Adjusting entries are prepared at the close of an accounting period so that your financial statement captures income and expenses as close to reality as possible. It’s usually done either at month-end or year-end, but not always on an accrual basis.
If you have to adjust entries at the end before closing the books for the year, is this an indication that your books aren’t as accurate as once thought? Dive into adjusting entries in accounting with an in-depth look at how they are made, what they change, and how to minimize their impact on your financial statements.
What are adjusting entries?
Adjusting entries are journal entries in the general ledger at the end of an accounting period. It is the means of accounting for transactions that have already occurred but were not recognized during that period. Many journal entries are recorded through a separate system, like customer invoicing and accounts payable, which comprise most of the daily debits and credits filling a business’s GL.
The end of every fiscal period calls for the preparation of an unadjusted trial balance. This balance represents the amount reflected in each GL account. The balances are checked by the accountant and adjustments are made whenever necessary to account for any transactions that might have been overlooked. Among such, three major ones are accruals and deferrals together with estimates. Accountants use accruals and deferrals to alter the timing of items recorded in the books as required by accounting. Among such are revenue recognition, wherein the accounting record should be made at the time earned rather than when cash is received, and matching, which relates the expenses to associated revenues in the same accounting period. They bring future cash transactions into the current time. They delay them to a later time, like accounts payable. These are estimates usually involving things that don’t involve cash, such as depreciation and amortization. They serve to ensure that value is correctly in assets and liabilities and that revenue and expenses are matched in the correct period. Accrued entries typically have an impact on the corporation’s balance sheet and income statement, so proper entry is fundamental.
You create adjusting journal entries for various reasons at the end of accounting periods, such as accruals, deferrals, or depreciation. The following are some of the most common types of adjusting entries that you can expect to make:
1. Accrued expenses
Accrued expenses, or accrued liabilities, happen when you incur an expense in a pay period but pay for it at some future date. This could happen with repeated bills, such as utilities or payroll. For instance, you might have employees who work all month long but don’t get paid until the first of the next month. Since you are paying for the work done during the prior month, you record an accrued expense.
2. Accrued revenues
Accrued revenue is when you earn money by providing products or services to customers, yet you are paid at a later date. Because it is very important that you record revenues in the proper accounting period accurately, you make an adjusting entry. This occurs frequently with services and interest accrual.
3. Deferred expenses
Deferred or prepaid expenses are amounts companies pay in advance for services or products. Unlike accrued expenses, you make this adjustment to the month in the future when the service occurs. This is common with advertising, advance rent payments, and insurance payments.
4. Deferred revenues
Deferred revenue is when you receive payment for a service you’ve yet to perform or a product you’ve yet to receive. This is common in subscription models or when retail stores sell gift cards. For example, you can receive payment as a gift card but may make the adjustment for the month when the customer redeems their card.
5. Depreciation expenses
Depreciation expenses are when you make a one-time payment to account for equipment’s loss in value. Calculate depreciation by subtracting the original value from the current value of an item. To record this as an adjusting entry, divide this amount by the number of months you’ve used the equipment. You can calculate depreciation in other ways, and how you record this can vary based on your cash and liability.
6. Provisions
Provisions are amounts of money given to a business in order to estimate costs. The most frequent provision is the allowance for doubtful accounts. You might use this if you give credit to customers and expect them to miss payments.
How to Make Adjusting Entries
Adjusting entries follows the basic principles of double-entry accounting. That is, they change the balance of at least two general ledger accounts using debits and credits equal in amount. In companies using manual accounting systems, accountants apply spreadsheets to record adjusting entries.
This can be cumbersome due to the number of adjustments, which then makes many bookkeepers keep off-line “closing checklists” to be organized. Additionally, hands-on procedures make it very hard for accountants to know when the adjustments should be made in subsequent periods.
Companies, on the other hand, which would employ journal-entry software can automatically reverse the adjusting entries later. This can prevent double counting of accrual adjustments, as the accrual transactions are indeed being processed during the processing of invoices or accounts payable. Software can also automate adjusting entries such as depreciation expenses, to occur each accounting period so that they will not be missed.
The following might require adjusting journal entries:
- Accrue wages earned by the employees but not paid to them.
- Accumulate employer contribution of FICA taxes owed.
- Collect property taxes.
- Record the interest cost paid on a mortgage or loan and amortize the loan balance.
- Record prepaid insurance
- Update the books with an inventory on hand at period end
- Accrue interest income earned but not yet received.
- Record depreciation expense
- Adjust for bad debts
- Accrue dividends payable if a corporation
- Keep the income taxes payable when the corporation
- The sale of fixed assets should be recorded.
- Set up an accounts receivable balance if your day-to-day books are maintained on a cash basis.
- Unrecord accounts payable balance in case your books are maintained on a cash basis.
Once all adjusting entries have been accomplished, follow these steps to complete your records for the accounting period:
- Foot the general journal.
