17. Adjusting Journal Entries: Why They Matter
Adjusting journal entries (AJEs) are a crucial part of the accounting cycle. These entries are made at the end of an accounting period to ensure that financial statements reflect the most accurate and up-to-date information. They account for events or transactions that may not have been recorded during the regular accounting process, ensuring that financial records are complete and accurate.
In this section, we will explore the purpose of adjusting journal entries, the types of adjusting entries, and why they are vital for preparing accurate financial statements.
Adjusting journal entries are entries made to correct, update, or modify account balances before the preparation of financial statements. These adjustments are necessary because not all transactions are recorded in the accounting system immediately, and some transactions span across accounting periods. Adjusting entries ensure that revenues and expenses are recognized in the correct period, in accordance with the accrual basis of accounting.
Under the accrual accounting method, businesses must record revenues and expenses when they are earned or incurred, not when cash is exchanged. This means that certain transactions must be adjusted at the end of the period to align with the financial reporting standards.
Adjusting journal entries are essential for several reasons:
Matching Revenues and Expenses: One of the main goals of adjusting entries is to ensure that revenues and expenses are recognized in the correct accounting period. This follows the matching principle in accounting, which states that expenses should be matched with the revenues they help generate within the same period. For example, if a company incurs expenses related to a service provided in one period, the cost must be recognized in the same period as the related revenue, even if the payment occurs in a different period.
Accurate Financial Reporting: Adjusting entries help ensure that the financial statements present an accurate picture of a company’s financial position. Without these adjustments, the financial statements might not reflect the true financial condition of the business, potentially leading to errors in analysis and decision-making.
Compliance with Accounting Standards: Adjusting entries ensure compliance with accounting standards, such as the Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). These standards require the use of the accrual method for financial reporting, which necessitates adjusting entries to maintain consistency and accuracy.
Timely Recognition of Expenses and Revenues: Adjustments ensure that expenses and revenues are recorded in the correct periods, even if the cash transactions happen later. This improves the accuracy of the income statement, balance sheet, and other financial reports, which are used to evaluate a company’s performance.
There are four main types of adjusting journal entries that businesses commonly use:
Accruals: Accruals occur when a company has earned revenue or incurred an expense, but the cash transaction has not yet been completed. These entries ensure that revenues and expenses are recognized in the correct period.
Accrued Revenues: These are revenues that have been earned but not yet billed or collected. For example, if a company provides a service in December but doesn’t bill the client until January, an accrued revenue adjustment would be made to recognize the revenue in December.
Accrued Expenses: These are expenses that have been incurred but not yet paid. For example, wages earned by employees in December but paid in January would require an accrued expense entry to ensure the wages are recognized in December.
Deferrals: Deferrals occur when cash has been received or paid, but the related revenue or expense is not yet recognized. These entries are necessary to allocate revenues and expenses to the appropriate periods.
Deferred Revenues (Unearned Revenues): This occurs when a company receives cash in advance for services or goods to be provided in the future. For example, a company might receive a deposit for a service that will be rendered next month. The deferred revenue entry ensures that the revenue is recognized in the period when the service is actually provided.
Deferred Expenses (Prepaid Expenses): This refers to payments made in advance for goods or services to be received in the future. For example, if a company pays rent for six months in advance, the adjusting entry will ensure that only the portion of rent expense related to the current period is recognized, with the remaining amount deferred to future periods.
Estimates: Sometimes, it is necessary to make adjusting entries based on estimates. These adjustments are typically used for expenses or revenues that are difficult to determine with precision at the end of the period.
Allowance for Doubtful Accounts: An estimate of the amount of accounts receivable that is unlikely to be collected. This estimate is recorded as an adjustment to the accounts receivable balance and is accounted for as bad debt expense.
Depreciation: Depreciation is the allocation of the cost of a long-term asset over its useful life. An adjusting entry is made at the end of each period to recognize depreciation expense and reduce the value of the asset on the balance sheet.
Corrections: Occasionally, errors or omissions occur in the accounting records. Adjusting entries are made to correct these mistakes. For example, if a transaction was recorded with the wrong amount or to the wrong account, a correcting entry would be made to rectify the mistake.
The process of recording adjusting journal entries typically follows these steps:
Identify the need for adjustment: At the end of the accounting period, review all accounts to determine whether any adjustments are needed. This may involve examining unrecorded revenues, unpaid expenses, or prepaid items.
Calculate the adjustment: Based on the nature of the transaction, calculate the amount to be adjusted. For example, if the company has provided services worth $1,000 but hasn’t yet billed the customer, the amount to be accrued would be $1,000.
Make the entry: Record the adjusting journal entry in the general journal. Each entry will include a debit and a credit, ensuring that the accounting equation remains in balance.
Post the adjustment: After recording the adjusting entry, post it to the appropriate accounts in the general ledger.
Review and verify: Finally, verify that the financial statements are accurate after the adjustments are made, ensuring that the debits and credits balance and that the accounts reflect the correct balances.
Let’s consider a company that pays rent in advance for the next three months:
Transaction: The company pays $3,000 for three months of rent on December 1st.
Initial Journal Entry (on December 1st):
Debit: Prepaid Rent $3,000
Credit: Cash $3,000
Adjustment (at the end of December):
Debit: Rent Expense $1,000
Credit: Prepaid Rent $1,000
This adjustment ensures that $1,000 of the prepaid rent is recognized as an expense in December, reflecting the rent that has been used up during the period.
Adjusting journal entries are critical for ensuring that a company’s financial records are accurate and complete. They ensure that revenues and expenses are properly matched to the period in which they occur, in accordance with the accrual basis of accounting. By making adjustments for accruals, deferrals, estimates, and corrections, businesses can prepare financial statements that accurately reflect their financial position and performance. Understanding the importance and process of adjusting journal entries is fundamental for anyone studying accounting or working in finance.