What are Adjusting Entries in Journal?
Adjusting Entries in Journal is the journal entry done by the company in the end of any accounting period on the basis of accrual concept of accounting as companies are required to adjust the balances of its different ledger accounts at the accounting period end in order to meet the requirement of the standards set by the various authorities.
Adjusting entries (also known as accounting adjustments) are journal entries generally made at the end of a particular accounting period/reporting period to record the transactions which took place in that accounting period but have not been recognized or recorded.
- These Accounting Adjustments are made to correctly allocate the income and expenses of a Company in the same period in which the transactions related to income and expenses took place.
- Adjusting entries are mostly made just before the release of the Company’s financials so that Company’s reported financials are in compliance with the relevant framework of international accounting standards such as IFRS and GAAPAnd GAAPGAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting.read more.
- These entries are made at the end of an accounting period so that the reported numbers of a company are in line with the concept of the revenue recognition principle and the matching principleMatching PrincipleThe Matching Principle of Accounting provides accounting guidance, stating that all expenses should be recognized in the income statement of the period in which the revenue related to that expense is earned. This means that, regardless of when the actual transaction is made, the expenses that are entered into the debit side of the accounts should have a corresponding credit entry in the same period.read more of accrual-based accounting.
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Source: Adjusting Entries in Journal (wallstreetmojo.com)
Example
Taking adjusting entries exampleAdjusting Entries ExampleAdjusting entries (AJE) are entries made in a business firm's accounting journals to adapt or update the revenues and expenses accounts in accordance with the accrual principle and the matching concept of accounting, and examples are Prepaid Expenses and Accrued but Unpaid Expenses.read more of a company named ABC Corporation, which availed long-term debt funding for implementation of its expansion plan. The financial reportingFinancial ReportingFinancial Reporting is the process of disclosing all the relevant financial information of a business for a particular accounting period. These reports are used by the stakeholders (investors, creditors/ bankers, public, regulatory agencies, and government) to make investing and other relevant decisions. read more period for the Company is January 2018 to December 2018 (January to December cycle).
- The debt funding terms by lenders to the company are such that it has to make the interest payments for debt on the 15th of every month. The company’s interest payment on the debt from 15th December 2018 to 15th January 2019 will be due on 15th January 2019. Therefore Company’s records will not have any entries for payment of interest to the bank for interest expense of 15 days of December month.
- However, the company’s reported numbers at the end of December 2018 must contain the interest of 15 days for the months of December 2018 to correctly represent the expenses incurred by the Company for the accounting periodAccounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.read more of January 2018 to December 2018. Therefore, the Company needs to make adjusting journal entries as below to include the 15 days’ interest expense in the reported number for the accounting period of January 2018-December 2018.
- Adjusting journal entries for this will involve adjustments in interest expense account in income statement and interest payable account in a balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more. Interest expense account in the income statement will have a debit entry for 15 days’ interest expense (of December month), and interest payable account in the balance sheet will have credit entry for the same amount.
Classification of Accounting Adjustments
Most of the adjusting journal entries made for accounting adjustments can be broadly classified under two major heads, i.e., deferral and accrualsDeferral And AccrualsAccrual is the process of recording revenue or expenses that have not yet been settled. Deferring means postponing the realization of revenue or expenditure until a later date.read more. Deferrals include those transactions wherein a company pays or receives cash before consumption (either by a company or its clients). The accounting adjustments for prepaid expensesAccounting Adjustments For Prepaid ExpensesPrepaid expenses are paid in advance and hence are treated as an asset to the company. The most common prepaid expenses are rent and insurance. These are future expenses which are taken care of in advance, providing future economic benefits.read more and unearned revenues come under deferrals. Accruals include those transactions wherein a company pays or receives cash after the consumption (either by a company or its clients). The adjusting journal entries for accrued expenses and accrued revenuesAccrued RevenuesAccrued revenues are the company's revenue in the normal course of business after selling the goods or providing services to a third party. However, the payment has not been received. Instead, it is shown as an asset in the balance sheet of the company.read more come under accruals.
#1 – Accrued Revenue
Accrued revenue is a transaction wherein a company renders its goods and services to customers but receive the payment with a certain time delay. Suppose a company makes a sale for USD 100 million in an accounting period but receives only 80% of the payment for the sales made in the same accounting year. In this scenario, the accounting adjustments are made as a credit in revenue account by USD 100 million and debit entry of USD 20 million (100*20%) to accounts receivable in a balance sheetAccounts Receivable In A Balance SheetAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more.
#2 – Unearned Revenue
When a Company receives the payment in advance for its goods or services to be rendered in the future, such amount received by the company refers to unearned revenueCompany Refers To Unearned RevenueUnearned revenue is the advance payment received by the firm for goods or services that have yet to be delivered. In other words, it comprises the amount received for the goods delivery that will take place at a future date.read more. Construction companies are a classic example of such transactions wherein they generally receive an advance from the client to start the work. They receive advance payments even before they start the construction work. If the company received the advance payment for the work in December 2018 and it is planning to start the work in January 2019. The Company will make adjusting journal entries in December 2019 to credit the revenue accountRevenue AccountRevenue accounts are those that report the business's income and thus have credit balances. Revenue from sales, revenue from rental income, revenue from interest income, are it's common examples.read more and debit the unearned revenue account.
#3 – Accrued Expenses
Accrued expenses are the expenses that are incurred and recorded by a company in an accounting period expenses are not paid for. These unpaid expenses are recorded in the payables account in the balance sheet of the Company. The most common example of payables is wage payables to employees, interest expense payable to banks, or payables to suppliers of raw materials. The adjusting journal entries for payables are made by way of a debit entryDebit EntryDebit represents either an increase in a company’s expenses or a decline in its revenue. read more in the respective expense account in the income statement and by credit entry in the payables account in the balance sheet of the company.
#4 – Prepaid Expenses
Prepaid ExpensesPrepaid ExpensesPrepaid expenses are expenses for which the company paid in advance in an accounting period but which were not used in the same accounting period and have yet to be recorded in the company's books of accounts.read more are classified as assets in a balance sheet. It arises when a company pays for consumables/services in advance, but the company uses these consumables /services over time. One common example of prepaid expenseOne Common Example Of Prepaid ExpensePrepaid expense examples will provide an idea of the various payments made by the company in advance for those goods or services which will be procured in future. Some of these include prepaid rent, advance salary and prepaid insurance.read more is the subscription fee paid by a company to a research company to avail its services (research reports, industry research, outlook on various industries). In such transactions, the company pays the subscription fee upfront. However, a company will use the services of the research company over the accounting period. The prepaid expenses, once used/consumed, become an expense and recorded in the income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more. The unused portion of such prepaid expenses will remain in the prepaid expense account.
Conclusion
The basic premise before making adjusting journal entries in the income statement and balance sheet is to make the reported financial statements in line with the concept of accrual-based accounting, i.e., basically conformance of the revenue recognition principleRevenue Recognition PrincipleThe revenue recognition principle falls under GAAP, which outlines the specific conditions under which the revenue is recognized and recorded. A business may receive payment early or later after delivering the goods and services to the customer, and still, revenue gets recognized.read more and matching principle in the reported financials. The accounting adjustments help incorrectly allocate the income, expenses, assets, and liabilities, thus resulting in correct reported financials.
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