- Accumulate the general journal totals on the general ledger.
- Sum the general ledger accounts to get the final adjusted balance for each account.
- Prepare a corrected trial balance using the amounts from the general ledger.
- Prepare the financial statements using the adjusted trial balance.
Types of Accounting Changes
Accounting adjustments are part of the accounting cycle, but they’re made at specific points. They help to make the accounting data more complete, current, and accurate. There are various kinds of accounting adjustments and also variations within each type. Let’s get closer to what that entails.
Accruals
Accruals are transactions that have already taken place, but cash has not yet been exchanged, and the transactions have yet to be included in a firm’s GL. Accountants use adjusting entries to level out this timing difference. For instance, accruals frequently get automatically reversed the subsequent month, as the transaction is completed through normal processing channels that include invoicing to customers and payment of a company’s bills. Accrual adjustments come in two forms: revenue accruals and expense accruals.
It is an accrued revenue that has been earned but the customer hasn’t received a bill. For example, if on March 28, an electrician completed his repair work for a customer in his house but hasn’t sent him a bill by the end of March 31, then a revenue accrual would be reflected to add the revenue to fiscal March. An expense accrual is applied to products that are delivered or services offered when the business has not yet received an invoice. For example, assume that a firm rents an office space in March but only receives the landlord’s bill by April. Then, the business would apply an expense accrual to properly record rent expenses in March.
Latencies
There are deferrals which defer transactions that occur now to a later period of accounting. Two journal entries have to be used when dealing with deferrals; there is the original journal entry recording the transaction then the adjustment to be done later. Like accruals, two types of deferrals are present, these include revenue deferrals and expense deferrals. There is a revenue deferral when a company presents its invoice or obtains remittance from a buyer prior to shipping the goods or performing the services. It is often seen that companies bill customers much faster than they would take to finish the work, especially on longer projects or when retainer fees or deposits are involved. The first entry highlights receipt of the payment. At a later date, it will make an adjusting entry to book revenue when earned. Consider an example of the catering company, which asks for an advance deposit to reserve a future event. It receives such a deposit in February 2023 for an event that is to be held in October 2024.
Whenever the wedding caterer handles the wedding, the money earned is then considered earned. The wedding caterer accounts for this change in books at the October close of 2024 by expensing debt and increasing income.
An expense deferral is an adjusting entry that the company has to do when paying for something before it uses it in real terms. A deferred expense is services or products for which payment was made but are to be consumed later. It is, therefore, an asset. The asset is used up as well as becomes an expense when consumed, and an adjusting entry is necessary in this regard. The most common example is a business’s annual insurance policy that it pays for outright in advance.
Every monthly period of the policy term, one-twelfth of the premium is expensed. The company accrues to record this month’s insurance cost and decreases the prepaid asset by the same. In 2024, every month an accountant makes the following adjusting entry so that the December 31, 2024 debit balance of the deferred expense is nil.
Estimates
Estimates are adjustments to accounts, typically not including cash. They represent the actual worth of what a business owns and owes on its balance sheet. This also covers estimates of future expenses on the income statement, as per the accounting rules that match income with expenses, and exercises the utmost care in verifying the information.
Accounting judgment and methods following GAAP are used by accountants to estimate logically. One of the adjusting entries for estimates is the inventory reserve. Over time, an accountant will realize that some percentages of the inventory they have will not sell. This is because it gets damaged or lost or simply becomes outdated. An adjusting entry to establish (or update) an inventory reserve makes the amount on the balance sheet more accurate concerning reporting and shows an expense on the income statement in the proper period. Depreciation and Amortization Depreciation and amortization are the kinds of adjustment-type entries falling under the more general category of estimates. These are used by accountants to spread the cost of long-lived assets over the life that they are anticipated to be utilized. In general, the term often applied is depreciation for tangible assets like buildings, vehicles, and manufacturing equipment. Amortization is utilized for intangible assets such as patents and licenses. Adjusting entries within the accounting close makes the scheduled, periodic reductions of these assets. The method of determining the value of each entry falls in line with the various rules of GAAP, such as by using the straight-line depreciation method. For instance, consider equipment worth $1.2 million, which would be worthless after 10 years.
Where is change needed in accounting:
Altering entries are usually prepared and checked by your accountant or bookkeeper before they are made to a trial balance. Your bookkeeper sometimes can enter a transaction that occurs regularly, and these entries will be posted automatically every month before the end of the period. Sometimes you need to adjust for each period. Your accountant will give you those adjusting entries to make after the accounting period is over. In each case, make sure that you understand why the entry is made. It does not mean that something is wrong with your bookkeeping practice if you have adjusted entries. If you feel that something is amiss with it, the best thing to do is consult your accountant; they will tell you if some changes need to be made to your bookkeeping processes so that you can avoid more of them.
