What are Adjusting Journal Entries?
Definition: An adjusting journal entry is an adjustment recorded at the end of an accounting period to an asset or liability account and related expense or income accounts to record business events that occurred in the period but were not recorded. In other words, it’s an end-of-period adjustment made to record prepaid expenses, unearned income, accrued expenses, accrued revenue, and non-cash activities. All of these different adjustments arise from business events that took place in the current period but were not actually recorded in the accounting system.
What Does Adjusting Entries Mean?
Recording adjusting journal entries is one of the major steps in the accounting cycle before the books are closed for the period and financial statements are issued. According to the matching principle, revenues and expenses must be matched in the period in which they were incurred. This means that expenses that helped generate revenues should be recorded in the same period as the related revenues.
The purpose of adjusting entries is to convert cash transactions into the accrual accounting method. Accrual accounting is based on the revenue recognition principle that seeks to recognize revenue in the period in which it was earned, rather than the period in which cash is received. As an example, assume a construction company begins construction in one period but does not invoice the customer until the work is complete in six months. The construction company will need to do an adjusting journal entry at the end of each of the months to recognize revenue for 1/6 of the amount that will be invoiced at the six-month point.
An adjusting journal entry involves an income statement account (revenue or expense) along with a balance sheet account (asset or liability). It typically relates to the balance sheet accounts for accumulated depreciation, allowance for doubtful accounts, accrued expenses, accrued income, prepaid expenses, deferred revenue, and unearned revenue. Income statement accounts that may need to be adjusted include interest expense, insurance expense, depreciation expense, and revenue. The entries are made in accordance with the matching principle to match expenses to the related revenue in the same accounting period. The adjustments made in journal entries are carried over to the general ledger which flows through to the financial statements.
In summary, adjusting journal entries are most commonly accruals, deferrals, and estimates. Accruals are revenues and expenses that have not been received or paid, respectively, and have not yet been recorded through a standard accounting transaction. Deferrals refer to revenues and expenses that have been received or paid in advance, respectively, and have been recorded, but have not yet been earned or used. Estimates are adjusting entries that record non-cash items, such as depreciation expense, allowance for doubtful accounts, or the inventory obsolescence reserve.
Not all journal entries recorded at the end of an accounting period are adjusting entries. For example, an entry to record a purchase of equipment on the last day of an accounting period is not an adjusting entry.
Depreciation is a good example of a non-cash activity where expenses are matched with revenues. When a company purchases a vehicle, the car isn’t immediately expensed because it will be used over many accounting periods. Instead, it is capitalized and reported on the balance sheet.
The company will use this car to generate revenues in future periods. Thus, the cost and expense of this car should be recognized in future periods when the income is earned.
At the end of each accounting period, an adjusting entry is made to record the current year’s vehicle cost allocation by debiting depreciation expense and crediting accumulated depreciation. Without this adjustment, the current year’s income wouldn’t be matched against the current year’s expenses.
The other adjusting entries are used to adjust asset and liability accounts to match revenues and expenses in the same way.
Why adjusting entries are needed
In order for a company’s financial statements to be complete and to reflect the accrual method of accounting, adjusting entries must be processed before the financial statements are issued. Here are three situations that describe why adjusting entries are needed:
Not all of a company’s financial transactions that pertain to an accounting period will have been processed by the accounting software as of the end of the accounting period. For example, the bill for the electricity used during December might not arrive until January 10. (The reason for the 10-day lag is that the electric utility reads the meters on January 1 in order to compute the electricity actually used in December. Next the utility has to prepare the bill and mail it to the company.)
Sometimes a bill is processed during the accounting period, but the amount represents the expense for one or more future accounting periods. For example, the bill for the insurance on the company’s vehicles might be $6,000 and covers the six-month period of January 1 through June 30. If the company is required to pay the $6,000 in advance at the end of December, the expense needs to be deferred so that $1,000 will appear on each of the monthly income statements for January through June.
Something similar to Situation 2 occurs when a company purchases equipment to be used in the business. Let’s assume that the equipment is acquired, paid for, and put into service on May 1. However, the equipment is expected to be used for ten years. If the cost of the equipment is $120,000 and will have no salvage value, then each month’s income statement needs to report $1,000 for 120 months in order to report depreciation expense under the straight-line method.
These three situations illustrate why adjusting entries need to be entered in the accounting software in order to have accurate financial statements. Unfortunately the accounting software cannot compute the amounts needed for the adjusting entries. A bookkeeper or accountant must review the situations and then determine the amounts needed in each adjusting entry.
Purpose of Adjusting Entries
The purpose of adjusting entries is to accurately assign revenues and expenses to the accounting period in which they occurred.
Whenever you record your accounting journal transactions, they should be done in real time. If you’re using an accrual accounting system, money doesn’t necessarily change hands at that time of the accounting entry; the purpose of adjusting entries is to show when the money was officially transferred, and to convert your real-time entries to entries that accurately reflect your accrual accounting system.
5 Types of Adjusting Entries
Each month, accountants make adjusting entries before publishing the final version of the monthly financial statements. The five following entries are the most common, although companies might have other adjusting entries such as allowances for doubtful accounts, for example.
- Accrued Revenues: If you perform a service for a customer in one month but don’t bill the customer until the next month, you would make an adjusting entry showing the revenue in the month you performed the service. You would debit accounts receivable and credit service revenue.
- Accrued Expenses: A good example of accrued expenses is wages paid to employees. When a business firm owes wages to employees at the end of an accounting period, they make an adjusting entry by debiting wage expenses and crediting wages payable.
- Unearned Revenues: Unearned revenues refer to payments for goods to be delivered in the future or services to be performed. If you place an order from an online retailer in February and the item does not arrive (and you don’t pay for it) until March, the company from which you placed the order would record the cost of that item as unearned revenue. During the month which you made the purchase, the company would make an adjusting entry debiting unearned revenue and crediting revenue.
- Prepaid Expenses: Prepaid expenses are assets that are paid for and then gradually used during the accounting period, such as office supplies. A company buys and pays for office supplies, and as they are depleted, they become an expense. During the month when the office supplies are used, an adjusting entry is made to debit office supply expense and credit prepaid office supplies.
- Depreciation: Depreciation is the process of allocating the cost of an asset, such as a building or a piece of equipment, over the serviceable or economic life of the asset. Adjusting entries are a little different for depreciation. Business owners have to take accumulated depreciation into account. Accumulated depreciation is the accumulated depreciation of a company’s assets over the life of the company.
The accumulated depreciation account on the balance sheet is called a contra-asset account, and it’s used to record depreciation expenses. When an asset is purchased, it depreciates by some amount every month. For that month, an adjusting entry is made to debit depreciation expense and credit accumulated depreciation by the same amount.
- Adjusting journal entries are used to record transactions that have occurred but have not yet been appropriately recorded in accordance with the accrual method of accounting.
- Adjusting journal entries are recorded in a company’s general ledger at the end of an accounting period to abide by the matching and revenue recognition principles.
- The most common types of adjusting journal entries are accruals, deferrals, and estimates.