Definition of Adjusting Entries
Adjusting entries journal entries that are made in the accounting journals at the end of an accounting period after the preparation of the trial balance. The main objective underlying the adjusting entries is that certain revenues and expenses are required to be matched with the accounting period in which they occurred.
How to Record Adjusting Entries?
The following are some of the steps necessary for recording and adjusting entries:
1. Firstly, the two or more accounts are to be identified which will be impacted due to the transaction under consideration.
- As per the thumb rule, one of the accounts will be from the balance sheet account, e.g., the Prepaid insurance account.
- On the other hand, the other account will be from the income statement account, e.g., the Insurance expense account.
2. Next, one must compete precisely and arrive at the exact amount for the transaction under consideration for the adjusting entry.
3. Next, both the accounts and the required adjustment have to be entered in the general journal.
4. Finally, one must be able to identify and then assign which account has to be debited and which one has to be credited.
Types of Adjusting Entries
Based on the types of financial activities that apply to a business, the adjusting entries can be classified into several types.
A few of the major adjusting entry types are mentioned below:
1. Accrued Revenue
Under accrual accounting, a business is required to recognize all the revenues (including receivables) generated during an accounting period. Consequently, accrued revenues cover items/services that have been delivered/performed, but the payment for the same is yet to be received.
Suppose a vendor prepares sends a bill to the customer for the work completed by him; the vendor may recognize the revenue by recording the adjusting entry for accrued revenue, debiting the receivable account and crediting the revenue account. When the vendor actually receives the payment, the vendor will then adjust the journal entry by debiting cash and crediting the concerned receivable account.
2. Accrued Expense
An accrued expense is the expense that one has incurred during an accounting period but has not paid yet.
Suppose a business firm has to pay wages to the employees at the end of an accounting period, an adjusting journal entry has to be made by debiting the wages expense account and crediting the wages payable account. When the wages are paid, reverse the journal entry by debiting cash and crediting the wages payable account.
3. Unearned Revenue
Unearned revenues or deferred revenue is the cash a business has received for services that have not yet been performed or items that have not yet been delivered. It is recognized as a liability until the item has been delivered or the service has been performed.
Suppose a vendor receives a deposit from one of the customers for services that will be performed over the next couple of months, then the vendor will debit cash and credit the unearned revenue account. Each month as the vendor books the monthly quota of the deposit, he will then make an adjusting journal entry and debit the unearned revenue account, and credit the revenue account.
4. Prepaid Expense
Prepaid expense or deferred expense is an asset that has been already paid for but will get consumed on a future date.
Suppose that one pays the annual premium of the insurance policy, then each month, he will record the monthly portion of the payment for accounting purposes. Basically, he will debit the insurance expense account and credit cash. While preparing the monthly adjusting entries in the journal, he will then debit the insurance expense account and credit the prepaid insurance account.
5. Depreciation
Depreciation is related to fixed assets or plant assets that are utilized in a normal business setup. It is the process of apportioning the cost of an asset (excluding any expected salvage value) over the useful or economic life of the asset. In the case of depreciation, the adjusting entries are prepared in a little different way such that accumulated depreciation is taken into account. The accumulated depreciation account on the balance sheet is also known as a contra-asset account, and it is utilized to capture depreciation expenses. Any increase is recognized as a credit in the accumulated depreciation account. If an asset is purchased, it is depreciated by some amount every accounting period. For that accounting period, an adjusting entry is prepared by debiting the depreciation expense account and crediting the accumulated depreciation account by the same amount.
Suppose office equipment is purchased for $500 with an economic life of five years, salvage value of $50, and it has to be depreciated with the straight-line method. Then, the annual depreciation expense recognized in the income statement is $90 (={$500 – $50} ÷ 5) while the accumulated depreciation at the end of the first year is $90, the second year is $180, and so on so forth.
Relevance and Uses
- It is important to understand the concept of adjusting entries because it allows an accountant to present a more accurate picture of the company’s financial health and performance at the end of the accounting period.
- In this way, all the transactions that have occurred during an accounting period will be reported in the financial statements even if the financial part of the transaction is expected to occur on a future date.
- If a financial statement were prepared without taking into consideration the adjusting entries, then it would be a misrepresentation of the financial health of the company.
Recommended Articles
This has been a guide to Adjusting Entries. Here we discussed how to record Adjusting Entries and their different types with the help of examples. You may also have a look at the following articles to learn more –
