Adjusting entries follow the matching principle that requires the expenses and revenue to be recorded in the same period when they occur. They are made to keep track of the flow of money in the different accounts of the company.
Adjusting entries also follow the accrual accounting system, where the journal entries are made to make recorded entries at the end of the accounting period.
Just like their names suggest, adjusting entries are passed or recorded whenever you need to inflict a change to an existing journal entry.
This often happens during each accounting cycle and that’s why adjusting entries are often required at the end of each period to ensure that everything in your books is accounted for.
To give a better perspective, let’s break it down with an example. In March, you generated an invoice for the goods sold to the customer for $1,000, but the customer makes the payment in April.
In March, you made the entry in the accounts receivable account on the general journal’s debit side because the nature of the account is an asset.
| Date | Account | Debit $ | Credit $ |
| March 3 | Accounts Receivable | 1,000 | |
| March 3 | Sales on Credit | 1,000 |
In April, when you actually receive the cash amount, the money moves from one asset (Accounts Receivable) into another (Cash). It will look something like this,
| Date | Account | Debit $ | Credit $ |
| April | Cash | 1,000 | |
| April | Accounts Receivable | 1,000 |
In adjusting entry, you don’t have to go back to the original entry to make changes. Adjusting entry makes a new entry where it edits or deletes to make appropriate adjustments into your existing journal entries.
For instance, if we go back to the previous example, you billed the customer with $1,000. But now, you also make the payment of 10% tax deductions on every sale. You’ll have to deduct $100 from your sales as tax expenses.
Why Is There A Need To Make Adjusting Entries?
Adjusting entries are made to ensure that the company’s accounts reflect their actual values at the end of the accounting period. Following the matching principle, the expenses and revenues should be aligned with the current period.
If adjusting entries aren’t made in time, your expenses and revenue won’t be aligned, creating a lot of confusion.The bookkeeper won’t identify whether the expenses are incurred or prepaid or whether the company’s revenue is actually earned or deferred.
In short, the bookkeeper won’t be able to keep track of the money. That will result in incorrect financial statements, which will put your company in a downward spiral since you don’t have the correct numbers to make well-informed decisions.
Who Should Make Adjusting Entries?
If you follow the accrual-based accounting system, you need to make adjusting entries. Otherwise, there is no need to make adjusting journal entries in a cash-based accounting system.
However, if you have a bookkeeper, they will take care of everything relating to your accounting books.
The Differences Among Spreadsheets, Accounting Software, And Bookkeepers
Each of these three types of adjusting entries bookkeeping system will have a different impact on your accounting books.
1. Bookkeeping Using Spreadsheets
Working on the accounting books yourself is a hassle as you have to make all the adjusting entries for the accounting period. There is no room for error in adjusting entries because the accountant will prepare the financial statement for the year based on the entries you provide.
2. Bookkeeping Using Accounting Software
It’s relatively much easier to adjust entries using accounting software as compared to spreadsheets. Nonetheless, the entries on the journal have to be proper and accurate. Otherwise, you won’t be able to get a clear picture of your financial statements.
3. Having a Bookkeeper
The third option you have is to get in touch with a professional online bookkeeping service that will take care of your accounting books. They will make the entries that need adjusting and prepare the financial statements representing the true values of all your accounts.
How Many Types Of Adjusting Entries Are There?
Adjusting entries are of five types, and each of them has a clear distinction from one another. Plus, we’ll try to explain each of them by type of entries they are used for with examples, and scenarios to understand their nature easily.
1. Accrued Revenue
Accrued revenue can either be from sales made on credit or revenue generated that is yet to be received from the customer. You still need to record it in your accounting books.
Example Scenario
You run a business of making leather shoes. In March, you make a sale of $2,000 worth of leather shoes for a customer and billed them to pay on April 5.
When making the leather shoes, you incurred the cost of goods manufactured, operating expenses such as rent, utilities, payroll, and others in the month of March. To reflect the true value of the generated income on credit sales, you need to record the transaction in a journal entry.
Income = Revenue – expenses
Since accrued receivables are your current assets and sales on credit are your revenue, you will earn later. You need to make adjusting entry to record an increase in assets and revenue.
