Introduction to Adjusting Entries | Financial Accounting
In this video, we cover introduction to adjusting journal entries.
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Understanding Adjusting Entries in Accounting
Adjusting entries are crucial in the accounting process to ensure that financial statements reflect the correct revenue, expense, asset, and liability amounts for a specific period. They are typically made at the end of an accounting period (month, quarter, or year) and are necessary for the accrual basis of accounting, which matches income and expenses to the period in which they occur, not necessarily when cash transactions happen.
1. Purpose of Adjusting Entries
Adjusting entries are necessary to:
Accurately Report Revenues and Expenses: Ensure that revenues and expenses are recognized in the period in which they are incurred, adhering to the matching principle of accounting.
Update Asset and Liability Accounts: Adjust the value of assets and liabilities to their correct balances.
2. Types of Adjusting Entries
There are typically four types of adjusting entries:
Accrued Revenues: For revenues earned in a period that have not yet been recorded nor received in cash.
Example: Services performed in December but not billed until January would require an accrued revenue entry in December.
Accrued Expenses: For expenses incurred in a period that have not yet been recorded nor paid in cash.
Example: Salaries for the last week of December paid in January would need an accrued expense entry to recognize the expense in December.
Deferred Revenues: For cash received in advance of providing a service or delivering a product; recognized as a liability until the service or product is delivered.
Example: Prepaid rent or annual software subscriptions received in advance require adjusting entries to recognize the revenue as it is earned over time.
Deferred Expenses (Prepaid Expenses): For payments made in advance for goods or services to be received in the future. These need to be allocated over the useful life of the service or product.
Example: Insurance or rent paid in advance should be recorded as an asset initially and then expensed over the period of benefit.
Depreciation and Amortization: Non-cash expenses that reduce the value of long-term tangible and intangible assets over their useful lives.
Example: Depreciation of office equipment and amortization of patents.
3. Process of Recording Adjusting Entries
Adjusting entries typically involve one income statement account (revenue or expense) and one balance sheet account (asset or liability). Here’s a step-by-step overview:
Identify the Need: Determine whether any revenues have not been recorded or any expenses have not been captured under accrual accounting at the end of the accounting period.
Calculate Amounts: Calculate the amounts that need to be adjusted based on documents such as invoices, contracts, and receipts.
Create Journal Entry: Make the appropriate debit and credit entries to record the adjusting entries.
Post to Ledger: Post the adjusting entries to the general ledger accounts to update the account balances.
4. Example of Adjusting Entries
Accrued Salaries:
Salaries for the last week of December totaling $5,000 are unpaid at year-end and will be paid in January.
Adjusting entry on December 31:
Debit Salaries Expense: $5,000
Credit Salaries Payable: $5,000
Prepaid Rent:
$12,000 was paid for a year's rent in advance starting from December 1.
Monthly rent: $1,000
Adjusting entry on December 31:
Debit Rent Expense: $1,000
Credit Prepaid Rent: $1,000
5. Reversing Entries
Some adjusting entries, particularly those involving accruals, are reversed at the beginning of the next accounting period. This simplifies the recording of future transactions by eliminating the need for certain adjustments and preventing double counting when the actual invoice or payment is processed.
Conclusion
Adjusting entries are an essential component of accrual accounting, ensuring that financial statements provide a true and fair view of a company's financial performance and position. Regularly making and reviewing these entries helps maintain accurate and compliant financial records.
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