What is Adjusting Entries?
Adjusting entries are made at the end of an accounting period after a trial balance is prepared to adjust the revenues and expenses for the period in which they occurred. Adjusting entries are necessary to get accurate and updated company records and the company follows the accrual method. (Under the Accrual method revenues/ incomes and related assets are reported when they are earned and not when the cash is received. Similarly, expenses and related liabilities are reported when they actually occur and not when the cash is paid.)
In Accrual accounting, revenues and expenses has to be reported in the same accounting period. Revenue Recognition principle also depicts that revenues and expenses must be recorded in the period when they are actually incurred. Suppose if the revenues are earned in one period and cash received in another period or expenses incurred in one period and paid in another period, there arises a mismatch. Therefore, to solve this mismatch Adjusting Entries are prepared.
When Adjusting Entries are prepared?
Adjusting Entries are 5th step in the accounting cycle. Adjusting Entries are prepared after the preparation of the Trial Balance. After the preparation of ‘initial Trial Balance’, adjusting entries has to be passed and after journals are posted to the ledger the adjusted trial balance is prepared.
Why do we prepare Adjusting Entries?
- The purpose of adjusting entries is to ensure that your financial statements will reflect accurate data.
- If adjusting entries are not passed, companies profit and loss, Balance Sheet, cash flow statement will not be accurate.
Accounts that need Adjusting Entries
1. Prepaid Expenses
Future expenses paid in advance are called Prepaid Expenses. For example, Rent is paid in advance.
2. Depreciation
A reduction or decrease in the value of an asset over time, due to wear and tear, etc. Accumulated depreciation refers to the accumulated depreciation of a company’s assets over the life of the company. Assets depreciate by some amount every month as soon as it is purchased. This is reflected in an adjusting entry as a debit to the depreciation expense and equipment and credit accumulated depreciation by the same amount.
3. Accrued Revenues
Accrued revenue means revenues earned but cash has not been received. Here service is given in one month but billed in the next month.
4. Accrued Expenses
Expenses that are incurred in one month and payments made in another month.
5. Unearned Revenue
Payments for goods to be delivered in the future or services to be performed are considered unearned revenue. For example, if you place an online order in September and that item does not arrive until October, the company you ordered from would record the cost of that item as unearned revenue. The company would make adjusting entries for September (the month you ordered) debiting unearned revenue and crediting revenue.
