Adjusting Entries: Definition, Types and Examples

• Definition of adjusting entries
• Importance of adjusting entries
• Types of adjusting entries
• Why are adjusting entries important for small business accounting?
• Examples of adjusting entries
• Frequently asked questions

What is adjusting entries

Adjusting entries refers to a set of journal entries recorded at the end of the accounting period to have an updated and accurate balances of all the accounts. Adjusting entries are mere application of the accrual basis of accounting.

Sounds bookish? Let’s make it easier for you.

It’s so common in business that you pay or receive or buy something who’s benefit is either yet to be consumed in full or something is paid today for tomorrows use.

For example, if you are paying an insurance premium of 65,000 Rs on 1st October and insurance covers for a period of 12 months from 1st October,2018 to 30th September,2019.

Now, if you closely look at the above example, an expense of 65,000 towards insurance premium is incurred in the accounting period 1st April,2018 to 31st March,2019 but the entire expense is not attributable to the financial year 2018-2019.

The reason is the premium covers till 30th September,2019 and only the portion of expenses till 31st March 2019 is attributable to F.Y 18-19. The remaining portion is treated as ‘Pre-paid’ expenses’ as on 31st March,2019.

For you to bring this impact in the books of accounts, you need to record an adjusting entry at the end of the accounting period so that expenses are rightly reflected in the financial statements.

Like the above examples, there are many situations in which expenses may have been incurred but not yet recorded in the journals. And also some of the income may also have been earned but not entered in the books.

Thus, adjusting entries help you keep your accounts updated before they are summarized into the financial statements. Adjusting entries are made for accrual of income, accrual of expenses, deferrals (income method or liability method), prepayments (asset method or expense method), depreciation, and allowances.

Importance of adjusting entries

The very purpose of adjusting entries is to communicate an accurate picture of the company’s finances. The management can have a complete look into the financial statements knowing that everything that occurred during the month is reported even if the financial part of the transaction would have warranted to have occurred at a later stage. A statement of finance prepared without considering adjusting entries would misrepresent the financial health of the company.

Types of adjusting entries

The following entries are the most common types of adjusting entries recorded in books of accounts.

• Accrued Revenues

If you perform a service for a customer in one month but don't bill the customer until the next month, you would make an adjusting entry showing the revenue in the month you performed the service and would also debit accounts receivable and credit service revenue.

• Accrued Expenses

One fine example of accrued expenses is wages paid to employees. When a business entity owes wages to employees at the end of an accounting period, they make an adjusting journal entry by debiting wages expense and crediting wages payable.

• Unearned Revenues

Unearned revenues refer to payments received for goods to be delivered in the future or services to be performed. In this case, the company would make an adjusting entry debiting unearned revenue and crediting revenue account.

• Prepaid Expenses

These are the assets that are paid for and which gradually get used up during the accounting period. It’s similar to the example of pre-paid insurance premium we discussed above.

• Deprecation

Depreciation is the process of allocating the cost of an asset, such as a building or a piece of equipment, over the serviceable or economic life of the asset. Due to various reasons, the asset value depreciates by some amount and adjusting entry is made to account the depreciation expenses.

Why are adjusting entries important for small business accounting?

Adjusting entries are primarily made to arrive at the accurate amount wrt income and expenses at the end of a certain period. These entries account for the income and expenses which are not yet recorded in the general ledger, and should be completed before closing of the books in that specific period. So why are adjusting entries so important in a small business?

Revenue appears to be low

Let's say you've earned some profit/revenue in a specific period, but it hasn't been accounted for yet. In such a scenario, the financial statements that's generated for that period, will be low. Non recording of this revenue earned, will mean that the company is not abiding by the revenue recognition principle of accounting, which states that revenue must be recognized when it is earned.

Understated expenses

Similar to the immediate recording of revenue earned, any expense incurred should also be immediately become a part of your company's accounts book. This is particularly significant when accruing payroll expenses as well as any expenses you have incurred during the month that you have not yet been invoiced for.

Inaccurate financial statements

It's extremely important that at the end of each month, you run a close check on all your company's financial statement - balance sheet, P/L statement, and cash flow statement. This is crucial to ensure that all closing entries are recorded and that statements are a true reflection of your company's financial health.

Examples of adjusting entries

As learnt, that to arrive at a correct figure of profits and loss as well as true figures in the balance sheet, certain accounts require some adjustments. Entries for making such adjustments are called as adjusting entries. Following are some of the examples of adjusting entries.

Example 1: Depreciation on Machinery Rs. 1,00,000 /- @ 10% per annum. The adjustment entry as on March. 31, 2019 will be as follows:

Example 2: Max Ltd, which owed 65,000 /- KES to the company has been adjudged insolvent since they are unable to pay. The adjusting entry to provide the effect to the above transaction is :

Example 3: Puspak Publications received subscriptions amounting to. 40,000 TAK during the financial year ending 30th June 2019. Out of this, 7,500 TAK represent subscriptions relating to the next financial year.

The adjusting entry to provide the effect to the above transaction is :

Example 4: The Accounts Receivable of RST Ltd. was 1,50,000 /- Dirhams as on 31st December 2018. It was estimated that 8,000 /- of the amount due may turn out to be uncollectable during the forthcoming year.

For the creation of the provision, the following adjusting journal will be recorded:

Frequently asked questions

In adjusting entries, how do I know which T-accounts to use?

Adjusting entries are always done for the amount that has been used or the amount that hasn't expired. So if the ending inventory is say INR 100, and the closing balance is INR 1000, you will record INR 100 on the left side of the T-account (Dr) and the remaining INR 900 will be recorded on the right side (Cr).

What is the difference between adjusting entries and closing entries?

Adjusting entries ensure that the accrual principle is followed when recording incomes and spending. Closing entries are those that are used to close temporary ledger accounts and transfer their balances to permanent accounts.

What is the difference between adjusting entries and correcting entries?

Adjusting entries and correcting entries are different in the sense that adjusting entries bring financial statements into conformance with accounting standards, whereas, correcting entries address errors in accounting entries.