Types of adjusting entries
/What is an Adjusting Entry?
Adjusting entries are used to adjust the ending balances in various general ledger accounts. These journal entries are intended to bring the financial statements of the reporting entity into compliance with the applicable accounting framework (such as GAAP or IFRS). There are three general types of adjusting entries, which are noted below.
Characteristics of Adjusting Entries
The key characteristics of adjusting entries are noted below:
Timing and frequency. Adjusting entries are made at the end of an accounting period before financial statements are prepared. They ensure that revenues and expenses are recognized in the correct period according to the accrual basis of accounting. Typically, these entries are recorded during the month-end, quarter-end, or year-end closing process.
Non-cash nature. Most adjusting entries do not involve cash transactions. They are used to allocate existing cash flows to the appropriate accounting periods, such as accruing unpaid expenses or recognizing earned but unbilled revenue. This characteristic distinguishes adjusting entries from regular, cash-based transactions.
Impact on financial statements. Adjusting entries affect both the income statement and balance sheet accounts simultaneously. For example, an entry might increase an expense account (income statement) and decrease a prepaid expense account (balance sheet). This dual impact ensures that financial statements reflect the true financial position of the business.
Use of accrual and deferral principles. Adjusting entries are used to record accrued revenues and expenses (amounts earned or incurred but not yet recorded) and deferrals (prepaid expenses and unearned revenues that need to be adjusted). These principles ensure that revenues are recognized when earned and expenses when incurred, not when cash changes hands.
Absence of source documents. Unlike regular journal entries that are based on source documents (like invoices or receipts), adjusting entries are based on estimates and accounting principles. For instance, depreciation expense is calculated based on useful life and salvage value, without a direct source document.
Reversibility. Certain adjusting entries, especially those involving accrued revenues and expenses, can be reversed at the beginning of the next accounting period. Reversing entries simplify bookkeeping by offsetting the original adjusting entry, making it easier to record cash transactions in the new period.
Necessity for accurate financial statements. Adjusting entries are essential for ensuring that financial statements comply with GAAP or IFRS and accurately reflect the company’s financial performance and position. Without them, revenues and expenses might be misstated, leading to misleading financial information.
These characteristics highlight the role of adjusting entries in achieving accurate, compliant, and reliable financial reporting.
Accrual Entries
An accrual entry is the most commonly-used adjusting entry. It is intended to record revenues or expenses that have not yet been recorded through a standard accounting transaction. Here are several examples of accrual entries:
Recognition of unbilled revenue. A company is constrained by a contractual arrangement with a government customer to not bill for services work until the end of a contract period. In the interim, the company accrues revenue, so that it can recognize some revenue from the contract, even though the contractual period has not yet been completed.
Recognition of unbilled expense. A company controller decides to accrue the expense associated with a significant delivery of goods, and for which no supplier invoice has yet arrived. The intent is to ensure that the cost of the goods is recorded in the financial statements for the period in which the goods arrived.
Related AccountingTools Courses
Deferral Entries
A deferral entry is intended to defer the recognition of a revenue transaction that has not been earned, or an expense transaction that has not yet been consumed. The outcome is the shifting of revenue or expense recognition to a future period. Here are several examples of deferral entries:
Deferral of revenue recognition. A customer pays in advance for a services contract that will be performed in equal installments over the next four months. A deferral adjusting entry can be used to shift 3/4 of the payment into the following three periods, when they will be recognized.
Deferral of expense recognition. A company pays the full-year $12,000 cost of a life insurance policy in advance, and uses a deferral entry to shift the recognition of 11/12 of this amount into the next 11 reporting periods.
Estimation Entries
An estimation adjusting entry is used to adjust the balance in a reserve. This is done in order to maintain adequate reserve levels that reasonably the reflect the amount of losses from existing assets that can be expected in future periods. This entry is usually based on a historical analysis of losses, and assumes that the same pattern of losses will extend into the future. Types of estimation entries are as follows:
Adjust the balance in the allowance for doubtful accounts
Adjust the balance in the reserve for obsolete inventory
Adjust the balance in the reserve for warranty claims
Who Uses Adjusting Entries?
Adjusting entries are a common part of the closing process for any business using accrual basis accounting. They are typically not used when a business is using cash basis accounting.
Related Articles
Examples of Key Journal Entries