When all the regular day-to-day transactions of an accounting period are completed, the next step is to check on the balances of certain accounts to see if those balances need to be updated or changed using a type of journal entry called an Adjusting Entry.
What is an Adjusting Entry?
The purpose of an adjusting entry is to update revenue and expense accounts at the end of each accounting period (month or year) to conform to the rules of accrual basis accounting. Accrual basis accounting requires that revenues and their associated costs be recorded in the same accounting period. For example, if a store sells merchandise in June, the cost of purchasing that merchandise should also be recorded in June.
Why are Adjusting Journal Entries Necessary?
Under Accrual Basis Accounting, Adjusting Entries are necessary to ensure revenues and expenses are being recorded in the correct month or year. In Accrual Basis accounting, timing is everything. Revenue earned in June should be recorded in June, regardless of when cash is received. Expenses that match with that revenue should also be recorded in June, regardless of when the goods or services were received or paid for.
What is the Adjusting Process?
At the end of each accounting period, adjusting journal entries are completed to update revenue and expenses accounts to accurately reflect changes to the accounts that have not been captured as part of day-to-day transactions. The adjusting process compares the current balance in an account to what the balance should be. An adjusting journal entry is completed to adjust the balance. Adjusting Entries are completed after all regular transactions are completed and before financial statements are created.
For example, a business has a delivery van for which $200 of depreciation expense is recorded each month. This is not captured in the day-to-day accounting transactions. It is done as an adjusting entry once a month to capture the expense.
What Accounts Need Adjusting Entries?
Every Adjusting Entry includes one balance sheet account (Asset or Liability) and one income statement account (Revenue or Expense). Typical accounts that need adjusting are:
- Prepaid asset accounts (Prepaid Insurance, Prepaid Rent, Prepaid Expenses)
- Unearned liability accounts (Unearned Revenue, Unearned Rent, Customer Deposits)
- Payable liability accounts (Salaries Payable, Interest Payable, Sales Tax Payable)
- Contra Asset accounts (Accumulated Depreciation, Allowance for Doubtful Accounts)
- Revenue and Expense accounts related to the accounts listed above (Insurance Expense pairs with Prepaid Insurance, Depreciation Expense pairs with Accumulated Depreciation)
Which Accounts Do Not Need Adjusting Entries?
Generally, the accounts that do not need adjusting entries are:
- Cash accounts–the transactions in cash accounts are recorded throughout the month and do not need adjusting
- Land–Land is recorded at purchase cost and the value remains the same on the books until it is sold. (Land does not get depreciated so it doesn’t need a depreciation adjusting entry.)
- Equity accounts–equity is recorded as transactions happen: stock sales, owner’s investments, owner’s withdrawals, dividends.
For a complete guide to Adjusting Entries including example transactions and adjusting journal entries, check out this article:
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