Understanding adjusting entries in accounting

Understanding adjusting entries in accounting

While summing up the financial year, it is important to get your accounting balance straight. Therefore, you should consider making adjusting entries. Without them, your final figure for the account can become inaccurate. Thus, to avoid inaccuracies and know the exact revenue generated by your business in the accounting year, it is important to record the adjusting journal entries.

Adjusting entries are the entries for the revenue and expenses that have yet to be recorded in the general ledger. And these are made by the end of the accounting period. 

What are the adjusting entries?

Adjusting journal entries are accumulated at the end of the accounting period and tell a business about their accurate bank balances. Without them, the financial total of the account remains incomplete. These are the transactions of expenses that are made at a later or advanced period in the accounting period. Therefore, these entries adjust unpaid or advanced paid expenditures into the total balance to make an accurate sense of the final bank balance.

The adjusting entries are the applications of accrued accounting.

Let us try to understand these entries through some simple examples.

  • When a company pays its employees after the end of the accounting year, for example, an engineer gets paid his salary for March in April. Then, the company will enter the amount paid to the engineer in its adjusting Journal. This is because the salary still comes under the accounting year. 
  • When a person is paid after providing a service, for example, a painter gets fully paid after delivering his artwork. Therefore, if the painter takes up the project in January and the timeline for completing the work is in March, he/she will get paid in March. But, this entry of expense will be recorded in adjusting entries in January, for the accurate earning and spending of the painter on the project.

Why are adjusting entries necessary?

The importance of such entries is that they make sure your accounts remain accurate. These are made up of accruals, deferrals, and estimates. Thus, it helps in creating a clear picture of the revenue generated by a business. These are also used to make corrections to accounting mistakes. If any amount is mistakenly missed or the sum of expenses is wrong, adjusting entries play their part in clearing out the fog from the hidden expenses or earnings as well as the entries that have not been recorded on the general ledger yet.

Types of adjusting entries with examples

The types of adjusting entries consist of accruals, deferrals, and estimates. 

Accruals

In accruals, there are two sub-categories – accrual revenue and accrual expense.

Accrual revenue

Accrual revenue is the adjusting entry when a payment for a service or product has to be received. In simple words, when a company renders a service but the customer pays the company only after the delivery of the product. The entries for the receivable amount and actual transaction need to be recorded in the adjusting journal entries.

For example, if a painter gets an order to paint a house in three months and the total expense that he’ll incur after completing the work is $3000. Then, each month’s earnings correspond to $1000 per month. But, the customer will not pay until the end of the task. So, in this way, the receivable revenue for each month needs to be recorded as $1000. Otherwise, the painter’s earnings for the previous 2 months will be $0 as compared to last month’s $3000. 

Therefore, the accrual entered needs to be made in journal entries as debiting the receivable into accounts and crediting the revenue of service into accounts.

Accrual revenue is mostly the part of the business that gets paid after their services. For example, engineering projects, construction projects, and so on.

Accrual expense

An accrual expense is when the company hasn’t paid for a service yet but will make the payment in the future. In accrual expense, the expenses that occurred are not yet recorded on the balance sheet of a company. This means that when a company purchases or makes use of a service, it pays for it after a certain period.

Examples of accrual expenses are salaries and bonuses given to the employees, and the interest rate to be paid by the company on the loan taken. 

To put it in simple language, let’s assume a company pays a salary to its employee in January for the work that he/she did in December. The money paid to the employee for the current period is received in the following period. So, here a mismatch can happen while noting the entries at the end of the accounting period because the employee will get only 11 months of salary from the company. Therefore, to omit such confusion, the amount paid in January is recorded in the adjusting entries. 

The accrual expenses are made by debiting the accounts payable account and crediting the cash account.

Deferrals

Deferral has two further sub-categories: deferral expense and deferral revenue.

Deferral expense (prepaid expense)

When a business makes payment in advance and the paid service is used for a long period, it is known as deferral expense. A deferral expense is also known as a prepaid expense because the payment is made upfront for the services yet to be used. At first, these prepayments are considered assets, but as time progresses and the assets are used, these items convert into expenses.

Examples of deferral expenses are rent paid for a whole year, purchasing office stationery for six months, and so on.

Let’s take the example of paying rent for the whole year. A company pays rent of $24,000 in January in advance; in July, the actual expense of the rent will be $7,000. But, instead of entering the amount for each month on the balance sheet, the whole expense is summed up in the adjusting entry at the end of a period. 

The journal entry for an expense is made at the end of the period. The deferred expenses are made by debiting the expense account and crediting the prepaid account for the expense.

Deferral revenue (unearned expenses)

When a customer pays a company in advance for the services yet to be provided, such transactions come under deferred revenue. This means that a company gets payment before delivering the service or product. 

