Adjusting Entries
Adjusting entries are made in the book at the end of the accounting period to reflect the correct balance of assets and liabilities. The main purpose of making adjusting entries is to record all the assets and liabilities at their true and fair value.
For example, equipment is initially recorded at the original cost. However, during the year, it might get depreciated by some value due to its usage in the business operation. The value at which it is recorded at the start of the year may not be the true value at the end of the year. Therefore, it is necessary to record the depreciation on the equipment for the period. After the depreciation, it will reflect its correct book value at the end of the period.
Types of adjusting entries:
1. Accrued Revenues: The adjusting entry for accrued revenue is made to record revenues that have been earned but not yet received or billed. For example, services have been provided to customers but it has not been billed to customers yet.
| Date | Description | Ref. | Debit | Credit |
| 31 Dec | Accounts receivable | $ xx | ||
| Service revenue | xx | |||
| (To accrue the service revenue already earned) |
2. Accrued Expenses: There may be many expenses that have already been incurred but not yet paid at the end of the accounting period. Such expenses are recorded by making adjusting entries. Examples of such expenses are rent expense, salaries expense, interest expense, etc.
| Date | Description | Ref. | Debit | Credit |
| 31 Dec | Rent/Salaries/Interest expenses | $ xx | ||
| Rent/Salaries/Interest payable | xx | |||
| (To accrue the rent/service/interest expense) |
3. Prepaid Expenses: Allocating the cost of prepaid expenses (expenses paid in advance) to the period in which they are consumed or used. For example, allocating prepaid insurance expenses to the current accounting period.
| Date | Description | Ref. | Debit | Credit |
| 31 Dec | Insurance expense | $ xx | ||
| Prepaid insurance | xx | |||
| (To record the insurance expense for the expired period) |
4. Unearned Revenues or Deferred Revenue: There are many instances when cash has been received from the customer and the services or the product is yet to be delivered. Recognizing revenue that has been received but not yet earned is known as deferred or unearned revenue. For example, cash is received in advance for services not yet provided.
| Date | Description | Ref. | Debit | Credit |
| Cash | $ xx | |||
| Deferred revenue | xx | |||
| (To record cash received in advance from customer) |
Once the services or product is delivered, the deferred revenue is converted into sales revenue by making the following entry:
| Date | Description | Ref. | Debit | Credit |
| 31 Dec | Deferred revenue | $ xx | ||
| Sales revenue | xx | |||
| (To record the earned revenue) |
5. Depreciation expense and Accumulated Depreciation: Recording depreciation expense and the accumulated depreciation of fixed assets to reduce their carrying value on the balance sheet.
| Date | Description | Ref. | Debit | Credit |
| 31 Dec | Depreciation expense | $ xx | ||
| Accumulated depreciation | xx | |||
| (To record the earned revenue) |
6. Adjustment for Bad Debts: Recognizing an allowance for doubtful accounts based on estimates of uncollectible accounts receivable.
| Date | Description | Ref. | Debit | Credit |
| 31 Dec | Bad debt expense | $ xx | ||
| Allowance for doubtful debt | xx | |||
| (To record the earned revenue) |
7. Adjustment for Inventory: Making adjustments to inventory values, such as recording inventory shrinkage or adjusting inventory to its net realizable value.
| Date | Description | Ref. | Debit | Credit |
| 31 Dec | Shrinkage expense | $ xx | ||
| Inventory | xx | |||
| (To record the inventory shrinkage expense) |
Impact on financial statements
Adjusting entries are recorded to accrue or defer expenses and revenue. Therefore, each adjusting entry affects the income statement and balance sheet (Statement of financial position).
The income statement is affected by accrual or deferral of income or expenses. For example, recording depreciation on an asset will increase the depreciation expense, hence, t will be shown as an expense on the income statement.
Balance sheet accounts are adjusted to their true and fair value. For example, the adjusting entry for depreciation will increase the accumulated depreciation account and hence, reduce the book value of the asset.
To summarize, adjusting entries play a crucial role in ensuring the accuracy of financial statements by reflecting the proper matching of revenues and expenses, adjusting for the consumption of assets, and complying with accounting principles. They help provide a true and fair view of a company’s financial performance and position.
