Adjusting entries are journal entries made at the end of an accounting period to ensure that financial statements accurately reflect the economic activities and financial condition of a business. These entries are necessary because many transactions and events may occur during the accounting period that the business has not yet recorded. By making adjusting entries, a company can properly match revenues and expenses to the period in which they are incurred, thereby providing a more accurate representation of its financial position.
Adjusting entries are an essential part of the accounting process that takes place at the end of each accounting period, typically at the close of the month, quarter, or year. Their purpose is to correct any discrepancies in the financial records and to align the reported financial information with the accrual basis of accounting.
There are two main types of adjusting entries: accruals and deferrals. Accrual entries involve recognizing revenues or expenses that have been earned or incurred but have not yet been recorded in the accounts. Deferral entries, on the other hand, involve adjusting for revenues or expenses that have been recorded but are either not yet earned or not yet incurred.
One common type of adjusting entry is the accrual of revenue. If a business has provided goods or services but has not yet received payment, it must recognize the revenue earned by debiting an accounts receivable account and crediting a revenue account. This adjustment ensures that the revenue is recognized in the appropriate period, even if the cash has not been received.
Similarly, adjusting entries may be required for accrued expenses, such as wages payable. If employees have worked but have not been paid as of the end of the accounting period, an adjusting entry must be made to recognize the wages owed. This involves debiting an expense account and crediting a liability account, such as wages payable.
Deferral entries are made to account for transactions that have been recorded but need to be recognized in a different period. For example, if a business pays in advance for a service but will use it over a period of time, it would initially record the payment as a prepaid expense. At the end of each accounting period, an adjusting entry is made to recognize the portion of the prepaid expense that has been used or expired. This involves debiting an expense account and crediting the prepaid expense account.
Adjusting entries ensure that financial statements are in accordance with the matching principle, which states that revenues and expenses should be recognized in the period in which they contribute to the generation of income and where they are incurred, respectively. By making these adjustments, financial statements provide users with a more accurate representation of a company’s financial position, operating results, and cash flows.
In conclusion, adjusting entries play a crucial role in the accounting process by ensuring that financial statements reflect the economic reality of a business. Through accruals and deferrals, these entries bring the books of accounts in line with the accrual basis of accounting and provide a more accurate picture of a company’s financial performance. By adhering to sound accounting practices and making necessary adjustments, businesses can make informed decisions and maintain the integrity of their financial information.
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.