click here to download the Accounting Cycle template Types of Adjusting EntriesThe three types of adjusting entries are given below:
Each of the above adjusting entries is used to match revenues and expenses to the current period. Imagine Company XYZ takes out a bank loan in October 2018 and the first repayment occurs after six months in April 2019. The company prepares its financial statements in December 2018 and needs to account for the interest expense due for the two months, November 2018 and December 2018. Although the total interest expense will not be paid until April 2019, the company must still accrue the two months interest expense as it is incurred in the current reporting period. This is also called accrual accounting. The methodology states that the expenses are matched with the revenues in the period in which they are incurred and not when the cash exchanges hands. Why are Adjusting Entries NecessaryFor each category of adjusting entry, we will go into detail and investigate why these are necessary to make at the end of the accounting cycle. PrepaymentsThis category would include both prepaid expenses and unearned revenues. Prepaid expenses include goods or services that a company has paid for but not utilized yet. Insurance is a good example of a prepaid expense. These are prepaid for a minimum of six months. However, the company cannot take full benefit of it until the end of that six-month period. At the end of the accounting period, only expenses that are incurred in the current period are booked while the remaining is recorded under prepaid expenses. Unearned revenue is payment from the customer for services which have not yet been rendered. Therefore, in a sense, the company owes the customer and must record this as a liability for the current period rather than an income. In the next accounting period, once services have been provided to the customers for the advance payment, the company can go on to book this as revenue. AccrualsOn many occasions, a company will incur expenses but won’t have to pay them until the next period. For instance, utility expenses for December would not be paid until January. It must be booked in December irrespective of when the actual cash is paid out. Therefore, in the accounting books at the end of December, utility expense for one month is shown as a liability due. Revenue can be accrued as well if a sale is made on account and the customer has not paid yet. For example, in December, a company makes a sale to a customer and gives him a three-month credit period to pay in full. Therefore, in the accounting books at the end of December, sales revenue would be recorded despite not being paid for. Non-Cash ExpensesAdjusting entries are also used to record non-cash expenses such as depreciation, amortization, etc. These are paper expenses for which there is no cash outlay. They are recorded at the end of the accounting period and closely relate to the matching principle. Recording Adjusting EntriesThere are three simple steps required to record an adjusting entry:
These adjusting entries are created in the general journal, posted to their respective t-accounts and then to the accounting worksheet in the subsequent step of the accounting cycle. Adjusting Entries ExampleContinuing with our example of Bob and his company, Bob’s Donut Shoppe, Inc., we need to adjust his unadjusted trial balance at the end of the accounting cycle. In Bob’s case, he likes to prepare financial statements on a monthly basis. The following are some of the month-end events for which he would like to make adjusting entries for:
Important Points to RememberThere are two key points to highlight as a summarizing note for when adjusting entries are necessary:
An adjusting entry will always reflect on the:
Next StepAfter all adjusting entries have been recorded, the company moves on to prepare an adjusted trial balance. FAQs1. What is an adjusting (journal) entry?Adjusting entries are journal entries made at the end of an accounting period to correct the books for any accruals or deferrals that have taken place during that period. 2. What are examples of adjusting entries?Some typical adjusting entries might include accruing revenue that has been earned but not yet received or recording a prepaid expense that will be used up in the near future. 3. What are the types of adjusting entries?There are three types of adjusting entries: 4. What is the purpose of adjusting entries?Adjusting entries are necessary to ensure that the financial statements presented are accurate and in accordance with Generally Accepted Accounting Principles (GAAP). It is also used to convert cash basis accounting to accrual basis accounting. 5. Who needs to make adjusting entries?All entities that use accrual basis accounting need to make adjusting entries in order to correctly reflect the financial position of the company. This includes for-profit businesses, not-for-profit organizations, and governments at all levels. |