For accounting purposes, your business must record a journal transaction each time a financial event like a customer sale or purchase of supplies occurs. But unless your company qualifies for and uses a cash accounting bookkeeping system, adjusting entries will also be necessary to keep your accounting records accurate.
Cash accounting is what happens when your company records payments from customers (income) and payments to vendors (expenses) as they occur (clear your bank or other financial institution). In an accrual accounting system meanwhile, transactions are recorded every time a sale or purchase takes place - regardless of when the money actually changes hands.
Why Adjusting Entries are Necessary
Monthly and annual adjustments are essential with accrual accounting because the tracking and recording system we use assumes that all financial activity inside your business is occurring in “real time”. There are many situations, however, where this simply isn’t the case. And that’s where adjusting entries come in.
Adjusting entries are used to allocate revenues and expenses to the accounting periods in which they actually occurred. In other words, we have to adjust our books regularly in accrual accounting to bring our records back in line with the reality of our company’s cash situation.
Your organization’s financial statements can only ever be as accurate as the accounting records that generate them. So diligently making any necessary adjusting entries at the end of each accounting period – and then posting those journal entries to the general ledger – is crucial to ensure your financial reporting is correct.
Exploring the Most Common Adjusting Entries
Two of the most common types of adjusting entries involve accrued revenues and accrued expenses. Accruals are simply bookkeeping adjustments that are made to account for:
- Income that’s been earned by your business, but that has yet to be received and/or recorded
- Expenses that have been incurred by your business, but that have yet to be paid for and/or recorded
Many companies sell products or services to customers in a given month but don’t actually get around to invoicing or receiving payment from those customers until the following month (or later!). Because accrual accounting says these sales must be recorded in the accounting period in which they occurred – payment or no - your business must make an adjusting entry at the end of such a month to debit the appropriate accounts receivable account and credit the revenue account.
Similarly, rather than paying for business supplies upfront, many companies work with vendors who request payment by invoice at a later date. Whenever your business makes a purchase that has yet to be paid for, a month-end adjusting entry is necessary to debit the relevant expense account and credit accounts payable. Another example of an accrued expense situation would be when your business owes wages to employees at the end of the month for hours they’ve worked but have yet to be paid for. In this case, your journal entry would debit the wage expense account and credit wages payable.
Here are three more types of adjusting entries that your business is apt to run into:
1. Unearned Revenue
In certain situations, your company might receive payment from a client in advance - before you provide them with services or fulfill their order. These “pre-payments” require that adjusting entries be made at the end of the accounting period in which payment is received and will typically involve a debit to your cash account, and a credit to your unearned revenue account. Once services have been rendered or the product delivered, you would debit unearned revenue and credit revenue.
2. Prepaid Expenses
Some purchases or services paid for in advance by your business will qualify as prepaid expenses. Prepaid expenses are typically expenditures that are consumed over a period of time, such as office supplies or business insurance. When you pay or renew your annual insurance premium, for example, you’re really paying for a full year’s worth of coverage. To account for this, your company would perform an adjusting entry each month that debits 1/12th of the original insurance amount credited to prepaid expenses, and credits the same amount to your insurance expense account.
Depreciation is what happens when an asset - like your company vehicle or computer equipment – decreases in value over time. Because it involves a series of journal entries that effectively “spread out” the original cost of the asset over the period of its serviceable life, depreciation expenses are one of the more complicated adjusting entries your business is likely to encounter. As with many contra-asset accounts, the proper tracking and recording of depreciation and accumulated depreciation is best left to your accounting professional.
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