What are adjusting entries?
Adjusting entries are usually made on the last day of an accounting period (year, quarter, month) so that a company's financial statements comply with the accrual method of accounting. In other words, the adjusting entries are needed so that a company's:
- Income statement reports the revenues that have been earned during the accounting period
- Balance sheet reports the receivables that it has a right to receive as of the end of the accounting period
- Income statement reports the expenses and losses that were incurred during the accounting period
- Balance sheet reports the liabilities it has incurred as of the end of the accounting period.
Example:
Here are a few examples of the need for adjusting entries:
- A company shipped goods on credit, but the company's sales invoice was not processed as of the end of the accounting period
- A company received some goods from a vendor but the vendor's invoice had not been processed by the company as of the end of the accounting period
- A company that prepares monthly income statements paid for 6 months of insurance coverage in the first month of the insurance coverage. (This means that 5/6 of the payment is a prepaid asset and only 1/6 of the payment should be reported as an expense on each of the monthly income statements.)
- A company's customer paid in advance for services to be provided over several accounting periods. Until the services are provided, the unearned amount is reported as a liability. After the services are provided, an entry is needed to reduce the liability and to report the revenues.
A common characteristic of every adjusting entry will involve at least one income statement account and at least one balance sheet account.
What is the difference between adjusting entries and closing entries?
Adjusting entries are made at the end of the accounting period (but prior to preparing the financial statements) in order for a company's financial statements to be up-to-date on the accrual basis of accounting.
Example:
The following are hypothetical examples of adjusting entries:
- Each day the company incurs wages expense for its hourly-paid employees. However, the payroll that includes the workers' wages for the last few days of the month won't be recorded until after the accounting period ends. Therefore, the company must prepare an adjusting entry dated for the last day of the month that debits Wages Expense and credits Wages Payable for the labor used and the amount owed.
- Similarly, the company uses electricity each day but receives only one bill per month, perhaps on the 20th day of the month (for electricity used through the 15th day of the month). The cost of the electricity used during the last half of the month must get into the accounting records through an adjusting entry for the financial statements to show all of the expenses for the month and all of the liabilities as of the end of the month.
- Another adjusting entry records the depreciation of assets used in the business. Every month the company must prepare an adjusting entry that debits Depreciation Expense and credits Accumulated Depreciation to report the month's depreciation.
Closing entries are dated as of the last day of the accounting period, but are entered into the accounts after the financial statements are prepared. Closing entries involve the temporary accounts (the majority of which are the income statement accounts).
Example:
The closing entries will transfer all of the year-end balances from the revenue accounts and the expense accounts to a corporation's retained earnings account or a sole proprietorship's owner's equity account. With today's accounting software, the closing entries are effortless.
Will the adjusting entry amounts appear in the balance sheet and income statement?
Absolutely. The adjusting entry amounts must be included on the income statement in order to report all revenues earned and all expenses incurred during the accounting period indicated on the income statement. The adjusting entry amounts must also be included in the amounts reported on the balance sheet as of the end of the accounting period.
In the following accounting period, the accrual-type adjusting entries will usually be reversed. They are reversed or removed because the actual invoices or other documents containing the accrued revenues or expenses will be arriving and will be entered into the accounting records by the bookkeeper or the accounts payable clerk.
What are accrual adjusting entries?
Accrual adjusting entries or simply accruals are one of three types of adjusting entries which are prepared at the end of an accounting period so that a company's financial statements will comply with the accrual method of accounting. Expressed another way, accrual adjusting entries are the means for including transactions that occurred during the current accounting period but have not yet been recorded in a company's general ledger accounts. Without accrual adjusting entries those transactions will likely be reported in a later accounting period. This means that the financial statements for two accounting periods will be reporting incorrect amounts.
