Why are adjusting entries necessary? Adjusting entries are made in a company’s accounting records to account for missing information, correct errors, or update information that has changed from the previous accounting period. Such journal entries are made at the end of an accounting period after the company has prepared its unadjusted trial balance.
Adjusting entries are designed to make sure that the financial statements of a company accurately reflect its financial position. They usually involve shifting or reclassifying amounts from one account to another and are necessary for a variety of reasons. In this article, we will be discussing why adjusting entries are important.
What are adjusting entries and why are they necessary?
Adjusting journal entries are entries in a company’s general ledger that occurs at the end of an accounting period to record any unrecognized expenses or income for the period. They are the changes made to previously recorded journal entries to ensure that the numbers match with the current accounting periods. Hence, they can be said to be financial reporting that corrects a mistake that has previously been made in an accounting period.
Adjusting entries are necessary when accounting for a transaction that starts in one accounting period and ends in a later period. During an accounting period, unrecognized expenses and income can occur. This happens when you sell products or services and account for costs but don’t receive or make payments for the products or services until a future date. In such instances, adjusting entries are needed in a company’s general ledger to match any unrecognized expenses and income between accounting periods. They ensure that any transaction a company makes balances out between current and past accounting periods in the general ledger.
A typical example of when adjusting entries are needed for your books is when you are paid to do some work for a client, for instance, in September, and you’re given $2,000 for the services but you did the work in the next month, in October. You record the $2000 in September as unearned revenue because you’re yet to do the work but have received the income. Then, when you complete the work in October, you have to record the money as revenue because it has now been earned. In such an instance an adjusting entry is needed to balance your financial records.
Generally, there are several types of adjusting entries such as accruals, estimates, unearned revenue, and deferrals. Accruals are revenues and expenses that are not yet received or paid such as accrued expenses and accrued revenues. Estimates, on the other hand, record non-cash items such as inventory, depreciation expense, etc. at the end of a product life cycle.
Unearned revenue involves income that has been received for goods or services that is yet to be delivered whereas deferrals refer to revenues and expenses that have been paid or received in advance and recorded but are yet to be used or earned such as prepaid expenses and supplies expense. This means that adjusting entries relate to balance sheet accounts such as accumulated depreciation, allowance for doubtful accounts, accrued expenses, accrued income, prepaid expenses, deferred revenue, and unearned revenue.
There are also income statement accounts that adjusting entries are needed such as depreciation expense, interest expense, insurance expense, and revenue. Adjusting entries are necessary in accordance with the matching principle in order to match expenses to the related revenue in the same accounting period. These adjustments in journal entries are then carried over to the general ledger that flows through to the financial statements.
Read also: Accumulated Depreciation on Balance Sheet
Why are adjusting entries necessary?
Adjusting entries are necessary in order to record revenues and expenses accurately. These journal entries follow the matching principle, which requires expenses to be recorded within the same period as the revenue that relates to these expenses. Hence, adjusting entries are needed to ensure accounting records reflect this matching principle at the end of each period.
Adjusting journal entries are used under the accrual accounting method which is based on the revenue recognition principle (Accounting Standards Update (ASU) 2014-09) that requires revenue to be recognized in the period in which it was earned, rather than the period in which cash is received. This means that these adjusting entries are necessary for the preparation of financial statements in accordance with the generally accepted accounting principles (GAAP).
Another reason why adjusting entries are necessary for bookkeeping is for recording depreciated assets. These kinds of assets are necessary for balancing financial records and reporting deductions for tax purposes. Hence, adjusting entries are needed to ensure the accuracy and completeness of a company’s financial records. They help to provide a more accurate picture of a company’s financial health when transactions are recorded in a timely and accurate manner.
In addition, adjusting entries are necessary as it can help a company manage its financial performance. Once, a company regularly reviews and adjusts its financial records, it can identify areas where it is underperforming and take corrective measures. This can help to increase the company’s chances of success and improve its financial health.
Why do companies make adjusting entries?
Adjusting entries are necessary in the financial records of companies in order to update all account balances before financial statements can be prepared. GAAP requires that companies follow certain rules and guidelines when preparing their financial statements, and adjusting entries are an important part of this process.
Companies make adjusting entries because many of them operate where the actual delivery of goods may be made at a different time than the payment. Delivery could be either beforehand as in the case of credit or afterward as in the case of pre-payment. Also, there are times when one accounting period will end with such a situation still pending, and as a result, adjusting entries will be needed to reconcile these differences in the timing of payments and expenses.
Therefore, if companies don’t make adjusting entries to their journals, there would be unresolved transactions left that are yet to close. These journal adjustments are caused by the passage of time or small changes in account balances. Hence, the accountant has to examine the current listing of accounts (known as a trial balance) to be able to identify amounts that need to be changed before the preparation of financial statements.
Check out: Sale of Assets journal entry examples
Reasons why adjusting entries are necessary
- Adjusting entries are necessary because they ensure that business transactions are accurately recorded and expenses are not being paid for before they happen.
- Adjusting entries are needed to reconcile transactions that have not yet closed but straddle accounting periods (i.e transaction that starts in one accounting period and ends in a later period).
- One of the major reasons why adjusting entries are necessary is that if they are not made, a company’s expenses will be understated and its net income, assets, and owner’s equity will be overstated.
- Adjusting entries are necessary because they help to ensure the accuracy and completeness of a company’s financial statements.
- Another reason why adjusting entries are necessary is that it enables companies to prepare their financial statements in accordance with GAAP and helps them to manage their financial performance.
- Adjusting entries are needed because companies can gain a better understanding of their financial position by regularly recording and reviewing adjusting entries and can take action to improve their financial health.
Obotu has 2+years of professional experience in the business and finance sector. Her expertise lies in marketing, economics, finance, biology, and literature. She enjoys writing in these fields to educate and share her wealth of knowledge and experience.