Adjusting Entry Example
When recording entries on your accounting books, you need to record the expected income from the sales on credit.
| Date | Account | Debit $ | Credit $ |
| March 5 | Accrued Receivables | 2,000 | |
| March 5 | Sales on Credit | 2,000 |
Upon receiving the credit amount in April, the Accrued Receivable account amount will be transferred to the Cash account.
| Date | Account | Debit $ | Credit $ |
| April 5 | Cash | 2,000 | |
| April 5 | Accrued Receivables | 2,000 |
2. Accrued Expenses
The concept of Accrued Expenses is quite similar to Accrued Revenue. They are expenses that are incurred first but paid at a later date.
Example Scenario
For instance, you hire a third-party contractor to help you in making leather shoes and the agreement is made that you’ll pay them $100 for their wages in April.
Adjusting Entry Example
You have to record the transaction for the labor expenses to the third-party contractor in the month of March,
| Date | Account | Debit $ | Credit $ |
| March 2 | Labor Expenses | 100 | |
| March 2 | Accrued Expenses | 100 |
Upon paying the third-party contractor in April, you will debit the accrued expenses and credit the cash account.
| Date | Account | Debit $ | Credit $ |
| April 12 | Accrued Expenses | 100 | |
| April 12 | Cash | 100 |
3. Unearned Revenue
As the name suggests, it’s the amount from the client/customer you received, but you haven’t actually earned it yet. It’s also called deferred revenue. You still need to record the transaction in the subsequent adjusting entries.
Example Scenario
In time, your company has become quite popular in making leather shoes in the market. So, now you’re getting payment in advance from the customers to make their shoes in due time.
One of the customers has paid the full amount in advance of $5,000 in June. You have to deliver their leather shoes in August. You have to record the unearned income you received from the customer by making an adjusting entry.
Adjusting Entry Example
Since you have received the unearned revenue, which is a liability, it will be recorded on the adjusting entry’s credit side. On the other hand, you also receive cash in advance, which will be recorded on the debit side, as mentioned below.
| Date | Account | Debit $ | Credit $ |
| June 8 | Cash | 5,000 | |
| June 8 | Unearned revenue | 5,000 |
Then, in August, you’ll transfer the unearned revenue to revenue when you finally deliver the leather shoes to the customer.
| Date | Account | Debit $ | Credit $ |
| August 10 | Unearned revenue | 5,000 | |
| August 10 | Revenue | 5,000 |
4. Prepaid Expenses
This is similar to the concept of unearned revenue and the only difference is that, here, you make the payment in advance to either supplier, rent, or others. The nature of prepaid expenses is assets, which is the opposite of the nature of unearned revenue.
Example Scenario
The leather shoe business has expanded, and now you need a bigger space. So, you rented a new place and decided to make payment in advance for the whole year in January.
Adjusting Entry Example
In January, you’ll record the transaction as a prepaid expense,which will increase the expenses and decrease the Cash from your account.
| Date | Account | Debit $ | Credit $ |
| January 1 | Prepaid Rent | 24,000 | |
| January 1 | Cash | 24,000 |
At the end of January, when you utilize the prepaid rent for the month, You’ll need to transfer the rent of January into expenses.
| Date | Account | Debit $ | Credit $ |
| January 31 | Rent Expense | 2.000 | |
| January 31 | Prepaid Rent | 2,000 |
5. Depreciation Expenses
When a fixed asset depreciates, it turns into an expense that you need to pay and record on multiple accounting periods throughout its life. Adjusting entry for depreciation expenses occurs on your business’ fixed assets, including plants, machinery, building, office equipment, and others.
When the accounting period ends, the fixed assets’ accumulated depreciation value is adjusted and recorded on the balance sheet. While depreciation expenses are recorded on your income statements.
Calculating depreciation is a highly complex procedure, especially for expensive assets. There are various methods to calculate depreciation, making it quite difficult to record in the accounting books. Therefore, it’s imperative to consult with a professional accountant before working on your assets’ depreciation.
Conclusion:
Adjusting entries might seem simple but often they quite complex, especially when something comes up during your period that you had no understanding of. For e.g. during the recent Covid 19 pandemic, the government announced stimulus checks to help businesses cover their wages and expenses, but a lot of business owners didn’t know how to pass off an adjusting entry for such a check.
This is where you can seek the support and guidance of online accounting service providers as they can help you through such difficult accounting procedures with incredible ease.
