Adjusting Entries

In order to create accurate financial statements, we must create adjusting entries for our expense, revenue, and depreciation accounts.

Adjusting entries are made at the end of an accounting period to properly account for income and expenses not yet recorded in our General Ledger, and should be completed prior to closing the accounting period.

Overview:

Adjusting Entries 9 Steps in the Accounting Cycle (See below Diagram):

an important part of accrual accounting.

Adjusting entries allow us to adjust income and expense totals to more accurately reflect our financial position.

After we prepare our initial trial balance, we can prepare and post our adjusting entries, later running an adjusted trial balance after the journal entries have been posted to our general ledger. The purpose of adjusting entries is to ensure that our financial statements will reflect accurate data.

If adjusting entries are not made, those statements, such as our balance sheet, profit and loss statement, (income statement) and cash flow statement will not be accurate.

Types of Adjusting Journal Entries:

In summary, adjusting journal entries are most commonly accruals, deferrals, and estimates.

Accruals:

Accruals are revenues and expenses that have not been received or paid, respectively, and have not yet been recorded through a standard accounting transaction.

For instance, an accrued expense may be rent that is paid at the end of the month, even though a firm is able to occupy the space at the beginning of the month that has not yet been paid.

Deferrals:

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. 

Unearned revenue, for instance, accounts for money received for goods not yet delivered.

Estimates:

Estimates are adjusting entries that record non-cash items, such as depreciation expense, allowance for doubtful accounts, or the inventory obsolescence reserve.

Note: 

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.

Why Are Adjusting Journal Entries Important?

Because many companies operate where actual delivery of goods may be made at a different time than payment (either beforehand in the case of credit or afterward in the case of prepayment), there are times when one accounting period will end with such a situation still pending.

In such a case, the adjusting journal entries are used to reconcile these differences in the timing of payments as well as expenses. Without adjusting entries to the journal, there would remain unresolved transactions that are yet to close.

Example of an Adjusting Journal Entry:

For example, a company that has a fiscal year ending December 31 takes out a loan from the bank on December 1.

The terms of the loan indicate that interest payments are to be made every three months.

In this case, the company’s first interest payment is to be made March 1.

However, the company still needs to accrue interest expenses for the months of December, January, and February.

Since the firm is set to release its year-end financial statements in January, an adjusting entry is needed to reflect the accrued interest expense for December.

To accurately report the company’s operations and profitability, the accrued interest expense must be recorded on the December income statement, and the liability for the interest payable must be reported on the December balance sheet.

The adjusting entry will debit interest expense and credit interest payable for the amount of interest from December 1 to December 31.

What Is the Purpose of Adjusting Journal Entries?

Adjusting journal entries are used to reconcile transactions that have not yet closed, but which straddle accounting periods. These can be either payments or expenses whereby the payment does not occur at the same time as delivery.

What Are the Types of Adjusting Journal Entries?

The main two types are accruals and deferrals:

Accruals refer to payments or expenses on credit that are still owed, while deferrals refer to prepayments where the products have not yet been delivered.

What Is the Difference Between Cash Accounting and Accrual Accounting?

The primary distinction between cash and accrual accounting is in the timing of when expenses and revenues are recognized.

With cash accounting, this occurs only when money is received for goods or services. Accrual accounting instead allows for a lag between payment and product (e.g., with purchases made on credit).

Who Needs to Make Adjusting Journal Entries?

Companies that use accrual accounting and find themselves in a position where one accounting period transitions to the next must see if any open transactions exist. If so, adjusting journal entries must be made accordingly.

More Detailed Explanation:

1. Revenue will appear too low:

If you earned revenue in the month that has not been accounted for yet, your financial statement revenue totals will be artificially low.

For instance, if Farah provided services on January 31 to three clients, it’s likely that those clients will not be billed for those services until February.

If Farah does not accrue the revenues earned on January 31, she will not be abiding by the revenue recognition principle, which states that revenue must be recognized when it is earned.

2. Expenses may be understated:

As important as it is to recognize revenue properly, it’s equally important to account for all of the expenses that you have incurred during the month.

This is particularly important when accruing payroll expenses as well as any expenses you have incurred during the month that you have not yet been invoiced for.

