Adjusting entries definition
/What are Adjusting Entries?
Adjusting entries are journal entries recorded at the end of an accounting period to alter the ending balances in various general ledger accounts. These entries are used to produce financial statements under the accrual basis of accounting. A business may use relatively few adjusting entries to produce its monthly financial statements, and substantially more of them when creating its year-end statements. The reason for this disparity is that the external auditors require a higher degree of precision in the year-end financial statements that they are examining, and this calls for more adjusting entries.
Why Make Adjusting Entries?
These adjustments are made to more closely align the reported results and financial position of a business with the requirements of an accounting framework, such as GAAP or IFRS. This generally involves the matching of revenues to expenses under the matching principle, and so impacts reported revenue and expense levels. In essence, the intent is to use adjusting entries to produce more accurate financial statements.
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When to Make Adjusting Entries
The use of adjusting journal entries is a key part of the period closing processing, as noted in the accounting cycle, where a preliminary trial balance is converted into a final trial balance. It is usually not possible to create financial statements that are fully in compliance with accounting standards without the use of adjusting entries. Thus, adjusting entries are created at the end of a reporting period, such as at the end of a month, quarter, or year.
Types of Adjusting Entries
An adjusting entry can used for any type of accounting transaction; here are some of the more common ones:
To record depreciation and amortization for the period
To record an allowance for doubtful accounts
To record a reserve for obsolete inventory
To record a reserve for sales returns
To record the impairment of an asset
To record an asset retirement obligation
To record a warranty reserve
To record any accrued revenue
To record previously billed but unearned revenue as a liability
To record any accrued expenses
To record any previously paid but unused expenditures as prepaid expenses
To adjust cash balances for any reconciling items noted in the bank reconciliation
When you record an accrual, deferral, or estimate journal entry, it usually impacts an asset or liability account. For example, if you accrue an expense, this also increases a liability account. Or, if you defer revenue recognition to a later period, this also increases a liability account. Thus, adjusting entries impact the balance sheet, not just the income statement.
Types of Adjusting Entries
As shown in the preceding list, adjusting entries are most commonly of three types. The first is the accrual entry, which is used to record a revenue or expense that has not yet been recorded through a standard accounting transaction. The second is the deferral entry, which is used to defer a revenue or expense that has been recorded, but which has not yet been earned or used. The final type is the estimate, which is used to estimate the amount of a reserve, such as the allowance for doubtful accounts or the inventory obsolescence reserve.
Reversing Entries
Since adjusting entries so frequently involve accruals and deferrals, it is customary to set up these entries as reversing entries. This means that the computer system automatically creates an exactly opposite journal entry at the beginning of the next accounting period. By doing so, the effect of an adjusting entry is eliminated when viewed over two accounting periods.
Adjusting Entry Best Practices
A company usually has a standard set of potential adjusting entries, for which it should evaluate the need at the end of every accounting period. These entries should be listed in the standard closing checklist. Also, consider constructing a journal entry template for each adjusting entry in the accounting software, so there is no need to reconstruct them every month. The standard adjusting entries used should be reevaluated from time to time, in case adjustments are needed to reflect changes in the underlying business.
Examples of Adjusting Entries
Depreciation: Arnold Corporation records the $12,000 of depreciation associated with its fixed assets during the month. The entry is:
| Debit | Credit | |
| Depreciation expense | 12,000 | |
| Accumulated depreciation |
12,000 |
Allowance for bad debts: Arnold Corporation adds $5,000 to its allowance for doubtful accounts. The entry is:
| Debit | Credit | |
| Bad debts expense |
5,000 | |
| Allowance for doubtful accounts |
5,000 |
Accrued revenue: Arnold Corporation accrues $50,000 of earned but unbilled revenue. The entry is:
| Debit | Credit | |
| Accounts receivable - accrued |
50,000 | |
| Sales |
50,000 |
Billed but unearned revenue: Arnold Corporation bills a customer for $10,000, but has not yet earned the revenue, so it creates an adjusting entry to record the billed amount as a liability. The entry is:
| Debit | Credit | |
| Sales |
10,000 | |
| Unearned sales (liability) |
10,000 |
Accrued expenses: A supplier is late in sending Arnold Corporation a materials-related invoice for $22,000, so the company accrues the expense. The entry is:
| Debit | Credit | |
| Cost of goods sold (expense) |
22,000 | |
| Accrued expenses (liability) |
22,000 |
Prepaid assets: Arnold Corporation pays $30,000 toward the next month's rent. The company records this as a prepaid expense. The entry is:
| Debit | Credit | |
| Prepaid expenses (asset) |
30,000 | |
| Rent expense |
30,000 |