Adjusting entries are used to adjust the ending balances in various general ledger accounts. These journal entries are intended to bring the financial statements of the reporting entity into compliance with the applicable accounting framework (such as GAAP or IFRS). There are three general types of adjusting entries, which are as follows:
Accruals. An accrual entry is the most commonly-used adjusting entry. It is intended to record revenues or expenses that have not yet been recorded through a standard accounting transaction. For example, a company is constrained by a contractual arrangement with a government customer to not bill for services work until the end of a contract period. In the interim, the company accrues revenue, so that it can recognize some revenue from the contract, even though the contractual period has not yet been completed. As another example, a company controller decides to accrue the expense associated with a significant delivery of goods, and for which no supplier invoice has yet arrived. The intent is to ensure that the cost of the goods is recorded in the financial statements for the period in which the goods arrived.
Deferrals. A deferral entry is intended to defer the recognition of a revenue transaction that has not been earned, or an expense transaction that has not yet been consumed. The outcome is the shifting of revenue or expense recognition to a future period. For example, a customer pays in advance for a services contract that will be performed in equal installments over the next four months. A deferral adjusting entry can be used to shift 3/4 of the payment into the following three periods, when they will be recognized. Similarly, a company pays the full-year $12,000 cost of a life insurance policy in advance, and uses a deferral entry to shift the recognition of 11/12 of this amount into the next 11 reporting periods.
Estimates. An estimation adjusting entry is used to adjust the balance in a reserve, such as the allowance for doubtful accounts or the reserve for inventory obsolescence. This is done in order to maintain adequate reserve levels that reasonably the reflect the amount of losses from existing assets that can be expected in future periods.
Adjusting entries are a common part of the closing process for any business using accrual basis accounting.