What are Adjusting Entries? Meaning and Importance
What are adjusting entries? For every business, there is a time frame (usually a fiscal year) in which a business chooses to prepare its financial statement. Hence, the life of every business is divided into accounting periods, and at the end of each accounting period, adjusting entries are made. Businesses need to make adjusting entries in order to update previously recorded journal entries so that expenses and revenues are recognized at the time they occur.
For instance, assume you bill a client $500 worth of service in December and then they pay you in January or February after the previous accounting period has ended. You have to first record the cash in December into accounts receivable as income expected to be received in the future. Then, when the client pays in February, an adjusting journal entry has to be made to record the receivable as cash. This is one of the types of adjusting entries referred to as accrued revenue.
Adjusting Entries Meaning
These accounting adjustments are caused by small changes in account balances or the passage of time. Hence, the accountant has to examine the trial balance to be able to identify amounts that need to be changed before the preparation of financial statements. Let’s discuss this further for a better understanding; in this article, we will discuss what adjusting entries are, their importance, and everything else you need to understand about making adjusting entries.
Related: General Journal Examples – Entries and Calculations
What are adjusting entries?
An adjusting journal entry is required to properly account for a transaction that started in one accounting period and ended in a later period. After you make the needed accounting adjusting entries in your journals, they’re posted to the general ledger, just like any other accounting entry. These adjusting entries are usually made at the end of an accounting period to accurately allocate expenditure and income to the period in which they actually occurred.
The basis for making adjusting entries is the revenue recognition principle that pertains to accrued and unearned revenues under accrual-basis accounting. According to the matching principle of accrual accounting, revenues, and the associated expenses are recognized in the same accounting period even though the actual cash may be received or paid at a different time. Hence, adjusting entries are made to assign the right amount of revenue and expenses to each accounting period.
In order to understand adjusting entries better, let’s look at an example- in September, an automobile service shop offers their clients repair services but the invoice of $1,500 was raised and sent to the clients after three months. However, in September, the automobile service shop had to record the unbilled revenue into accrued revenue as cash expected to be received. Then when the client sends the payment in November, an adjusting entry had to be made to convert the receivable into revenue. This adjusting entry would look like this:
| Date | Account | Debit | Credit |
|---|---|---|---|
| September 30 | Accrued revenue | $1,500 | |
| Revenue | $1,500 |
| Date | Account | Debit | Credit |
|---|---|---|---|
| November 1 | Accounts receivable | $1,500 | |
| Accrued revenue | $1,500 |
| Date | Account | Debit | Credit |
|---|---|---|---|
| November 10 | Cash | $1,500 | |
| Accounts receivable | $1,500 |
Now, you may be wondering why the automobile service shop had to go through all this hassle and couldn’t just record cash at once when the client sends it. This is because of an accounting principle that businesses have to comply with known as the matching principle which requires that expenses are recognized when they occur (not when they’re paid) and revenue is recognized when earned(not when cash is received).
Types of adjusting entries
There are different types of adjusting entries. Businesses account for adjusting entries any time they conduct sales in a current accounting period and the customers don’t pay until the next accounting period (accrued revenue) or they incur an expense in one accounting period but are billed in the next accounting period (accrued expense).
Businesses can also make adjusting entries when they pay for an expense in advance (prepaid expenses) or when a customer pays for a product or service in advance (deferred revenue). In addition, adjusting entries are entered in the books to record depreciated assets which are necessary for balancing financial records and reporting deductions for tax purposes.
In most cases, accountants categorize adjusting entries into accruals, deferrals, and estimates:
| Accruals | Deferrals | Estimates | |
|---|---|---|---|
| Definition | Accruals are either unbilled revenues that have not been received or unbilled expenses that have not yet been paid; that have not yet been recorded through a standard accounting transaction | Deferrals are either revenues that have been received but have not yet been earned or expenses that have been paid in advance but have not yet been used | Estimates are adjusting entries that record non-cash items |
| Accounts with adjusting entries | Accrued expenses and Accrued revenue | Deferred revenue (or unearned revenue) and Deferred expense (or Prepaid expenses) | Allowance for doubtful accounts, Inventory obsolescence reserve, and Depreciation expense |
See also: Accrued expenses debit or credit?
Importance of adjusting entries
What are adjusting entries and why are they necessary? There are so many reasons why adjusting entries is necessary and important. The majority of companies operate where the actual delivery of goods may be made at a different time than the payment. That is, delivery of goods may be either before payment as in the case of credit or delivery may be after payment as in the case of pre-payment.
Due to this, there are times that companies experience situations whereby one accounting period will end with a transaction still pending. To solve this, adjusting entries will be needed to reconcile the differences in the timing of payments and expenses. Therefore, adjusting journal entries are very important for the purpose of communicating an accurate picture of a company’s finances.
By making adjusting entries, management can have a complete look into the financial statements knowing that everything that occurred during the month has been reported even though the financial part of the transaction would have warranted to have occurred at a later stage. Hence, adjusting entries are important because any financial statements prepared without accounting adjustment would misrepresent the financial health of the company.
You tend to report business transactions accurately in time when you make adjusting entries to your journal. This is essential to help keep track of your receivables and payables and identify the exact profit and loss of the business at the end of the fiscal year. Without taking adjusting entries into consideration, a company’s net income and owner’s equity will be overstated, and its expenses and liabilities will be understated in its financial statements. This means the financial health of the company will be completely distorted.
In conclusion, adjusting entries are important in the financial records of a company in order to update all account balances before the company’s financial statements can be prepared. When preparing financial statements, GAAP requires that companies follow certain rules and guidelines and adjusting entries are definitely an important part of the process. Hence, if they don’t make adjusting entries to their journals, there would have unresolved transactions left in their financial records that are yet to close.
Read about: Adjusting entry for supplies: examples and how to
