What Are Adjusting Entries? (Importance and Types)
By Indeed Editorial Team
Published 12 October 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Adjusting entries are an important part of the accounting process. You can make these entries at the end of each accounting period to correct any errors or omissions and to record any transactions that weren't previously recorded. Knowing what they are can help you ensure that your financial statements are accurate. In this article, we explain what adjusting journal entries are, discuss their importance, outline the five types and answer some frequently asked questions about this topic.
What are adjusting entries?
Adjusting entries are the changes you make to previously recorded journal entries. You do this at the end of an accounting period to correct errors and omissions that occurred in the recording of transactions during the period. They track accruals and deferrals, namely the revenue and expenses that you earned or incurred but didn't yet record in the books. This helps companies keep track of their finances. If you forget to record a sale that took place on the last day of the accounting period, you can make an adjusting journal entry to add that revenue into the books.
Similarly, if you incurred an expense but didn't yet pay for it, you can make an adjusting journal entry to record the liability. For example, if the company bills a customer $985 for services performed in March, they record the money as income that they're expecting to receive, namely in their accounts receivable. Then, when the customer pays them the money in April, the company makes a new entry that amends the old one. This means that they record the $985 as cash deposited in their bank account. This new entry is the adjusting journal entry.
Importance of adjusting entries
There are a few key reasons why adjusting journal entries are important for businesses:
Ensures that the financial statements are accurate
They ensure that the financial statements reflect the true financial position of the company. This gives stakeholders an accurate picture of the business's health and performance. They use financial statements to make decisions about the company, such as whether to invest in it or lend it money, so it's crucial that the statements are accurate.
Reduces the risk of fraud
Another reason why adjusting journal entries are important is that they reduce the risk of fraud since they provide checks and balances. This is because if someone wanted to commit fraud, they would likely do so by omitting entries or recording false ones. For example, they might omit to record a sale that took place or record a false sale. Adjusting journal entries makes it harder to commit fraud since they find and correct any errors or omissions.
Helps businesses make better decisions
Adjusting journal entries also helps businesses make better decisions since they give managers a more accurate picture of the company's financial position. This information is important for making sound decisions about where to allocate resources and how to grow the business. For example, if a company is close to its debt limit, adjusting journal entries can help managers see this and take steps to reduce expenses.
Helps businesses comply with accounting standards
Another reason why they're vital is that they help businesses comply with accounting standards by ensuring that the financial statements are accurate. This is important since businesses follow certain accounting standards, such as the Generally Accepted Accounting Principles, to produce their financial statements. If the statements don't comply with these standards, it can result in legal penalties.
Related: How to Become a Freelance Accountant
5 types of adjusting entries
These are the five types:
1. Accrued revenues
Accrued revenues are adjusting journal entries that you can make if you want to record revenue that you earned but didn't yet record. This might happen because the company didn't invoice the customer yet or because the customer didn't pay the company yet. An accrued revenue journal entry is a debit to cash and a credit to revenue, meaning that it increases both cash and revenue.
For example, if a company provides consulting services and bills its customers at the end of each month, but it only records revenue once the customer pays, it would then make an accrued revenue journal entry at the end of each month. This is because the company earned the revenue in that month, even though it didn't record it yet. Therefore, the journal entry is an accrued revenue since it's accrued, or earned, but not yet recorded.
2. Accrued expenses
Accrued expenses are adjusting journal entries that can record an expense that you incurred but didn't yet record. This might happen because the company didn't receive the bill or payment yet. This increases both cash and expenses since it's a debit to cash and a credit to expenses.
For example, if a company pays its employees every two weeks but incurs the expense in the current month, it would then make an accrued expense journal entry. This is because the company incurred the expense in that month, even though it didn't pay it yet. Therefore, the journal entry is an accrued expense since it's accrued but not yet paid.
3. Deferred revenues
Deferred revenues are adjusting journal entries that you can make if you want to record revenue that you earned but won't yet record. This might happen because the company didn't provide the service yet or because the customer didn't pay yet. A deferred revenue journal entry is a credit to cash and a debit to revenue, meaning that it decreases cash and increases revenue. This happens because the company receives the cash upfront but won't record the revenue until later.
For example, if a firm sells a one-year subscription to its software, but the customer pays upfront, it can then make a deferred revenue journal entry. This is because the company received the cash in the current month, but doesn't record the revenue until the customer uses the software in the future. Therefore, they only earn revenue in the future.
4. Depreciation expense
Depreciation expense is an adjusting journal entry that you can use to record the wear and tear of an asset over time. Wear and tear means that the asset isn't worth as much compared to when new. This is important because it reduces the value of the asset on the balance sheet which is important for financial reporting. The depreciation expense journal entry is a debit to depreciation expense and a credit to the asset, meaning that it increases depreciation expense and decreases the asset since it's worth less.
For example, if a company buys a new computer for its business, it can then make a depreciation expense journal entry every month. This is because the computer decreases in value every month due to wear and tear. Therefore, the journal entry is a depreciation expense since it's an expense that reduces the value of an asset.
5. Prepaid expense
A prepaid expense is an adjusting journal entry that you can use to record an expense that you already paid but didn't yet incur. This might happen because you paid for a service in advance or because you paid for an expense that occurs in the future. A prepaid expense journal entry is a credit to cash and a debit to the prepaid expense, meaning that it decreases cash and increases the prepaid expense. This is because the company pays for the expense upfront but doesn't record it until later.
For example, if a firm buys insurance for its business, it can then make a prepaid expense journal entry. This is because the company pays for the insurance in advance, but the insurance doesn't start until the next month. Therefore, the journal entry is a prepaid expense since it's an expense that they pay but don't yet receive.
These are some frequently asked questions about adjusting journal entries:
What is the difference between the accrual system and the cash basis system?
The accrual system is an accounting method that records transactions when they occur, regardless of when the money transfers. If you use this system, it usually means you make your own adjusting journal entries. The cash basis system is an accounting method that only records transactions when the money transfers. If you use this system, you likely won't make adjusting journal entries.
What is the difference between an adjusting journal entry and a correcting journal entry?
An adjusting journal entry is an accounting transaction that you make to keep your financial statements accurate. A correcting journal entry is an accounting transaction that you make to fix an error in the financial statements. The difference between these two is that you plan to make an adjusting journal entry, while a correcting journal entry is unplanned.
Who makes adjusting journal entries?
The person who makes adjusting journal entries is typically the accountant or bookkeeper. In some cases, the business owner might make these entries. It usually depends on the company's accounting method and the company's policies. Private individuals might also make adjusting journal entries in their personal finances if they use the accrual system.
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