Accounting Adjusting Entries
The accounting cycle can be broken down into several steps, one of which is the accounting adjusting entries phase. Accountants record adjusting journal entries into general ledger accounts. These accounts are prepared at the end of the financial year.
What is an Adjusting Entry?
As mentioned, adjusting entries are made at the end of the period. These entries are made to correct accounts before accountants prepare financial statements. Creating an accounting adjusting entry is the fourth step in the cycle. These entries are commonly used alongside the matching principle to balance revenue and expenses for a given period.
It’s easy to see how and why accounting adjusting entries are made. They are used to change journal entries. These entries are particularly important when discussing numbers that are already recorded for specific periods. These entries represent an irreplaceable step to correctly reflect how businesses make and spend money.
Classification of Adjusting Entries
Adjusting entries are classified into three distinct types;
- Prepayments
- Prepaid expenses, such as money paid ahead of receiving assets
- Unearned revenue, which is money received for services yet to be rendered
- Accruals
- Accrued expenses, which is expenses that have happened but not been recorded yet
- Accrued revenue, which is earned income that has not been recorded yet
- Non-cash expenses/estimates, which cover non-cash items such s debts and depreciation.
Adjusting Journal Entry Examples
Here are some examples of the four main types of adjusting entries;
- Adjusting entries to convert assets to expenses
Companies make cash expenditures to obtain benefits that last for more than a single accounting period. Some examples of this include insurance and rent, office equipment and supplies, and other fixed assets. These expenses are accounted for by debiting an appropriate asset and crediting the cash account. This is referred to as postponing or deferring expenses. The adjusting entry is made at the end of the period to convert the appropriate portion of an asset into an expenditure.
Example;
The Sun Company paid $12,000 in an advance rant on January 1st, 2016. The rental payment covered the full first quarter of the year. The company updates its records monthly as follows;
Original entry on January 1st;
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| Jan. 1, 2016 | Prepaid Rent | 12,000 | 12,000 |
Adjusting entry for January 31st that converts part of the rent (asset) to an expense;
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| Jan. 31, 2016 | Rent Expense | 4,000 | 4,000 |
Given that the advance payment covered a full quarter of rent (three months), the adjusting entry made at the end of the month is made again at the end of the other two months in the quarter.
- Adjusting entries to convert liabilities to revenues
Some companies collect money ahead of time for goods and services to be delivered at a later date. This money is accounted for by debiting cash and crediting the “unearned revenue” liability account. The procedure is known as deferral or postponement of income. The unearned revenue is then converted to earned revenue at the end of the accounting period with adjusting journal entries.
Example:
The Sun Company accepts $200,000 from one of its clients on January 1, 2016. The company provides the client with $20,000 worth of services by the end of the month. If the company were to adjust their accounts at the end of each month, then it would look something like this.
Original entry on January 1st;
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| Jan. 1, 2016 | Cash – Unearned Revenue | 200,000 | 200,000 |
Adjusting entry for January 31st that converts part of the unearned revenue into earned revenue;
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| Jan. 31, 2016 | Unearned revenue – Client Revenue | 20,000 | 20,000 |
- Adjusting entries for accruing unpaid expenses
An unpaid expense is an expense a company has incurred but doesn’t pay for during that period. These expenses are accounted for by creating an adjusting entry at the end of the period. This process is called accruing unpaid expenses.
Example:
The Sun Company pays employee salaries on the fifth of the month. The company pays a total of $10,000 in employee salaries. If the company uses adjusting entries at the end of the month to account for these salaries, then here’s how the books would look at the end of the month;
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| Jan. 31, 2016 | Salaries Expense Salaries Payable |
10,000 | 10,000 |
- Adjusting entries for accruing uncollected revenue
The uncollected revenue for a company is the revenue they earn but don’t collect in a period. This revenue is recorded by adjusting journal entries at the end of the accounting period. This process is called accruing uncollected income.
Example:
The Sun Company provides a client with services worth $40,000 across January. The client is billed for the services next month. The company records the revenue with the following accounting adjusting entry;
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| Jan. 31, 2016 | Accounts Receivable Client Revenue |
40,000 | 40,000 |
After putting together all the adjusting entries, these entries are posted to ledger accounts or directly to an unadjusted trial balance. Posting it to the unadjusted trial balance helps to prepare the adjusted trial balance for a company.
Why Make Adjusting Entries?
No doubt you already understand the importance of making accounting adjusting entries. These entries give you a complete picture of how money moves with your business. You can also make all of the records as and when they are required. These entries also leave room for correction if something changes, such as expenses increase for some reason, such as utility bill hikes.
One way to understand why you should make accounting adjusting entries is to consider what would happen if you didn’t. If you didn’t make these entries, then you wouldn’t be able to;
- Match income with expenses
- Track revenues accurately, which is an issue for any business
- Have accurate financial statements
These problems compound and ultimately mean you file the wrong taxes and make the wrong decisions because you don’t have the right information. You should make these entries because you care about the future of the business. You don’t want to find yourself in financial trouble with the IRS or making bad business moves because you don’t have as much money as you expected.
Who Needs to Make Adjusting Entries?
You could try to keep up with the records by yourself. There’s nothing stopping you from making an accounting adjusting entry, except perhaps your accounting system of choice. Chances are you’re making adjusting entries already if you’re using an accrual system. It’s vital for this system that you make adjustments as necessary.
Adjusting entries are less important for companies operating on a cash basis, but it is recommended that they continue to make these entries anyway. Consider hiring an accountant or bookkeeper who knows their way around the different types of adjusting entries.
Now you understand the importance of these journal entries and can answer the question of “What are adjusting entries?” it’s time you made producing them a habit.
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