An adjusting entry is a journal entry made at the end of an accounting period to properly record and recognize revenues and expenses that have occurred but have not yet been recorded. This accounting practice ensures that financial statements accurately reflect the financial position of a company and adhere to the accrual basis of accounting. An adjusting entries example is a practical illustration that helps individuals understand how these entries are recorded and their impact on financial statements.
To clearly grasp the concept of adjusting entries, consider the following adjusting entries example. Suppose a company provides services to a client in December but does not receive payment until January of the following year. Based on the accrual accounting principle, revenue recognition should occur in December, when the services were provided, not in January when payment is received. In this scenario, an adjusting entry is required to properly record the revenue and match it with the expenses incurred to generate that revenue.
In this adjusting entries example, the company would make the following entry:
Debit: Accounts Receivable
Credit: Service Revenue
By debiting Accounts Receivable, the company recognizes that it is owed money by the client. This entry increases the Accounts Receivable balance on the balance sheet, reflecting the company’s right to receive payment for services provided.
On the other hand, by crediting Service Revenue, the company records the revenue earned during the period. This entry increases the Service Revenue account on the income statement, which shows the company’s revenue and earned income.
This example demonstrates the importance of adjusting entries in accurately reporting financial information. Without adjusting entries, financial statements could be misleading, presenting an inaccurate picture of a company’s financial status.
Adjusting entries examples can also involve the recognition of prepaid expenses and accrued expenses. Prepaid expenses refer to payments made in advance for goods or services that will be utilized in the future. For example, if a company pays for insurance coverage for the next 12 months, it would need to recognize a portion of that payment as an expense in each monthly accounting period.
On the other hand, accrued expenses are expenses incurred but not yet paid. For instance, a company might accrue salaries expense for the last week of December, even if the payroll will be processed and paid in January. By recognizing the expenses in the correct accounting period, financial statements accurately reflect the company’s liabilities and the true cost of operations.
To summarize, adjusting entries examples help illustrate how adjusting entries are utilized to correct and update financial statements, ensuring their accuracy and compliance with the accrual basis of accounting. These entries capture revenues and expenses that have been earned or incurred during an accounting period, but have not been recorded yet. By making adjusting entries, a business can provide stakeholders, such as shareholders, investors, and creditors, with reliable and accurate financial information for decision-making processes.
Note: It is important to consult with a certified public accountant (CPA) or a trusted financial professional for specific guidance and advice regarding adjusting entries and their application in your unique financial situation.
This glossary is made for freelancers and owners of small businesses. If you are looking for exact definitions you can find them in accounting textbooks.