Adjusting entries are journal entries that are used at the end of an accounting period to adjust the balances in various general ledger accounts. These adjustments are made to more closely align the reported results and financial position of a business to meet the requirements of an accounting framework, such as GAAP or IFRS. This generally involves the matching of revenues to expenses under the matching principle, and so impacts reported revenue and expense levels.
The use of adjusting journal entries is a key part of the period closing processing, as noted in the accounting cycle, where you convert a preliminary trial balance into a final trial balance. It is usually not possible to create financial statements that are fully in compliance with accounting standards without the use of adjusting entries.
An adjusting entry can used for any type of accounting transaction; here are some of the more common ones:
- To record depreciation and amortization for the period
- To record an allowance for doubtful accounts
- To record a reserve for obsolete inventory
- To record a reserve for sales returns
- To record the impairment of an asset
- To record a warranty reserve
- To record any accrued revenue
- To record previously billed but unearned revenue as a liability
- To record any accrued expenses
- To record any previously paid but unused expenditures as prepaid expenses
- To adjust cash balances for any reconciling items noted in the bank reconciliation
As shown in the preceding list, adjusting entries are most commonly of three types, which are:
- Accruals. To record a revenue or expense that has not yet been recorded through a standard accounting transaction.
- Deferrals. To defer a revenue or expense that has been recorded, but which has not yet been earned or used.
- Estimates. To estimate the amount of a reserve, such as the allowance for doubtful accounts or the inventory obsolescence reserve.
When you record an accrual, deferral, or estimate journal entry, it usually impacts an asset or liability account. For example, if you accrue an expense, this also increases a liability account. Or, if you defer revenue recognition to a later period, this also increases a liability account. Thus, adjusting entries impact the balance sheet, not just the income statement.
Since adjusting entries so frequently involve accruals and deferrals, it is customary to set up these entries as reversing entries. This means that the computer system automatically creates an exactly opposite journal entry at the beginning of the next accounting period. By doing so, the effect of an adjusting entry is eliminated when viewed over two accounting periods.
A company usually has a standard set of potential adjusting entries, for which it should evaluate the need at the end of every accounting period. You should have a list of these entries in the standard closing checklist. Also, consider constructing a journal entry template for each adjusting entry in the accounting software, so there is no need to reconstruct them every month.
Adjusting Entry Examples
Depreciation: Arnold Corporation records the $12,000 of depreciation associated with its fixed assets during the month. The entry is:
| Accumulated depreciation
Allowance for bad debts: Arnold Corporation adds $5,000 to its allowance for doubtful accounts. The entry is:
|Bad debts expense
| Allowance for doubtful accounts
Accrued revenue: Arnold Corporation accrues $50,000 of earned but unbilled revenue. The entry is:
|Accounts receivable - accrued
Billed but unearned revenue: Arnold Corporation bills a customer for $10,000, but has not yet earned the revenue, so it creates an adjusting entry to record the billed amount as a liability. The entry is:
| Unearned sales (liability)
Accrued expenses: A supplier is late in sending Arnold Corporation a materials-related invoice for $22,000, so the company accrues the expense. The entry is:
|Cost of goods sold (expense)
| Accrued expenses (liability)
Prepaid assets: Arnold Corporation pays $30,000 toward the next month's rent. The company records this as a prepaid expense. The entry is:
|Prepaid expenses (asset)
| Rent expense