This site contains affiliate links to products and services. We may receive a commission for purchases made through these links.
Adjusting Entries
Accountants keep the accounting books of a business. Every month certain transactions must be recorded to update and correct the figures to be reported as part of the financial statements. Those transactions are known as adjusting entries, every accountant must understand its use and proper recording. The use of adjusting entries are most employed when working with revenue and expense recognition principles.
The trial balance that summarize the transactions requires certain adjusting entries to present the financial results with accurate and complete data. The following holds true about the need of adjusting entries;
- Several financial transactions are not recorded daily; for example, the use of supplies.
- Certain costs expire with the passage of time; for example, insurance.
- Some transactions must be estimated and recorded when not available at closing the month; for example, an utility bill.
Adjusting entries are required every time a company prepares its financial statements. Every adjusting entry has one (or more) income statement account and one (or more) balance sheet account.
Types of Adjusting Entries
There are two categories of adjusting entries: deferrals or accruals.
- Deferrals are:
- Prepaid expenses – expenses paid in cash before they are used or consumed.
- Unearned revenues – cash received before services are performed.
- Accruals are:
- Accrued revenues – revenues for services performed but not yet received payment (cash).
- Accrued expenses – expenses incurred but not yet paid (cash).
Discussion of Deferrals
Prepaid expenses arise when companies record payments of expenses that will benefit more than one accounting period. Initially the recording is debiting a prepaid account, which is an asset since because the benefit will be in the future as a form of an expense, when consumed. Example of common prepayments are insurance, supplies, and rent. A common characteristic is that prepayments are costs that will expire the passage of time or use. The necessity of an adjusting entry for this category is the prepaid asset recorded at the beginning of the period is overstated and the related expense is understated; thus the adjusting entry is recorded to increase the expense and decrease the asset.
A typical entry will look like this:
Beginning of the accounting period:
(debit) Prepaid insurance $1,200
(credit) Cash $1,200
For annual insurance coverage.
End of the accounting period (adjusting entry)
(debit) Insurance Expense $100
(credit) Prepaid insurance $100
To record adjustment of insurance for one month.
Unearned revenues arise when companies receive payments for services before services are performed. The company will record a liability by increasing an account called unearned revenues. Thus, the company recognizes that it has receive cash for services not performed and it has a liability of its books, not a revenue. Example of those possible unearned revenues are rents, customer deposits, and tuition deposits. Unearned revenues must be adjusted when services are performed, since the liability has been fulfilled and the revenue can be recognized. At the end of the accounting period, an adjusting entry is necessary since the liabilities (unearned) is overstated and the revenues are understated. The adjusting entry necessary to update the financial information is debiting (decreasing) unearned revenue and crediting (increasing) the revenue account.
A typical entry will look like this:
Beginning of the accounting period:
(debit) Cash $3,000
(credit) Unearned revenue $3,000
For monthly rent receipt.
End of the accounting period (adjusting entry)
(debit) Unearned revenue $3,000
(credit) Rent revenue $3,000
To record revenue earned for rent.
Discussion of Accruals
Accrued revenues are services performed but not yet recorded at the statement date. An example of accrued revenues are interest, since interest is calculated over time and its receipt may not be at the time of the financial statement date. In addition, services rendered but not payment received is another example. At the end of the accounting period both the assets and the revenues are understated. Thus an adjusting entry is required to correct by recording an accrual journal entry. The adjusting entry will increase the asset side by debiting accounts receivable and increasing the revenues side by crediting the revenues account.
A typical entry will look like this:
- During a month a service provider, performed services to clients worth $2,000 and were not billed.
End of the accounting period (adjusting entry)
(debit) Accounts receivable $2,000
(credit) Service revenue $2,000
To record service revenue performed but not billed.
Please note that this are services performed and not billed; if billed then no adjusting entry needed since the billing process must have already recorded this transaction during the accounting period.
In some other period (payment received)
(debit) Cash $2,000
(credit) Accounts receivable $2,000
To record receipt of cash on account.
Note that when cash is received on payment for the related service, it only affects the accounts receivable account, not the revenue.
Accrued expenses incurred but not yet paid or recorded at the end of the financial statement date. Examples of accrued expenses: interest, taxes, and salaries. At the end of the accounting period date both liabilities and expenses are understated; thus, requiring an adjusting entry. The adjusting entry will increase (debit) an expense account and an increase (credit) to a liability account.
A typical entry will look like this:
Beginning of the accounting period:
Event- You have a loan payable that accrue interest but you pay interest every three months; and the monthly interest is $100 and you will pay $300 (simple, for example purposes only)
End of one accounting period (adjusting entry)
(debit) Interest expense $100
(credit) Interest payable $100
To record interest on loan payable
At payment date (three months), the transaction will look at this:
(debit) Interest payable $300
(credit) Cash $300
To record interest payment on loan payable. Please note that on payment date the interest payable is the only account affected, not the interest expense.
In Summary:
Adjusting entries are divided in two categories, and there are four types of adjusting entries. When recording adjusting entries keep in mind that always you will record one (or more) balance sheet accounts and one (or more) income statement accounts.