While journal entries are made continuously throughout a reporting period as transactions occur, adjusting journal entries are typically made as part of the reconciliation process.
This is the process to correct errors and enter adjustments to finalize balances before the books are closed at the end of a reporting period.
Journal entries record all transactions for a business. Transactions are broadly defined as any financial activity that impacts the business. They are not limited to the buying and selling of goods and services, but include any exchange of monetary value.
Adjusting journal entries can be made in many different ways. They may be made to correct mistakes, errors, or omissions that were made with other journal entries.
These correcting entries typically apply to incorrect entries, errors in calculations, or overlooked transactions.
Adjusting journal entries may also be made to record certain types of financial transactions that are not accurately or entirely accounted for through normal journal entries, such as depreciation, interest, or unearned income.
They are calculated and applied to the period even though the original transaction occurs or is completed in a different reporting period.
These types of entries fall into one of three categories:
Accruals refer to money that has not been paid or received, but for which the business is either obligated to pay or entitled to receive, such as interest, rent, revenue, taxes, and utilities. They can refer to either expenses or revenue.
Deferrals refer to money that has been received or paid in advance, but which has not technically been earned or used, such as unearned income, insurance premiums, or prepaid rent. These can also refer to either expenses or revenue.
Estimates are adjusting entries that record non-cash items. The most common type of estimate is for depreciation of assets, which is the calculation of lost value over time.
Within these three broad categories, there are many types of adjusting journal entries.
Many businesses prepay insurance premiums, for six months or a year, to receive a favorable discount. Because the subsequent accounting periods will receive the benefit of the insurance without actually having to make a (monthly) premium payment, the expense is said to be deferred.
No benefit can be credited to the business without recording its associated cost. In the case of a deferred expense like prepaid insurance, an adjusting journal entry is made during each of the affected accounting periods to accurately record what the monthly cost of the premium would be.
This is done by dividing the total cost of the prepaid expense by the number of months to which it applies. Some businesses also prepay rent. An adjusting journal entry would be made for this deferred expense in a similar manner.
Businesses may receive payment in advance for services or products that are not yet provided. A journal entry would initially be made for this deferred revenue, also known as unearned income.
An adjusting journal entry would then be recorded during the accounting period when the product or service is delivered. The two entries would cancel each other out.
Businesses may accrue expenses or revenue, just as they defer them. In the first case, a business may accrue or accumulate expenses before paying for them.
These will be recorded as accounts payable. Later, adjusting journal entries will be made during the account periods when the bills are paid.
These entries will reduce the accounts payable by the amount of the payments that have been made. When all of the bills are paid, the adjusting journal entries will have reduced the accounts payable to zero.
Similarly, if a customer has not paid for products or services received, this is recorded as accrued revenue or accounts receivable. When the customer pays the bills, in whole or in part, an adjusting journal entry is recorded which reduces the accounts receivable, or amount owed to the business, by the corresponding amount.
When a business purchases equipment, such as computers or machinery, these items have a projected lifespan. Ten years is a common timeframe. The business records the gradual loss in value to the asset as depreciation over the duration of its lifespan. An adjusting journal entry is made to record this incremental, non-cash transaction for each accounting period within the lifespan, at the end of which the value of the asset will have reached zero.
An adjusting journal entry allows certain transactions to cancel or balance out. They frequently involve multiple entries. For example, a business may deliver a product or service to a customer for a value of $1,000, but the customer does not pay right away, either because of a deferred payment option or because credit was extended.
In either case, a journal entry for $1,000 will be recorded under revenue.
Another journal entry for the same amount will be recorded as a debit under accrued revenue or accounts receivable, to show that payment has yet to be received.
When the customer pays for the service or product, either in whole or in installments, an adjusting journal entry will be made for the amount paid as a credit under accrued revenue or accounts receivable. In this fashion, the adjusting journal entry cancels or balances out the amount owed to the business, and the transaction is accurately recorded as payments are received.
The original $1,000 entry for revenue remains unchanged, but the accrued revenue/accounts receivable balance will eventually reach zero as the customer pays for the full value of the product or service that was delivered.
Businesses make adjusting journal entries for several reasons:
To correct errors and omissions and to maintain accuracy in its accounting records
To accurately record transactions and activities that do not occur during a reporting period, but which have an impact on the balance of the reporting period
To correctly match expenses with benefits that are received
To correctly record and apply non-cash transactions
Adjusting journal entries are made according to the matching principal, which states that revenue and related expenses must be recorded in the same accounting period when the transaction occurs, regardless of when money actually changes hands.
For example, if a business buys manufacturing equipment that is expected to last for ten years, the value of that equipment will be recorded as depreciation in equal amounts during each accounting period over the ten-year lifespan. This will allow the business to apply or “match” the expense of the equipment evenly to the revenue the equipment generates over its useful life.
The matching principal is applied in accordance with the accrual basis of accounting.