Adjusting Entries in Journal

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 GAAP.
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 principle of accrual-based accounting.

Example

Taking adjusting entries example of a company named ABC Corporation, which availed long-term debt funding for implementation of its expansion plan. The financial reporting 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 15^th of every month. The company’s interest payment on the debt from 15^th December 2018 to 15^th January 2019 will be due on 15^th 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 period 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 sheet. 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 accruals. 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 expenses 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 revenues come under accruals.

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#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 sheet.

#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 revenue. 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 account 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 entry 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 Expenses 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 expense 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 statement. 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 principle 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.