What are Adjusting Entries
For accounting purposes, adjusting entries are journal entries made at the end of an accounting period. Adjusting entries allocate income and/or expenses to the period in which they actually occurred . The revenue recognition principle states that income and expenses must match. This is why adjusting entries need to be made under an accrual based accounting system. Based on this, revenues and associated costs are recognized in the same accounting period. However, the actual cash may be received or paid at a different time.
The General Ledger
The General Ledger contains all entries from both the General Journal and the Special Journals.
The Types of Adjusting Entries
There are several different types of adjusting entries. Each one accounts for a different situation.
- Prepayments - adjusting entries for prepayments are necessary to account for cash that has been paid prior to delivery of goods or completion of services. When this cash is paid, it is first recorded in a prepaid expense asset account; the account is to be expensed either with the passage of time (e.g. rent, insurance) or through use and consumption (e.g. supplies). The adjusting entry would credit the asset (e.g. supplies) account and debit a related expense account (e.g. supplies expense)
- Accruals - accrued revenues are revenues that have been recognized (that is, services have been performed or goods have been delivered), but their cash payment have not yet been recorded or received. When the revenue is recognized, it is recorded as a receivable. Accrued expenses have not yet been paid for, so they are recorded in a payable account. Expenses for interest, taxes, rent, and salaries are commonly accrued for reporting purposes.
- Estimates - An adjusting entry for an estimate occurs when the exact amount of an expense cannot easily be determined. For example, the depreciation of fixed assets is an expense that has to be estimated. The entry for bad debt expense can also be classified as an estimate.
- Inventory - in a periodic inventory system, an adjusting entry is used to determine the cost of goods sold expense. This entry is not necessary for a company using perpetual inventory.
Consider our yoga studio example. Some of our previously recognized transactions need to be adjusted in later periods:
July
a. Recognize insurance expense
Prepaid Insurance -100, Insurance Expense 100; Assets(-)=Equity(-)
b. Depreciation @ $20/month
Accumulated Depreciation 20, Depreciation Expense 20; Assets(-)=Equity(-)
August
a. Recognize insurance expense
Prepaid Insurance -100, Insurance Expense 100; Assets(-)=Equity(-)
b. Depreciation @ $20/month
Accumulated Depreciation 20, Depreciation Expense 20; Assets(-)=Equity(-)
c. Pay wages from July
Cash -300, Wage Payable -300; Assets(-), Liabilities(-)
d. Pay utilities from July
Cash -200, Utility Payable -200; Assets(-), Liabilities(-)
The journal entries to record these transactions would be as follows:
July
a. Expiration of insurance
Insurance expense.....................................200
-----Prepaid insurance..........................................200
b. Depreciation on studio equipment (500 for 25 months = 20/month)
Depreciation expense.................................20
-----Accumulated Depreciation.................................20
August
a. Expiration of insurance
Insurance expense.................................200
-----Prepaid insurance .................................200
b. Depreciation on studio equipment (500 for 25 months = 20/month)
Depreciation expense.................................20
-----Accumulated Depreciation........................20
c. Pay wage from July
Wage payable.................................300
-----Cash................................................300
d. Pay utility bill from July
Utility payable.................................200
-----Cash.................................................200