When are adjusting entries recorded? Adjusting entries are recorded when using the accrual accounting method which is based on the revenue recognition principle that requires that revenue should be recognized in the period in which it was earned, rather than in the period that cash is received.
Therefore, the essence of an adjusting journal entry is to convert cash transactions into the accrual accounting method. In this article, we will discuss when adjusting entries are recorded and how they are recorded.
Adjusting entries explained
Adjusting entries are journal entries that are entered in a general ledger at the end of an accounting period to record any expense or income that was unrecognized for the period. An adjusting journal entry is necessary to properly account for a transaction that started in one accounting period and ends in a later period. Such accounting adjustments usually involve an income statement account (expense or revenue) and a balance sheet account (liability or asset).
The different types of adjusting entries associated with certain balance sheet accounts include unearned revenue or deferred revenue, accumulated depreciation, accrued revenue, allowance for doubtful accounts, accrued expenses, and prepaid expenses. Income statement accounts such as insurance expense, interest expense, depreciation expense, and revenue may also need to be adjusted to match revenue to the related expenses in the same accounting period.
Where are adjusting entries recorded?
Adjusting entries are recorded in a company’s general ledger at the end of an accounting period in accordance with the matching and revenue recognition principles. Hence, adjusting entries are recorded when accounting for accruals, deferrals, and estimates.
In order to understand recording adjusting entries better, let’s look at an example. Assume you begin a job in an accounting period but do not invoice the customer until the work is complete in six months. At the end of each month, you will need to do an adjusting journal entry to recognize revenue for 1/6 of the amount that will be invoiced at the end of the six months.
See also: Is Investment Debit or Credit?
When are adjusting entries recorded?
Adjusting entries are recorded at the end of an accounting period to assign the right amount of revenue and expenses to each accounting period. When a transaction starts in one accounting period and ends in a later period, adjusting entries are recorded to update the previously recorded journal entry so that the end-of-year financial statements are accurate and up-to-date.
Adjusting entries are recorded to alter the ending balances in various general ledger accounts; they are made after the unadjusted trial balance and before the preparation of financial statements. Therefore, bringing the amounts in the general ledger accounts to their correct balances. These accounting adjustments are made to closely align the financial statement of a business with the requirements of GAAP or IFRS. This generally involves the matching of revenues to expenses under the matching principle.
There are certain types of transactions in business that require an adjusting entry. That is, adjusting entries are recorded when either of the following transactions occurs:
Revenue is accrued
Adjusting entries are recorded when a business earns revenue in one accounting period from selling a good or service but does not invoice the client or receive payment until the next accounting period. The journal entries for these earned but unbilled revenues are known in accounting as the adjusting entries for accrued revenue.
When a business earns money for providing goods or services but receives the payment for them at a later date an adjusting journal entry for accrued revenue is recorded to ensure revenue is accurately recorded in the correct accounting period. Accrued revenues are usually common with services and interest accrual.
In order to record accrued revenue, you debit the accrued revenue account and credit the revenue account. However, when you eventually send the invoice in the next accounting period, you make an adjusting entry by debiting the accounts receivable account and then credit the accrued revenue account.
Expense is accrued
Adjusting entries are recorded when a business incurs expenses that haven’t been paid yet in one accounting period and then pays the expenses in the subsequent accounting period. This is known as an accrued expense (or accrued liability) and is common with recurring bills, like payroll, salaries, interest expenses, or utility expenses.
The journal entry to record the accrued expenses is a credit to the accrued expense account and a debit to the expense account. However, when the expenses have been paid, an adjusting journal entry for accrued expenses is done, which is a debit to the accrued expense account and a credit to the cash account.
Expenses are paid in advance (prepaid expenses)
When a business makes an expense that is beneficial to more than one accounting period, such as the prepayment of insurance or advance payment of rent, this expense is recognized as a prepaid expense. These advance payments are first recorded as assets, and as time passes by, they are expensed through adjusting entries. Hence, adjusting entries are recorded when a business accounts for prepaid expenses such as prepaid rent or prepaid insurance.
When an advance payment is done, it is recorded as a debit to a prepaid expense account (prepaid rent or prepaid insurance) and a credit to the cash account. Then, when the paid service has been used up, recording adjusting entries for prepaid expenses would be a debit to the expense account and a credit to the prepaid expense account.
Advance payment of goods or services from customers (deferred revenue)
Adjusting entries are recorded when a customer pays the business for services that haven’t been received yet, such as yearly memberships and subscriptions. When cash is received, the transaction is recorded as a liability because the business hasn’t earned it yet. But, over time, this liability is turned into revenue as the revenue is fully earned.
When a customer or client pays for a product or service in advance, a debit entry is made to the cash account and a credit entry to the deferred revenue account (or unearned revenue account). Then, as the business earns the revenue over time, an adjusting entry is recorded as a debit to the unearned revenue account and a credit to the revenue account.
Accounting for depreciated assets
Adjusting entries are also recorded when accounting for the depreciation of assets such as equipment, furniture, buildings, etc. This is the allocation of the cost of a fixed asset over the course of its useful life. These assets are expensed according to the time that they get used by the business, thus, an adjusting entry is required.
Depreciation can be calculated by subtracting the original value of the asset from its current value. Therefore, to record this in the books, you have to divide this amount by the number of months that you’ve used the asset. Hence, the adjusting entry for recording depreciation will be a debit to the depreciation expense account and a credit to the accumulated depreciation account.
Therefore, as an asset is depreciated at the end of an accounting period, the total amount of accumulated depreciation on the balance sheet changes. Other similar non-cash expenses that may be adjusted include amortization,stock-based compensation, depletion, etc.
Allowance for doubtful accounts
Adjusting entries are recorded when a business offers credit to customers and anticipates that it may miss payments. There is a possibility that some debts will never be collected, thus, the adjusting entry for allowance for doubtful accounts is used to offset the account. The allowance for doubtful accounts is an estimate of the total amount of bad debts that are related to the receivable amount.
A debit entry is made to the bad debt expenses account and a credit entry is to the Allowance for doubtful accounts. However, if the customer later settles his debts, the Allowance for doubtful accounts will be debited and the accounts receivable account will be credited.
Read also: Is the capital stock a debit or credit?