Adjusting entries are essential accounting activities that companies carry out at the end of an accounting period to ensure that their financial records accurately reflect their financial position and performance.
Many transactions that occur during an accounting period are not recorded until a later period or not recorded at all, making it necessary to make adjusting entries. These entries help to reconcile a company’s financial records with the guidelines and principles of Generally Accepted Accounting Principles (GAAP) and ensure that the financial statements are accurate and up-to-date.
Why Are Adjusting Journal Entries Important?
Adjusting journal entries is essential for ensuring that a company’s financial statements are accurate and reliable. These entries are important as they ensure that the company’s financial statements reflect the true financial position of the firm at the end of the period.
They help to correct errors that may have occurred during the accounting period. For example, an error in recording an expense or revenue could result in an inaccurate financial statement. Adjusting journal entries can be used to rectify these errors.
Another reason why adjusting entries is important is that they help to allocate expenses and revenues to the correct accounting period. Sometimes, expenses and revenues may be incurred over multiple accounting periods, and adjusting entries can be used to allocate these expenses and revenues to the correct period, thereby allowing for a more accurate financial statement.
Types of Adjusting Entries
There are two main types of adjusting entries:
- Accruals: These entries are used to record revenue or expenses that have been earned or incurred but have not yet been recorded in the accounts. For example, if a company has provided services to a customer in December, but has not yet received payment, an accrual entry is made to recognize the revenue earned in December. This ensures that the revenue is recorded in the correct period, even though payment has not yet been received.
- Deferrals: These entries are used to record revenue or expenses that have been received or paid but have not yet been earned or incurred. For example, if a company has paid for insurance coverage for the next year, an adjusting entry is made to recognize the expense over the period of coverage, rather than in the period the payment was made.
Example of An Adjusting Entry
An example of an adjusting entry is the recognition of an accrued expense.
Suppose a company receives a utility bill for $1,000 for the month of December, which is due in January of the following year. If the company’s accounting period ends on December 31, it needs to record an adjusting entry to recognize the expense that it incurred in December, even though it has not paid the bill yet.
The adjusting entry would involve debiting the utility expense account for $1,000, which represents the expense incurred during the period, and crediting the accrued expenses account for $1,000, which represents the amount the company owes for the utility bill at the end of the period.
Once the bill is paid in January, the company will record a separate transaction to debit the accrued expenses account for $1,000 and credit the cash account for the same amount to reflect the payment. This way, the company’s financial statements will accurately reflect the expenses incurred in December, even though the payment was made in January.
For small business owners or those without an accounting background, adjusting entries can be challenging to handle. Making accurate and timely adjusting entries is essential to maintain precise financial records and make informed business decisions. Businesses can guarantee the accuracy and compliance of their adjusting entries with GAAP principles by working with a professional accountant or consultant.