Have you ever wondered how businesses keep track of their money? Companies record their financial activities, like sales and expenses, using a system called accounting. But sometimes, not all transactions fit neatly into the books at the time they happen. This is where adjusting entries come in!
Adjusting entries helps make sure that a company's financial records are correct and up to date before preparing financial statements. These special entries ensure that revenues and expenses are recorded in the right time period. In this blog, we will explore what adjusting entries are, why they are important, and the different types of adjusting entries with examples.
What Are Adjusting Entries?
Adjusting entries are changes made in accounting records at the end of an accounting period. These entries help ensure that all income and expenses are recorded in the correct period, following the matching principle in accounting. The matching principle means that businesses should record revenues and expenses when they actually happen, not just when cash is received or paid.
Why Are Adjusting Entries Important?
- Ensure Accuracy – They help correct mistakes and missing transactions in the books.
- Follow Accounting Rules – They help companies follow Generally Accepted Accounting Principles (GAAP).
- Match Revenues and Expenses – They make sure that the income earned and the expenses incurred in a certain period are properly recorded.
- Prepare Correct Financial Statements – They ensure that reports like the income statement and balance sheet show the true financial position of a company.
- Prevent Financial Misstatements – Without adjusting entries, businesses may overstate or understate their income, leading to incorrect financial reports.
- Help in Tax Preparation – Adjusting entries ensure that companies report accurate income and expenses when calculating taxes.
- Improve Financial Decision-Making – Proper adjustments help businesses understand their actual profits and expenses, leading to better financial planning.
Types of Adjusting Entries
There are five main types of adjusting entries:
1. Accrued Revenues
Accrued revenues are money that a company has earned but has not yet received. This means the company has provided a service or delivered a product, but the customer has not yet paid.
Example: A graphic designer completes a project for a client in December but does not receive payment until January. The company should record the revenue in December because that is when the service was provided.
Adjusting Entry for Accrued Revenue:
- Debit: Accounts Receivable (Money to be received)
- Credit: Service Revenue (Earned income)
2. Accrued Expenses
Accrued expenses are costs that a company has incurred but has not yet paid for. This usually happens with things like salaries, rent, or utilities.
Example: A business pays its employees every two weeks. The last payday was December 25, but employees continued working until December 31. The company will pay them in January, but those wages still count as an expense for December.
Adjusting Entry for Accrued Expense:
- Debit: Salaries Expense (Cost of wages)
- Credit: Salaries Payable (Money owed to employees)
3. Deferred Revenues (Unearned Revenues)
Deferred revenue is when a company receives money in advance for services or goods that will be provided in the future. Until the work is done, the money is recorded as a liability (something the company owes).
Example: A gym collects membership fees for a whole year in advance. The gym has not yet provided all of its services, so it cannot count all the money as revenue immediately.
Adjusting Entry for Deferred Revenue:
- Debit: Unearned Revenue (Liability account)
- Credit: Service Revenue (Earned income)
4. Prepaid Expenses
Prepaid expenses are payments made for things that will be used in the future, such as rent, insurance, or supplies. Since these are paid in advance, they are recorded as an asset until they are used.
Example: A company pays $1,200 in December for six months of insurance (January to June). In January, it should adjust the records to show that one month of insurance has been used up.
Adjusting Entry for Prepaid Expense:
- Debit: Insurance Expense (Cost used for the month)
- Credit: Prepaid Insurance (Remaining asset)
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5. Depreciation Expenses
Depreciation is the process of spreading the cost of expensive items, like buildings or machines, over their useful life. Instead of recording the full cost in one year, businesses spread it over several years.
Example: A company buys a delivery truck for $30,000 and expects it to last for 5 years. Each year, it records part of the cost as an expense.
Adjusting Entry for Depreciation:
- Debit: Depreciation Expense (Annual cost)
- Credit: Accumulated Depreciation (Total depreciation over time)
More Examples of Adjusting Entries
Example 1: Accrued Revenue
Imagine you own a tutoring business and complete a $500 tutoring session on December 30, but the customer pays on January 5. Since you earned the money in December, you should record it as accrued revenue.
Adjusting Entry:
Example 2: Accrued Expense
Your company uses electricity throughout December, but the bill arrives in January. The expense still belongs in December.
Adjusting Entry:
- Debit: Utility Expense $200
- Credit: Utilities Payable $200
Example 3: Prepaid Expense
Your business pays $3,600 for a year of rent in January. Each month, you record one month's expense ($300).
Adjusting Entry:
- Debit: Rent Expense $300
- Credit: Prepaid Rent $300
Example 4: Deferred Revenue
A customer pays you $1,200 for six months of website hosting in advance. Each month, you earn $200 of that payment.
Adjusting Entry:
- Debit: Unearned Revenue $200
- Credit: Service Revenue $200
Example 5: Depreciation
A company buys office furniture for $5,000, expecting it to last 5 years. Each year, it records $1,000 in depreciation.
Adjusting Entry:
Example 6: Interest Accrual
A business takes out a loan of $10,000 at 5% annual interest. At the end of the month, interest accrues but is not yet paid.
Adjusting Entry:
- Debit: Interest Expense $42
- Credit: Interest Payable $42
How to Record Adjusting Entries
- Identify the Account Needing Adjustment – Find out if the company has unrecorded revenues or expenses.
- Determine the Correct Amount – Calculate how much should be recorded in the correct period.
- Make the Adjusting Entry – Use the right accounts to update the records.
- Prepare Financial Statements – After all adjustments, companies create reports showing their financial position.
- Review and Verify Entries – Double-check for accuracy to prevent errors in financial statements.
- Consult an Accountant – If you are unsure about adjustments, seek professional help.
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Ensuring Financial Accuracy by Adjusting Entries
Adjusting entries is essential for ensuring that a company’s financial statements are accurate and reflect its true financial position. These entries align revenue and expenses with the correct periods, providing a clear and reliable picture of the business’s performance. Without proper adjustments, financial reports can become misleading, leading to poor decisions and errors in tax filings.
For businesses looking to streamline this process, outsourcing accounting tasks to experts like Global FPO is a smart solution. Global FPO’s professional team ensures that adjusting entries are made accurately, helping businesses stay compliant with accounting standards. This allows companies to focus on their core operations while maintaining financial accuracy and integrity, driving informed decision-making and long-term success.
FAQs
1. What are adjusting entries?
Adjusting entries are changes made to keep records correct.
2. Why do we need adjusting entries?
We need them to make sure the numbers in reports are right.
3. What are the types of adjusting entries?
There are four types:
- Accruals: When we earn money but don’t get paid yet.
- Deferrals: When we pay for something before we get it.
- Estimates: When we guess how much something will cost.
- Corrections: When we fix mistakes.
4. Can you give an example of adjusting entries?
If a company works in December but gets paid in January, they will change the records to show the money in December.
5. Who can help with adjusting entries?
Global FPO can help make sure adjusting entries are done right.
+61 (485) 921-100
+1 (347) 781-5928
+44 (7700) 170-900
contact@globalfpo.com