Adjusting entries

Adjusting entries are journal entries recorded at the end of an accounting period to alter the ending balances in various general ledger accounts. These adjustments are made to more closely align the reported results and financial position of a business with 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 a preliminary trial balance is converted 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 an asset retirement obligation
  • 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. These entries should be listed 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. The standard adjusting entries used should be reevaluated from time to time, in case adjustments are needed to reflect changes in the underlying business.

Adjusting Entry Examples

Depreciation: Arnold Corporation records the $12,000 of depreciation associated with its fixed assets during the month. The entry is:

  Debit Credit
Depreciation expense 12,000  
     Accumulated depreciation

Allowance for bad debts: Arnold Corporation adds $5,000 to its allowance for doubtful accounts. The entry is:

  Debit Credit
Bad debts expense
     Allowance for doubtful accounts

Accrued revenue: Arnold Corporation accrues $50,000 of earned but unbilled revenue. The entry is:

  Debit Credit
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:

  Debit Credit
     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:

  Debit Credit
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:

  Debit Credit
Prepaid expenses (asset)
     Rent expense