Adjusting entries, also known as account adjustments, are entries made in a company’s general ledger at the conclusion of an accounting period. This might be done monthly, quarterly, or annually.
Adjusting entries exist to guarantee that a company’s financial records remain accurate, presentable, and dependable, and they are often required to fulfil crucial Generally Accepted Accounting Principles (GAAP).
Definition of Adjusting Entries
Adjusting entries, as opposed to entries produced as a consequence of a business’s transactions, are purely focused on internal company events.
At the conclusion of an accounting period, adjusting entries are made to verify that the value of a company’s revenues, costs, obligations, and assets is appropriately accounted for on its financial statement.
Accounts in a firm’s entry journal are often set up in a “unadjusted” manner, and business owners or accountants subsequently apply adjusting entries at the conclusion of each accounting period.
This is done to ensure that the data in a company’s financial statements correctly represent the company’s economic status and prospects, making it more appealing to prospective investors and lenders.
Simply defined, adjusting entries are practical means for a corporation to ensure that it follows the accrual accounting principle, which specifies that revenues and costs must be recorded in the accounting period in which they were earned or expensed, rather than the period in which payment was made.
The most typical accounts that need to be updated are:
Insurance purchased in advance
Depreciation that has accumulated
Wages
Unearned Income
What Is an Adjusting Entry?
Even if you are “adjusting” your company’s financial records, creating an adjusting entry requires a proactive rather than a reactive strategy. This implies you won’t have to travel “back in time” to amend or change any data. Instead, you’ll just create a new entry with the “amended” data.
For example, suppose you sold a service to a client for $500. If you follow GAAP, you would record the acquired revenue when your service was performed, regardless of whether the payment was provided in advance or a few days later.
If, after recording the $500, your client calls and requests a 5% reduction, which you choose to accept, you would create an adjusting entry to decrease your reported revenue by $25 (5% of $500), rather than going back and changing your original $500 number to $475.
This guarantees that you follow the accounting concept of matching (in which all costs reported are “matched” with the revenues that they assist bring in).
This is in place, like other accounting procedures, to assist corporate transparency, credibility, and financial clarity, and it guarantees that your records correctly represent your firm’s finances in the right time period.
You don’t want to be in a scenario where you’ve “paid” for expenditures before they happen, or where you’ve “collected” unearned money before you can utilise it.
When Should You Make Adjusting Entries?
At the conclusion of each accounting period, adjusting entries must be made. As previously said, depending on the corporate entity, this may be done on a monthly, quarterly, or yearly basis.
If you do not amend your entries at the conclusion of each accounting period, your company’s financial statements will be very unreliable and unpresentable. This might severely stifle your company’s future development by reducing the amount of investment alternatives accessible.
Adjusting entries are also an important element of a company’s depreciated assets, therefore failing to complete them might result in a loss of substantial tax benefits.
Accounting Adjustments of Various Types
Accounting adjustments are classified into five types:
Revenue earned
Expenses incurred
Revenue deferred
prepaid expenditure
Depreciation cost
While the distinctions are evident, they all serve the same purpose: they enable company owners and accountants to comply with the “matching” accounting concept, which assures that all revenues and costs are recorded in the time period in which they were created.
Revenue Adjustments Received
Accrued revenue is any income collected by your company in a prior accounting period but not recognised until a subsequent one.
This could include selling a service to a client, performing the service, billing them, and not receiving payment for several months.
In this case, you should have reported all of the expenditures spent as a consequence of selling your service — as well as the revenues that they helped produce — in the month in which you performed (and so earned) them, rather than when you were paid.
Adjustments for Accrued Expenses
Similarly to accumulated revenue, adjustments made on accrued costs correspond to any expenses incurred in a prior accounting period but not paid for until a subsequent one.
If you engage a freelancer to provide a service for your company, the freelancer is entitled to payment as soon as their task is done. This means that your company will have incurred an expense at that time, regardless of when you pay them.
Revenue Adjustments Deferred
Deferred revenue adjustments are made to account for payments received in advance to you by a customer.
Even though you get the money today, if you fulfil your contractual commitments a month from now, you must account for it when recording revenues in your financial statement in line with the accrual principle.
This is because, as in the previous cases, the money you have been paid has not yet been “earned” – at least from an accounting sense. When delivering a product or service, you will almost certainly incur some expenditures (e.g., in connection to human capital, materials, etc.), and these (together with the income that they helped produce) must be accounted for in the appropriate accounting period.
Adjustments to Prepaid Expenses
Prepaid expenses are nearly identical to deferred revenues, with the only real difference being that, rather than receiving funds for a product or service that you have yet to deliver, you are paying for a product or service in advance and then correctly choosing to make a “adjustment” so that it is recorded in the time period that it was used in.
At example, if you decide to pay a year’s worth of rent ahead with your business landlord in August (e.g., for a discount, etc.), it would be erroneous to record that complete price in your monthly financial record, since only a part (1/12th) of that cost would have been “spent.”
As a result, you would record the whole amount as a “prepaid cost,” and then, at the end of each month, you would make an adjustment entry identifying and recording the “used up” component of that expense, updating your financial records appropriately.
Adjustments for Depreciation Expenses
Depreciation may be classified into two types:
Physical deterioration (i.e., depreciation due to frequent use, etc.)
Economic deterioration (i.e., depreciation due to inadequacy or obsoletion)
This type of expense is typically associated with very large purchases, such as equipment or a property lease, and entails making a single payment but dividing its expense over multiple accounting periods, taking into account its decreasing value over time, and ensuring a more accurate representation of a company’s current assets is recorded.