Adjusting entries are journal entries made at the end of an accounting period to update the balances of certain accounts to accurately reflect their balances as of the reporting date. These entries are necessary to ensure that the financial statements prepared at the end of the accounting period adhere to the accrual basis of accounting and the matching principle.
Adjusting entries can be classified into five main categories:
- Accrued revenues: These entries record revenues that have been earned but not yet billed or received. The adjusting entry typically involves debiting an asset account (e.g., accounts receivable) and crediting a revenue account.
- Accrued expenses: These entries record expenses that have been incurred but not yet paid or recorded. The adjusting entry usually involves debiting an expense account and crediting a liability account (e.g., accrued expenses or accounts payable).
- Deferred revenues: These entries involve revenues that have been received in advance but not yet earned. The adjusting entry usually involves debiting a liability account (e.g., unearned revenue) and crediting a revenue account.
- Prepaid expenses: These entries involve expenses that have been paid in advance but not yet incurred. The adjusting entry typically involves debiting an expense account and crediting an asset account (e.g., prepaid expenses).
- Depreciation and amortization: These entries allocate the cost of a long-term asset over its useful life. The adjusting entry usually involves debiting an expense account (e.g., depreciation expense or amortization expense) and crediting a contra asset account (e.g., accumulated depreciation or accumulated amortization).
Adjusting entries help to ensure that financial statements are accurate, consistent, and in compliance with generally accepted accounting principles (GAAP) or other relevant accounting standards.
Example of Adjusting Entries
Let’s assume a company provides consulting services and has completed a project for a client on December 20th. However, the invoice for the project will not be sent to the client until January 5th of the next year. The company’s accounting period ends on December 31st.
In this case, the company has earned the revenue related to the consulting project in December, but it hasn’t billed or received payment from the client yet. To record the earned revenue in the correct accounting period, an adjusting entry is required.
Let’s say the consulting project is worth $10,000. The adjusting entry at the end of December would be:
- Debit Accounts Receivable for $10,000 (to record the amount owed by the client)
- Credit Consulting Revenue for $10,000 (to recognize the revenue earned in the current accounting period)
This adjusting entry ensures that the company’s financial statements accurately reflect the revenue earned during the accounting period, even though the invoice has not been sent and payment has not been received. When the company sends the invoice and receives the payment in January, it will record the collection of the receivable without affecting the Consulting Revenue account again, as the revenue has already been recognized in the previous accounting period.