Adjusting entries: Definition, examples, and basics

In this post, we will delve into the world of adjusting entries, exploring their significance, working principles, benefits, potential downsides, and alternatives. By the end, you'll have a comprehensive understanding of how adjusting entries can simplify and automate your accounting tasks.

What are adjusting entries?

Adjusting entries are journal entries made at the end of an accounting period to ensure that the financial statements accurately reflect a company's financial position. These entries are necessary to recognize revenues and expenses in the appropriate accounting period.

Adjusting entries typically involve recording accrued revenues or expenses, prepayments, depreciation, and other adjustments needed to present an accurate and complete view of a company's financial position and performance.

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How do adjusting entries work?

Adjusting entries work by bringing the accounts on a company's financial statements up-to-date and in line with the accrual accounting method. At the end of an accounting period, certain economic events may have occurred that have yet to be recorded in the books. Adjusting entries aim to rectify this discrepancy by recognizing revenues earned but not yet billed or collected, and expenses incurred but not yet paid or recorded.

For instance, accrued revenues are recorded to show income earned but not yet received, ensuring accurate revenue recognition. Similarly, accrued expenses are entered to account for expenses incurred but not yet paid, matching them with the corresponding revenues.

By making adjustments for items like accrued revenues, accrued expenses, prepaid expenses, and unearned revenues, adjusting entries align the company's financial statements with the economic reality of its operations. 

Benefits of adjusting entries

Adjusting entries offers several benefits to accountants and businesses:

• Accurate financial statements: Adjusting entries ensures that financial statements accurately represent  the business's financial position, performance, and cash flow.
• Compliance: By adhering to accounting principles, adjusting entries ensures compliance with regulatory requirements and maintains the integrity of financial reporting.
• Transparent performance evaluation: Accurate financial statements facilitate the assessment of business performance, aiding in identifying strengths and weaknesses.
• Informed decision making: Reliable financial information resulting from adjusting entries supports strategic decision-making, investment analysis, and resource allocation.

Downsides to adjusting entries?

Adjusting entries, despite their crucial role in ensuring accurate financial reporting, comes with certain downsides that warrant consideration. Some potential downsides include:

• Complexity: Adjusting entries involves technical accounting knowledge, requiring expertise to identify and record the appropriate entries.
• Time-consuming: Preparing adjusting entries can be time-consuming, particularly for businesses with numerous transactions or complex financial operations.
• Prone to errors: Inaccurate or incorrect adjusting entries can lead to financial misstatements, compromising the reliability of financial statements.

When to record adjusting entries

Adjusting entries should be recorded at the end of each accounting period. Here are the key considerations:

• Accrual basis: Adjusting entries are necessary for businesses that follow the accrual basis of accounting, where revenues and expenses are recognized when earned or incurred, regardless of cash flow.
• Timing: Adjusting entries should be made after all regular transactions for the accounting period have been recorded to ensure that the financial statements accurately reflect the period's financial activities.
• Consistency: Consistently recording adjusting entries at the end of each accounting period maintains uniformity and facilitates accurate financial reporting.

Types of accounts that require adjusting entries?

Various accounts may require adjusting entries to ensure accurate financial reporting:

Accrued accounts

• Accrued Revenues: Revenue earned but not yet received or recorded.
• Accrued Expenses: Expenses incurred but not yet paid or recorded.

Prepaid and deferred accounts

• Prepaid Expenses: Payments made for future expenses that need to be recognized as expenses in a future period.
• Unearned Revenues: Payments received in advance for goods or services that need to be recognized as revenue in a future period.

Depreciation and amortization

• Depreciation: Allocating the cost of tangible assets over their useful lives.
• Amortization: Allocating the cost of intangible assets over their useful lives.

Allowance accounts

• Allowance for Doubtful Accounts: Estimating and adjusting for potential bad debts.
• Allowance for Sales Returns and Allowances: Estimating and adjusting for potential returns or allowances.

Best practices when making adjusting entries

To ensure accuracy and efficiency when handling adjusting entries, follow these best practices:

Regular review

Perform regular reviews of financial transactions to identify any discrepancies or omissions that may require adjusting entries. A systematic review helps catch errors and ensures that all relevant adjustments are made promptly.

Maintain documentation

Maintain thorough documentation for all adjusting entries, including the reason for the adjustment, supporting calculations, and any relevant references to accounting standards. This documentation is essential for audits and provides transparency in financial reporting.

Verify accuracy

Verify the accuracy and precision of adjusting entries before finalizing them. Avoid making estimates or assumptions that could lead to inaccuracies in financial statements.

Segregation of duties

Implement a segregation of duties to separate the responsibilities of preparing, reviewing and approving adjusting entries, minimizing the risk of errors or fraud.

Regular reconciliation

Perform regular reconciliations to ensure that adjusting entries align with account balances and subsidiary records.

Frequently asked questions

Are adjusting entries reversible?

Yes, adjusting entries can be reversible. Reversing adjusting entries are typically made at the beginning of the subsequent accounting period. Reversing entries nullify the effect of specific adjusting entries that are no longer applicable or were made in error. Reversal simplifies the recording process for the new period and ensures accurate financial reporting.

How are adjusting entries different from regular journal entries?

Adjusting entries and regular journal entries differ primarily in their timing and purpose. Regular journal entries are made throughout the accounting period to record day-to-day business transactions, such as sales, purchases, expenses, and cash receipts. These entries ensure that all financial activities are accurately captured and classified in the general ledger.

On the other hand, adjusting entries are made at the end of an accounting period to ensure that the financial statements reflect the economic events that occurred during that specific period. These entries correct inaccuracies, allocate revenues and expenses to the appropriate period and align the financial records with accounting principles like the matching principle and accrual accounting.

Can adjusting entries impact taxes?

Yes. Adjusting entries are made at the end of an accounting period to ensure that financial statements reflect accurate and up-to-date information. These entries address accrued revenues and expenses, unrecorded transactions, and depreciation. When these adjustments are made, they can directly affect the company's net income, which ‌influences the amount of taxable income reported to tax authorities.

Do adjusting entries affect cash flow?

While adjusting entries play a crucial role in presenting a more accurate financial picture, they don't directly involve the flow of cash. Instead, they adjust non-cash items, such as accrued expenses, prepaid expenses, depreciation, and accounts receivable, among others. The impact on cash flow comes from the subsequent business activities that these adjusting entries help portray more accurately in the financial statements. 

What happens if adjusting entries are not made?

Failing to make necessary adjusting entries can result in inaccurate financial statements, leading to misrepresentation of a business's financial position.

Can adjusting entries be made in the middle of an accounting period?

While adjusting entries are commonly made at the end of an accounting period, they can also be made in the middle of a period if needed.