For example, your computer crashes in late February. A computer repair technician is able to save your data, but as of February 29 you have not yet received an invoice for his services.

In order to account for that expense in the month in which it was incurred, you will need to accrue it, and later reverse the journal entry when you receive the invoice from the technician.

3. Financial statements will not be accurate:

At the end of each month, you should run financial statements: a balance sheet, profit and loss or income statement, and a cash flow statement.

Used to make any closing entries, it’s important that these statements reflect the true financial position of your company.

Types of Adjusting Entries:

There are five main types of adjusting entries that you or your bookkeeper will need to make monthly. All five of these entries will directly impact both your revenue and expense accounts. They are:

1. Accrued Revenues:

Accrued revenue is revenue that has been recognized by the business, but the customer has not yet been billed. Accrued revenue is particularly common in-service related businesses, since services can be performed up to several months prior to a customer being invoiced.

Revenue must be accrued, otherwise revenue totals would be significantly understated, particularly in comparison to expenses for the period.

For example, Jameel owns a CPA firm. His firm does a great deal of business consulting, with some consulting jobs taking months.

Jameel will want to accrue the revenue earned in those months before he is able to bill his clients, otherwise his expenses will appear quite high on his income statement, while his revenue will be artificially low.

2. Accrued Expenses:

An accrued expense is an expense that has been incurred before it has been paid.

For example, Taimur owns a small supermarket, and pays his employers bi-weekly. In March, Taimur’s pay dates for his employees were March 13 and March 27.

However, his employees will work two additional days in March that were not included in the March 27 payroll.

Taimur will have to accrue that expense, since his employees will not be paid for those two days until April. Payroll expenses are usually entered as a reversing entry, so that the accrual can be reversed when the actual expenses are paid.

3. Deferred Revenues:

Deferred revenue is used when your company receives a payment in advance of work that has not been completed. This can often be the case for professional firms that work on a retainer, such as a law firm or CA / CPA firm.

In many cases, a client may pay in advance for work that is to be done over a specific period of time. When the revenue is later earned, the journal entry is reversed.

4. Prepaid Expenses:

Prepaid expenses also need to be recorded as an adjusting entry.

For instance, if you decide to prepay your rent in January for the entire year, you will need to record the expense each month for the next 12 months in order to account for the rental payment properly.

If you don’t, your financial statements will reflect an abnormally high rental expense in January, followed by no rental expenses at all for the following months.

5. Depreciation Expenses:

Depreciation expense and accumulated depreciation will need to be posted in order to properly expense the useful life of any fixed asset.

Depreciation is always a fixed cost, and does not negatively affect your cash flow statement, but your balance sheet would show accumulated depreciation as a contra account under fixed assets.

How to Prepare Your Adjusting Entries:

Each adjusting entry will be prepared slight differently.

Here are examples on how to record each type of adjusting entry.

Step 1: Recording Accrued Revenue:

Any time that you perform a service and have not been able to invoice your customer, you will need to record the amount of the revenue earned as accrued revenue.

For Example, Jamshaid owns a cleaning service. He bills his clients for a month of services at the beginning of the following month.

His bill for January is AED.2,000, but since he won’t be billing until February 1, he will have to make an adjusting entry to accrue the AED.2,000 in revenue he earned for the month of January.

Once Jamshaid bills his client in February, he will have to make the following entry:

The journal entry is completed this way to reverse the accrued revenue, while revenue entry remains the same, since the revenue needs to be recognized in January, the month that it was earned.

Tips for Accruing Revenue:

Accruing revenue is vital for service businesses that typically bill clients after work has been performed and revenue earned.

• Know when to use an accrual account and when to use an accounts receivable account: If you’re using manual journals to record accruals, you can make a journal entry directly to your accounts receivable account. However, if you use accounting software, once you bill your client, the invoice balance will be posted automatically to the accounts receivable balance, overstating the balance.
• Don’t forget to reverse your accruals: If Jamshaid didn’t reverse his original entry, his revenue account would be overstated.

Step 2: Recording Accrued Expenses:

Payroll is the most common expense that will need an adjusting entry at the end of the month, particularly if you pay your employees bi-weekly.

