Adjusting Entries – Meaning, Types, Importance And More

Organizations usually make Adjusting Entries on the last day of an accounting period to ensure that the accounts are in line with the accrual method of accounting and the matching principle. As per the accrual concept, a company should recognize income when it earns and not when it receives. Similarly, the company should recognize the expense when it incurs and not when it pays for it. The matching principle, on the other hand, says the company should recognize the expenses when it recognizes the revenue it generates from such expenses.

Adjusting entries are the journal entries and are part of the accounting cycle. Companies usually go for such entries after making the trial balance. If the trial balance does not match, then these entries help the company to fix the discrepancy.

Towards the end of the accounting period, there are income and expense that a company needs to record or update. Thus, these entries help the company to record or update accounts. If the company fails to give adjusting entries, a few incomes, asset, liability may not reflect their true values in the financial statements.

What’s the Need?

Adjusting Entries helps to ensure;

  • The income statement of the company only reports revenues that the company earns during the accounting period.
  • Receivables in the balance sheet reflect the true amount that the company has the right to receive at the end of the accounting period.
  • Income statement includes the expenses and losses that a company incurs during the accounting period.
  • Balance sheet consists of the liabilities that the company incurs as of the end of the accounting period.

Adjusting Entries helps a company:

  • To calculate exact revenues and expense.
  • Update financial statements.
  • To fix an error.

Examples of When Adjusting Entries Are Needed

  • If a company ships good on credit, but didn’t process the sales invoice as of the end of the accounting period.
  • A company receives goods from a supplier, who didn’t send the invoice as of the end of the accounting period.
  • A company pays advance tax for the next accounting period.
  • If a company prepares an income statement on a monthly basis. And, it pays for six months of insurance in the first month only. In this case, the company, in the first month, will show five months of insurance as prepaid.

Adjusting Entries

Types of Adjusting Entries

Adjusting entries are primarily of six types:-

Accrued Revenues

These entries help a business to report all the revenues it earns during the accounting period. There might be a case when a company has already provided a service, but it has not yet got the payment for the same. So, accrual type adjusting entries are shown in the financial statements to account for such revenues.

Accrued Expenses

Just like the accrued income or revenue, a company should only record the expenses that it incurs. A business must report an expense even if it does not pay for it. Take for example; a company hires a worker from on a contract basis. The company is expecting to get an invoice on January 2nd and remit the payment on January 10th. However, the services of the worker were availed in December. Therefore, the company needs to account the expense and liability as of December 31.

Deferred Expense

Deferred expenses are the payment made in the present for future expenses. One must refer these payments as deferred until the expenses expire or the company avails the service. For example, a company pays $10000 on December 25 towards vehicle insurance for the six-month period starting January 1. This means the insurance is prepaid for a period between December 25th and December 31.

Depreciation Expense

It is in relation to the use of a fixed asset in the business. Examples of fixed assets are machinery, equipment, vehicles, furniture and so on. Usually, a company depreciates an asset at a certain rate that has a useful life for more than one year. Through depreciation, the company allocates the cost of the asset as an expense in the accounting periods in which the company uses the asset. For instance, a machine costing $50000 with no salvage value and useful life of 20 years will result in a monthly depreciation expense of $50000/240 (20*12).

Deferred Revenue

If the company receives any amount as advance before earning, it should mention it as a liability in the current accounting period. For instance, a company gets an advance of $5000 for offering a service that it will offer at a later date. As on December 31st, the company should determine the portion of the service that it has already delivered. This portion will come as income, and the balance will be deferred revenue.

Doubtful Accounts or Bad Debts

Not all debtors pay their dues. To account for this, the company makes provision for bad debts, and it needs to update the balance regularly to account for more bad debt or bad debt making payment.

Composition

Adjusting entries affect one real account and at least one nominal account. For the real account (or permanent accounts or balance sheet accounts), an accountant measures the balance cumulatively. Few examples of real account are Cash, Capital, Rent Receivable and more.

For nominal account (temporary accounts or income statement accounts), an accountant measures the balance from period to period. It includes all accounts in the Income Statement and owner’s withdrawal. Some examples are Salaries Expense, Rent Expense, Drawing and more.

A point to note is that not all entries that the company records at the end of an accounting period are adjusting entry. For instance, an entry for sale on the last day of the accounting period does not make it an adjusting. Remember, an adjusting entry will always affect income or expense account one (nominal account).

Last updated on : September 6th, 2019
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