Adjusting Entries Definition
Unlike entries made as a result of a business’s transactions, adjusting entries are solely focused on internal company events.
At the end of a specified accounting period, adjusting entries are carried out to ensure that the value of a business’s: revenues, expenses, liabilities, and assets is accounted for correctly on that company’s financial statement.
Accounts in a business’s entry journal are commonly established in an “unadjusted” format, and business owners or accountants then implement adjusting entries towards the end of an accounting period.
This is done to confirm that figures within a business’s financial statements accurately reflect the economic situation and prospects of that business, which can then make it more attractive to potential investors and lenders.
Simply put, adjusting entries are tangible ways of making sure that a business satisfies the accrual accounting principle, which states that revenues and expenses need to be recorded in the accounting period in which they were earned or expensed, rather than in the period in which payment was actually made.
The most commonly seen accounts that need to be adjusted relate to:
- Prepaid insurance
- Accumulated depreciation
- Unearned Revenue
How Do I Make an Adjusting Entry?
Even though you are “adjusting” your business’s financial records, making an adjusting entry involves a proactive approach rather than a reactive one. This means that you will not need to go “back in time” to correct or alter any data. Instead, you will merely input a new entry with the “amended” data.
For example, imagine you sold a service to a customer for a price of $500. If you are conforming with GAAP, you would record the acquired revenue after your service has been completed, regardless of whether the payment was made in advance or a couple of days later.
If, after you have already recorded the $500, your customer calls and asks for a 5% discount — which you choose to agree to — you would make an adjusting entry to reduce your accounted revenue by $25 (5% of $500), rather than go back and change your initial $500 figure to $475.
This ensures you conform with the matching principle of accounting (whereby all expenses recorded are “matched” with the revenues that they help bring in).
Like most accounting measures, this is in place to facilitate company transparency, credibility, and financial clarity, and it ensures that your books accurately reflect your company’s finances in the correct time period.
You do not want to be in a situation where you have “paid” for expenses before they have occurred or where you have “collected” unearned revenue before you can actually use it.
When to Make Adjusting Entries
Adjusting entries need to be made at the end of each accounting period. As we have noted above, this can be done on a monthly, quarterly, or annual basis depending on the business entity in question.
Failing to adjust your entries at the end of each accounting period will mean that your company’s financial statements are heavily unreliable and unpresentable. This can significantly bottleneck your business’s future growth by limiting the number of investment opportunities available.
Adjusting entries are also an essential part of a business’s depreciated assets, so not doing them can mean that you miss out on valuable tax deductions.
Different Kinds of Accounting Adjustments
There are five types of accounting adjustments:
- Accrued revenue
- Accrued expense
- Deferred revenue
- Prepaid expense
- Depreciation expense
While the difference between them is relatively clear, they all serve the same purpose: they allow business owners and accountants to satisfy the “matching” accounting principle, which ensures that all revenues and expenses are recorded in the time period that they were generated.
Accrued Revenue Adjustments
Accrued revenue is any revenue that your business has earned in a previous accounting time period but that you have not recognized until a later one.
This could involve selling a service to a client, performing the service, invoicing them, but not actually receiving payment for several months.
In such a situation, you would preferably have recorded all of the expenses which you incurred as a result of selling your service — and the revenues that they helped generate — in the month in which you performed (and thus earned) them, and not when you actually got paid.
Accrued Expense Adjustments
Similarly to accrued revenue, adjustments made on accrued expenses related to any expenses which have been generated in a previous accounting time period but for which payment was not sent until a consequent one.
If you hire a freelancer to carry out a service for your business, then as soon as that freelancer has completed their work, they are entitled to payment. This means that your company will have generated an expense at that point in time regardless of when you actually pay them.
Deferred Revenue Adjustments
Deferred revenue adjustments are made to account for payments which are made to you in advance by a client.
Even though you may receive the money now, if you actually perform your contractual obligations a month from now, you will need to account for that when recording revenues in your financial statement in accordance with the accrual principle.
This is because, similarly to the above examples, the money that has been paid to you has not actually been “earned” yet — at least from an accounting standpoint. In providing a product or a service, you will likely incur certain expenses (e.g., in relation to human capital, materials, etc.), and these (combined with the revenue that they helped generate) will need to be accounted for in the correct accounting period.
Prepaid Expense Adjustments
Prepaid expenses are virtually identical to deferred revenues, with the only real difference being that instead of receiving funds for a product or good that you have yet to deliver, you are paying for a product or service in advance, and then correctly choosing to make an “adjustment” so that it is recorded in the time period that it was used in.
For example, if you have decided to pay a year’s worth of rent upfront with your commercial landlord in August (e.g., for a discount, etc.), it would be incorrect to record that entire expense in your monthly financial record, as realistically only a fraction (1/12th) of that cost would have been “used.”
Consequently, you would record the full amount as a “prepaid expense,” and then at the end of each month, you would make an adjusting entry where you identify and record the “used up” portion of that expense — updating your financial records accordingly.
Depreciation Expense Adjustments
There are two types of depreciation:
- Physical depreciation (i.e., depreciation due to frequent use, etc.)
- Economic depreciation (i.e., depreciation due to inadequacy or obsoletion)
This sort of expense usually relates to very large purchases — such as equipment or a property lease — and involves making a single payment but dividing its expense over multiple accounting periods, taking into account its decreasing value over time and ensuring that a more accurate representation of a company’s current assets is recorded.
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Frequently Asked Questions
Why are adjusting entries important for small business accounting?
Regardless of a business’s size, adjusting entries are important because they provide a reliable way of ensuring that financial statements remain: accurate, presentable, and in compliance with GAAP.
This can greatly improve a business's chances of acquiring financing through conventional lenders (such as banks) by averting a situation whereby revenues seem lower than they actually are.
What is the difference between adjusting entries and closing entries?
Adjusting entries allow business owners and accountants to comply with the accrual accounting principle when recording a business’s finances, whereas closing entries are used to close temporary ledger accounts and transfer all of their balances to permanent alternatives.
This means that, unlike adjusting entries, closing entries do not really affect a business’s profitability at all, and they can in fact be carried out with very little human involvement.
Are adjusting entries and correcting entries different?
The difference between adjusting entries and correcting entries is simple. While adjusting entries ensures that a business’s financial statements and records comply with GAAP and other general accounting frameworks straight from the get-go, correcting entries are focused on identifying and correcting any mistakes made within a business’s accounting entries.
What is the accounting cycle?
The accounting cycle involves eight steps. It begins as soon as a business transaction occurs and ends with “closing the books.”
The purpose of the accounting cycle is to facilitate a transparent accounting setting where all of the money that is paid out and received by a company is accounted for and accurately reflected in that business’s financial statements.
What is GAAP?
GAAP is a “guiding mechanism” used by accountants and business owners within the US. It encompasses several different accounting principles — including the principle of materiality, the matching principle, the principle of going concern, and the principle of objectivity.
Even though most businesses (apart from the ones that are publicly traded) are not legally required to comply with GAAP, doing so can play a key role in ensuring that their financial statements remain structured, accurate, and presentable.