Examples of deferred revenue are retail e-commerce websites like Amazon and Walmart. Yearly subscriptions to over-the-top streaming platforms such as Netflix, Amazon Prime, and Disney+.

Let’s consider that a company gives an annual subscription for $1,200. The advanced payment by a customer doesn’t get recognized as earnings, but it comes under liabilities. The revenue for that company for each month would be $100. And as time passes, the revenue increases by $100 each month until the end of the 12-month subscription. And the entry in the liabilities (deferral revenue) becomes $0 in the end because it gets converted to the revenue earned.

The entry for deferral revenue is made by debiting the account of unearned revenue and crediting the account of the service revenue.

Depreciation

Depreciation is when some assets companies buy to use for more than one accounting year. The depreciation assets are generally expensive and have a longer lifetime. When a company buys an expensive item, say equipment such as a computer or copying machine, this equipment works for at least five to six years. Therefore, expenses for these assets are depreciated over time as they are used.

For example, if a company buys laptops for office use, the total amount it spends on the laptop will match the whole lifetime of the device. This means that the spent value for the laptops will get expensed with the continuous use of these laptops.

Other examples of depreciation are assets like buildings, vehicles, devices, furniture, and so on.

How to prepare adjusting entries

Each type of adjusting entry is recorded differently based on the transactions.

Preparing Accrued Revenue

When a customer has to pay for a service done by a business,

For example, a painter painting a house charges $3000 for three months of his service. When he starts work in January, then the accrual revenue entry for the month in the data sheet will be;

DateAccount DebitCredit
1-31-2022Accrued revenue$3000

Revenue
$3000

And once he gets paid in March, the entry will get reversed to

DateAccountDebitCredit
4-1-2022Account receivable $3000

Accrued revenue
$3000

Preparing Accrued Expenses

Say if a company pays a salary to its employee, and his monthly salary is $4,000. The salary paid to the employee in February is the salary for the month of February. Therefore, the adjusted entry for January will be filled in as

Date AccountDebitCredit
1-1-2022Salary expense$4000

Salary payable
$4000

However, once the salary is paid in February the entries get reversed.

Date AccountDebitCredit
2-10-2022Salary payable$4000

Salary expense
$4000

Preparing deferred revenue

If a customer pays a company for a six-month service in advance, the transaction made doesn’t come under revenue until the service is completed. If the advance cash paid is $6,000 for six months, then each month’s income equals $1,000. This income of $1000 gets entered into the datasheet of the company with the proceeding of the service.

So, the entry for deferred revenue for the first month will look like this.

Date AccountDebitCredit
1-1-2022Cash $6000

Deferred revenue
$6000

For the next month, 

Date AccountDebitCredit
2-1-2022Deferred revenue$1000

Service revenue
$1000

Preparing deferred expense (prepaid expense)

Suppose a tenant pays his rent for the whole year in advance. Then, the prepaid expense needs to be divided into 12 months to get the earning income for each month. Therefore, the deferred expense entry for the first month will be prepared as given below.

DateAccount DebitCredit
1-1-2022Prepaid rent$12000

Cash
$12000

The deferred expense entry for next month will be

DateAccountDebitCredit
12-1-2022Rent expense$1000

Prepaid rent
$1000

Preparing for depreciation

Suppose a company bought some laptops for the office. And the total expense that the company paid at one time was $5000. Then, as this investment by the company is going to be used in the long run, the expense of the items is depreciated with the usage time. 

So, if these laptops work for five years, and then, for each year, the expenses will be $1000, and for a month, it will round up to 83.3. 

So, for the beginning month (say, April 1, 2022), the depreciation entry will be

Date AccountDebit Credit
4-1-2022Depreciation expense$83.3

Accumulated depreciation
$83.3

Who must make the adjusting entries?

The bookkeeper and accountant of a company are the ones who are responsible for creating adjusting entries. They calculate and adjust entries for each period and use them at the end of the accounting period. However, businesses with cash-basis accounting don’t need to adjust journal entries. 

Financial analysts also take the help of adjusting journal entries to study the probability of future revenue and expenses for the companies they work for.

Conclusion

Adjusting entries are the entries made for the expenses and revenue that are paid later or in advance in the business. These describe the accurate picture of a business’s financial state and the precise profit made by an organization. The various types of these entries are used in different forms of business, and each type resolves any inaccuracy in the financial growth of the businesses. 

Frequently asked questions

What is the purpose of adjusting entries?

Adjusting entries tell a business about the profit it makes throughout an accounting period. It also tells us about the accurate growth of the business, and professional financial analysts use these entries to foresee the future revenues and expenses for their companies.

Which accounts don’t require adjusting journal entries?

Fixed assets and drawing accounts, capital accounts don’t need these entries.

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