Example of an accrual adjusting entry for expenses:
To illustrate, let's assume that New Corp begins its business on December 1 and uses Sales Rep Company for calling on customers. For this service, New Corp agrees to pay commissions of 5% of sales with payment made 10 days after the month ends. Assuming that December's sales are \Rs.1,00,000 New Corp will be incurring commissions expense of Rs.5,000 and a liability of Rs.5,000. However, the payment will actually occur on January 10. Without an accrual adjusting entry as of December 31 New Corp's financial statements will have the following problems:
- Its December income statement will report Rs.0 commissions expense in getting December's sales of Rs.1,00,000
- Its January income statement will report Rs.5,000 in commissions expense that were actually incurred in order to get December's sales
- Its December 31 balance sheet will not be reporting its Rs.5,000 liability to Sales Rep Company
In order for New Corp's December's income statement to match the Rs.5,000 of commissions expense with December's sales of Rs.1,00,000, and for New Corp's December 31 balance sheet to report the liability of Rs.5,000, the following accrual adjusting entry is needed as of December 31: debit Commissions Expense for Rs.5,000; credit Commissions Payable for Rs.5,000.
Example of an accrual adjusting entry for revenues
Over at Sales Rep Company, for its financial statements to comply with the accrual method of accounting it needs to record the following accrual adjusting entry as of December 31 (assuming its billing will take place in early January): debit the asset account Commissions Receivable for Rs.5,000; credit Commissions Revenues for Rs.5,000. Without this accrual entry as of December 31, Sales Rep Company's December financial statements will have the following problems:
- Its December income statement will report Rs.0 in revenues that were earned from representing New Corp during December
- Its January income statement will report Rs.5,000 in revenues that were actually earned in December when Sales Rep Company was incurring expenses in order to make the sales calls
- Its December 31 balance sheet will not be reporting the receivable of Rs.5,000 that it has a right to receive for its December's efforts
Since accrual adjusting entries will be followed by the actual transactions (checks written, billing invoices issued, etc.), a helpful accounting procedure is to record reversing entries on the first day of the next accounting period.
What are the various types of adjusting entries?
Adjusting entries, which are required in order to have a company's financial statements comply with the accrual method of accounting, are often categorized into three types:
Accruals
Accruals or accrual adjusting entries are prepared at the end of an accounting period to report amounts that have occurred in the current accounting period but were not yet entered into the general ledger accounts. An example is a retail store's emergency plumbing repair on December 31, the last day of its accounting period. The repair occurred in the December accounting period but the bill will not be received until the January accounting period. As of December 31, the retailer needs an accrual adjusting entry so that its December financial statements will report the expense and the liability. Also on December 31, the plumbing company will need an accrual adjusting entry so that its financial statements will report the revenues and the receivables that were earned in December.
Deferrals
Defferals or deferral adjusting entries are prepared at the end of an accounting period to defer expenses and/or revenues that have already been recorded in the general ledger accounts. The reason is that some of the recorded amounts will actually be used up and/or earned in a future accounting period. An example is a retailer's payment of Rs.1,200 for six months of property insurance that was paid in advance. For instance, if the payment was made on December 1 for protection during the upcoming period of December 1 through May 31, the retailer's December's income statement should report Insurance Expense of Rs.200 (the expired 1/6 of the Rs.1,200) and the December 31 balance sheet should report Prepaid Insurance of Rs.1,000 (a current asset that represents the unexpired 5/6 of Rs.1,200). The amount used in the deferral adjusting entry should be whatever is necessary to get the proper amounts to appear on the financial statements. The insurance company must also make a deferral adjusting entry so that its December revenues will include only the Rs.200 that was earned. Its December 31 balance sheet should show the unearned Rs.1,000 as the current liability Deferred Premiums.
Other
Other adjusting entries will likely include:
- Depreciation of assets used in a business. This is done with a debit to Depreciation Expense and a credit to Accumulated Depreciation.
- Reporting bad debts expense pertaining to accounts receivable. This is done by either debiting Bad Debts Expense and crediting Allowance for Doubtful Accounts, or by writing off an account with a debit to Bad Debts Expense and crediting Accounts Receivable.
Why are accruals needed every month?
Accrual adjusting entries are needed monthly only if a company issues monthly financial statements.
Two reasons for the monthly accrual adjusting entries are:
- To report the revenues and the related receivables which were earned during the month, but the transactions had not been recorded in the accounts as of the end of the month
- To record the expenses, losses, and their related liabilities which were incurred during the month, but the transactions had not been recorded in the accounts as of the end of the month
Monthly accruals and deferrals and other adjusting entries must be recorded prior to issuing monthly financial statements in order to comply with the accrual basis of accounting.