Any hours worked in the current month that will not be paid until the following month must be accrued as an expense.

Here is the journal entry for recording accrued payroll expenses:

Tips for Accruing Expenses:

Be aware that there are other expenses that may need to be accrued, such as any product or service received without an invoice being provided.

• Make sure that you include all expenses: While payroll is one of the easier expenses to remember to accrue, it’s important that you remember to accrue any expense that has occurred prior to receiving an invoice.
• Remember to reverse accrued payroll expenses: You can set up your payroll accrual to reverse automatically.

Step 3: Recording Deferred Revenue:

If your business typically receives payments from customers in advance, you will have to defer the revenue until it’s earned.

For example, your business offers security services. One of your customers pays you AED.3,000 in advance for six months of services.

Since the revenue has not yet been earned, it has to be deferred. Here is the journal entry for recording the initial payment:

For the next six months, you will need to record AED.500 in revenue until the deferred revenue balance is zero.

Tips for recording Deferred Revenue:

If you receive payment in advance for services that have not yet been performed, the payment must be posted as deferred revenue, with a monthly journal entry necessary until the prepaid revenue has been earned.

• Payment for more than one month must be deferred: If you receive a payment for two months, the second month’s payment must be deferred.
• Create a recurring journal entry: Create a recurring journal entry for advance payments, so you don’t have to remember to process a journal entry each month.

Step 4: Recording Prepaid Expenses:

Prepaid expenses are handled like deferred revenue.

For instance, you decide to prepay your rent for the year, writing a check for AED.12,000 to your landlord that covers rent for the entire year.

Since you don’t want to take a AED.12,000 expense in January, you will place the AED.12,000 in a prepaid rent account, and expense it each month for the next 12 months. Your initial journal entry would look like this:

For the next 12 months, you will need to record AED.1,000 in rent expenses and reduce your prepaid rent account accordingly.

Tips for recording Prepaid Expenses:

Common prepaid expenses include rent and professional service payments made to accountants and attorneys, as well as service contracts.

• Make it recurring: If you’re using accounting software, be sure and make the journal entry recurring for the next 12 months.
• Be sure to record all prepayments: Anytime you pay for more than one month of a service, the expense should be divided up between the months that the payment covers.

Step 5: Recording Depreciation Expenses:

Any time you purchase a big-ticket item, you should also be recording accumulated depreciation and your monthly depreciation expense. Most small business owners choose straight-line depreciation to depreciate fixed assets since it’s the easiest method to track.

For instance, if you purchase an item for AED.5,000, with a useful life of five years and a salvage value of AED.1,000, you can depreciate the asset for five years. based on the number of years that asset will last, making your monthly depreciation total AED.66.67 per month for five years.

To record depreciation, your journal entry would be:

This journal entry can be recurring, as your depreciation expense will not change for the next 60 months, unless the asset is sold.

Tips for recording Depreciation Expense:

Here are a few ways to make recording depreciation expenses easier:

• Make your journal entries recurring: If you’re using accounting software, you can choose to make your depreciation expense journal entries recurring, eliminating the need to enter them each month.
• Create a spreadsheet: Unless you’re using high-end accounting software or your software includes a fixed assets module, chances are that the application does not calculate your depreciation expense for you. To make it easier to track expenses, especially if using a depreciation method other than straight-line, create a spreadsheet of upcoming depreciation expenses for the year.

Prepare Your Adjusting Entries:

Whether you’re posting in manual ledgers, using spreadsheet software, or have an accounting software application, you will need to create your journal entries manually.

The easiest way to do this is by using accounting software, which makes it much easier to track entries, create automatic reversing entries and recurring entries, and help ensure more accurate financial statements.

Once you complete your adjusting journal entries, remember to run an adjusted trial balance, which is used to create closing entries.

Adjusting Entries are Vital:

In order to have an accurate picture of the financial health of your business, you need to make adjusting entries. How can you convince a potential investor to invest in your business if your financial statements are inaccurate?

How can we prepare financial projections for the coming months if we don’t have an accurate picture of what our monthly revenue and operating expenses are?

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