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Adjusting Journal Entries: Why Are They Necessary?

Adjusting Journal Entries: Why Are They Necessary?

7 minute read

What Are Adjusting Journal Entries?

Adjusting journal entries are used to adjust a company’s financial statements and bring them into compliance with relevant accounting standards, such as generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS). The activity of adjusting journal entries is routinely performed by accountants to allocate income and expenses to the actual period in which the income or expense occurred or earned—a feature of accrual accounting.

Five Common Types of Adjusting Journal Entries

There are many different types of adjusting journal entries, but the five most common types are:

1. Accrued Revenue

Accrued revenue is revenue that has been recognized by the business, but the customer has not yet been billed. This type of revenue is common in service-related businesses, as services can be performed several months before a customer is invoiced. Revenue must be accrued, otherwise revenue totals would be understated, especially compared to expenses for the period. 

2. Accrued Expenses

Accrued expenses are those that have been incurred before they have been paid. For example, a company purchases supplies from a vendor but has not yet received an invoice for the purchase. Other examples of accrued expenses include interest payments on loans, warranties on products or services, and taxes.

3. Deferred Revenues

Deferred revenue indicate when a company receives payment in advance of work that has not yet been completed. This is common for professional firms that work on a retaine—such as a law or CPA firm. A client may pay in advance for work that is to be done over a period of time. When the revenue is later earned, the journal entry is reversed.

4. Prepaid Expenses

Prepaid expenses need to be recorded as an adjusting entry. Many companies prepay rent for an entire year. The company will record the expense each month for the next 12 months to account for the rental payment properly. Without this, financial statements will reflect an unusually high rental expense in one month, followed by no rental expenses at all for the following months.

5. Depreciation Expenses

Depreciation expenses, including depreciation expense and accumulated depreciation, need to be posted to properly expense the useful life of a fixed asset. Depreciation is a fixed cost and does not negatively affect cash flow, but the balance sheet would show accumulated depreciation as a contra account under fixed assets.

Given the nature of adjusting entries, they often impact both the balance sheet and the income statement. Adjusting entries are also used to correct financial errors and must be completed before a company’s financial statements can be issued. For example, something is capitalized and booked to a Fixed Asset account that, under company policy, should be booked to an expense account like Supplies Expense, or vice versa.

Where Do Adjusting Journal Entries Fit into the Financial Close Process?

At the end of each financial period, accountants go through all the prepaid and accrued expenses as well as unearned and accrued revenue and identify necessary adjusting entries.

This is often a time-consuming process that involves spreadsheets to track expenses and payments made against those expenses as well as revenue earned and payments received against that revenue.

These adjustments are often a result of the account reconciliation process during the financial close. They may also be detected by doing variance analysis of account balances to detect any unusual balance fluctuations.

How to Record Adjusting Journal Entries

When the need for an adjusting journal entry is identified, accountants prepare the journal entry to credit and debit appropriate accounts. In theory, the process for recording an adjusting journal entry can be broken into 3 steps:

1)    Determine the current account balance

2)    Determine what the current balance should be

3)    Record an adjusting entry

This is likely oversimplifying, since companies may have hundreds or thousands of adjusting journal entries to make each period, but it gives an overview of the process needed for each entry. In addition, adjusting journal entries should include supporting documentation, links to applicable policies and procedures, and be properly reviewed and approved before being posted.

Examples of Adjusting Journal Entries

One example is to accrue for unpaid wages at month-end. A potentially more intricate example may be rebate accruals. Rebates are payments made back to you from a supplier (or from you to a customer) retrospectively, reducing the overall cost of a product or service.

In this case, you may have an arrangement with a supplier to earn a quarterly rebate based on your overall spend with that supplier. Imagine the supplier's policy is to pay the rebate at the end of the year. Then, from an accounting perspective, this may need to be accrued for when the rebate is earned, not when it is received.

When preparing the entry, it's helpful to reference your company's policy and procedure to ensure compliance, and it is best practice to attach supporting documents to the journal entry, like the contract and terms. This will help speed up the approval process, as well as any audit work later.

What Solutions Does BlackLine Offer?

BlackLine Journal Entry automates the process for creating and managing adjusting journal entries. It provides an integrated system for the creation, review, approval, and posting of adjusting journal entries. Journal entry templates ensure standardization across the organization, and validation rules check entries for errors before posting. 

Advanced features include the automatic creation of journal entries through cloning of recurring journal entries or import of journal and journal lines from report writers or spreadsheets. It also provides integrated storage of supporting documentation, links to policies and procedures, and automatic posting and status tracking for real-time updates.

BlackLine Account Reconciliations integrates with Journal Entry to automate and streamline the account reconciliation process. This gives accounting teams more time to analyze and book any necessary adjusting journal entries.

This solution also simplifies the process of handling prepaid amounts. It includes an amortizable prepaid template that records the original amount, open date, and the dates amortization should begin and end.

Amortized amounts are automatically calculated based on this information. The amounts can also be manually updated if there is a change to the balance or if an item should not be amortized on a straight-line basis.

A built-in control displays when the amounts entered do not equal the total amount being amortized. This template provides an easy way for accountants to handle prepaids, eliminating the need to manually set up and manage spreadsheets.

Account Reconciliations also integrates with BlackLine Transaction Matching to provide automated analysis of transaction details. The integration of these products with Journal Entry centralizes all information concerning a given journal in one easily accessible place with comments, documents, and links to underlying matching transactions and reconciling items.

In addition, BlackLine Variance Analysis monitors fluctuations in account balances and helps identify errors that require adjusting journal entries.

Get your copy of this white paper to learn more about how your F&A organization can make the move to modern accounting by centralizing, managing, and automating journal entries.