Adjusting Entries: Enhancing Accuracy in Accounting
What are Adjusting entries in accounting?
Adjusting entries in accounting are essential financial transactions made at the end of an accounting period to ensure that financial statements accurately reflect the company’s financial position and performance. These entries are crucial in accrual accounting, where revenues and expenses are recognized when they are earned or incurred, not when cash transactions occur. Adjusting entries help account for unrecorded transactions, expenses, or revenues that have occurred during the accounting period but have not yet been captured in the general ledger.
Financial statements like balance sheet, income statement or trial balance are prepared based on the below entries to check and adjust. Based on company policy on Revenue recognition principle either Cash Basis or Accrual basis entries are done.
First based on accounting cycle, initial trial balance is prepared with Accumulated Depreciation entries through depreciation accounts, enter and balance operating expenses, Wages expense, Depreciation expenses entries with fixed asset accounts etc with passing Adjustment entries to the closing entries. Accountants would pass entry for Bad debt expense, accounts payable, advance for services and salary etc.
Deferral journal entry likes rent expenses / prepaid rent, salary or wages payment etc are booked this month. But paid during the actual time of payment. Once its done, preparation of trial balance is finalised for financial reporting. Based on Trial balance, the Balance Sheetand Income statement are finalised.
Cash flow Statements are reviewed and if anything to adjust then Adjustment entries are applied on Balance sheet accounts to ensure the financial health of company is presented correctly.
Note: in case you use an accounting software or Enterprise Resource Planning System the many of these adjustments can be avoided. Automation of these process avoids the mistakes.
Why adjusting entries are important in accounting?
Adjusting entries play a vital role in maintaining accurate and transparent financial records. Here are some reasons why adjusting entries are essential in accounting:
Matching Principle
Adjusting entries ensure that revenues and related expenses are matched in the same accounting period, providing a more realistic representation of a company’s profitability.
Accurate Financial Statements
By capturing all relevant revenues and expenses, adjusting entries result in more accurate financial statements, which are vital for making informed business decisions.
Compliance
Properly recorded adjusting entries help businesses comply with accounting principles and standards, providing reliability and credibility to their financial reports.
Tax Reporting
Adjusting entries impact a company’s taxable income, ensuring that the appropriate taxes are paid and reported in accordance with tax regulations.
Give a few Adjusting Journal Entries examples?
Below are the few Adjusting Journal Entries Examples. There are many depending on the business and the type of ERP tool that you use.
a. Prepaid Expenses: If a company has pre-paid insurance for six months, at the end of each month, they will record an adjusting entry to recognize the portion of the insurance expense applicable for that month.
b. Accrued Revenues: When a company provides services or delivers goods but has not yet issued an invoice, they will record an adjusting entry to recognize the revenue earned.
c. Accrued Expenses: Businesses may accrue certain expenses, like salaries or interest, which have been incurred but not yet paid, to reflect the financial obligation.
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Types of Adjusting Journal Entries and Adjusting entries examples
There are four main types of adjusting entries:
Accrued Revenues
Accrued revenues are revenues that have been earned but not yet received or recorded in the accounting books. These entries are made to recognize the revenue in the period it is earned, even if the cash payment is expected to be received in a future period. Accrued revenues are common in businesses that provide services or goods on credit. Here’s an example:
Example: A consulting company provides services to a client throughout the month of December but sends the invoice to the client on January 5th. Since the services were provided in December, the company needs to record the revenue for December by making an adjusting entry:
Journal Entry:
Debit: Accounts Receivable (Asset) – Amount
Credit: Consulting Revenue (Income) – Amount
Accrued Expenses
Accrued expenses are expenses that have been incurred but not yet paid or recorded. These entries are made to recognize the expenses in the period they are incurred, even if the cash payment is expected to be made in a future period. Accrued expenses are common for expenses like salaries, interest, utilities, and taxes. Here’s an example:
Example: A company’s accounting period ends on December 31st, and the company’s employees are paid on the 5th of the following month. The company needs to accrue the salary expenses for the days worked by the employees in December:
Journal Entry:
Debit: Salary Expense (Income Statement) – Amount
Credit: Accrued Salaries (Current Liability) – Amount
Deferred Revenues (Unearned Revenues)
Deferred revenues, also known as unearned revenues, are revenues received in advance for goods or services that are yet to be delivered. These entries are made to recognize the revenue in the period when the goods are delivered or the services are provided. Deferred revenues are common for businesses that receive prepayments or advance payments from customers. Here’s an example:
Example: An IT company receives an advance payment of $1,000 from a client for a software project that will be delivered in two months. To properly account for the advance payment, the company makes the following adjusting entry:
Journal Entry:
Debit: Cash (Asset) – $1,000
Credit: Unearned Revenue (Liability) – $1,000
Deferred Expenses (Prepaid Expenses)
Deferred expenses, also known as prepaid expenses, are expenses paid in advance for goods or services that will be consumed or used in the future. These entries are made to allocate the prepaid expense to the periods in which the goods or services are consumed or used. Deferred expenses are common for items like insurance, rent, and supplies. Here’s an example:
Example: A company pays the annual insurance premium of $3,600 on December 1st for insurance coverage from December 1st to the next November 30th. To allocate the insurance expense to the correct periods, the company makes the following adjusting entry:
Journal Entry:
Debit: Prepaid Insurance (Asset) – $3,600
Credit: Insurance Expense (Income Statement) – $300 (assuming 12 months of insurance coverage)
Understanding and properly recording these types of adjusting entries ensure that financial statements accurately reflect a company’s financial position and performance, providing valuable insights for decision-making and financial analysis.
FAQ on adjusting entries
What are the adjusting entries made in accounting?
Adjusting entries are made at the end of an accounting period, before preparing financial statements.
What happens if adjusting entries are not recorded?
Failure to record adjusting entries can lead to inaccurate financial statements, misrepresentation of revenues and expenses, and incorrect tax reporting.
Are adjusting entries reversible?
While some adjusting entries can be reversed in the next accounting period, others, like accruals, may not be reversed.
Who prepares adjusting entries in a company?
Accountants or financial professionals are responsible for preparing adjusting entries based on the company’s financial data.
Can adjusting entries impact a company’s profitability?
Yes, adjusting entries impact the recognition of revenues and expenses, which directly affect a company’s profitability and financial performance.
Adjusting entries are crucial in accounting as they ensure financial accuracy, adherence to accounting principles, and reliable reporting. By capturing all relevant revenues and expenses, adjusting entries provide businesses with a clearer and more insightful financial picture. Properly recorded adjusting entries help companies make informed decisions, comply with accounting standards, and achieve financial transparency, ultimately contributing to their long-term success.