What Is an Adjusting Journal Entry?
An adjusting journal entry is an entry in a company's general ledger that occurs at the end of an accounting period to record any unrecognized income or expenses for the period. When a transaction is started in one accounting period and ended in a later period, an adjusting journal entry is required to properly account for the transaction.
Adjusting journal entries can also refer to financial reporting that corrects a mistake made previously in the accounting period.
- Adjusting journal entries are used to record transactions that have occurred but have not yet been appropriately recorded in accordance with the accrual method of accounting.
- Adjusting journal entries are recorded in a company's general ledger at the end of an accounting period to abide by the matching and revenue recognition principles.
- The most common types of adjusting journal entries are accruals, deferrals, and estimates.
- It is used for accrual accounting purposes when one accounting period transitions to the next.
- Companies that use cash accounting do not need to make adjusting journal entries.
Understanding Adjusting Journal Entries
The purpose of adjusting entries is to convert cash transactions into the accrual accounting method. Accrual accounting is based on the revenue recognition principle that seeks to recognize revenue in the period in which it was earned, rather than the period in which cash is received.
As an example, assume a construction company begins construction in one period but does not invoice the customer until the work is complete in six months. The construction company will need to do an adjusting journal entry at the end of each of the months to recognize revenue for 1/6 of the amount that will be invoiced at the six-month point.
An adjusting journal entry involves an income statement account (revenue or expense) along with a balance sheet account (asset or liability). It typically relates to the balance sheet accounts for accumulated depreciation, allowance for doubtful accounts, accrued expenses, accrued income, prepaid expenses, deferred revenue, and unearned revenue.
Income statement accounts that may need to be adjusted include interest expense, insurance expense, depreciation expense, and revenue. The entries are made in accordance with the matching principle to match expenses to the related revenue in the same accounting period. The adjustments made in journal entries are carried over to the general ledger that flows through to the financial statements.
Types of Adjusting Journal Entries
In summary, adjusting journal entries are most commonly accruals, deferrals, and estimates.
Accruals are revenues and expenses that have not been received or paid, respectively, and have not yet been recorded through a standard accounting transaction. For instance, an accrued expense may be rent that is paid at the end of the month, even though a firm is able to occupy the space at the beginning of the month that has not yet been paid.
Deferrals refer to revenues and expenses that have been received or paid in advance, respectively, and have been recorded, but have not yet been earned or used. Unearned revenue, for instance, accounts for money received for goods not yet delivered.
Estimates are adjusting entries that record non-cash items, such as depreciation expense, allowance for doubtful accounts, or the inventory obsolescence reserve.
Not all journal entries recorded at the end of an accounting period are adjusting entries. For example, an entry to record a purchase of equipment on the last day of an accounting period is not an adjusting entry
Why Are Adjusting Journal Entries Important?
Because many companies operate where actual delivery of goods may be made at a different time than payment (either beforehand in the case of credit or afterward in the case of pre-payment), there are times when one accounting period will end with such a situation still pending. In such a case, the adjusting journal entries are used to reconcile these differences in the timing of payments as well as expenses. Without adjusting entries to the journal, there would remain unresolved transactions that are yet to close.
Example of an Adjusting Journal Entry
For example, a company that has a fiscal year ending December 31 takes out a loan from the bank on December 1. The terms of the loan indicate that interest payments are to be made every three months. In this case, the company’s first interest payment is to be made March 1. However, the company still needs to accrue interest expenses for the months of December, January, and February.
Since the firm is set to release its year-end financial statements in January, an adjusting entry is needed to reflect the accrued interest expense for December. To accurately report the company’s operations and profitability, the accrued interest expense must be recorded on the December income statement, and the liability for the interest payable must be reported on the December balance sheet. The adjusting entry will debit interest expense and credit interest payable for the amount of interest from December 1 to December 31.
What is the purpose of adjusting journal entries?
Adjusting journal entries are used to reconcile transactions that have not yet closed, but which straddle accounting periods. These can be either payments or expenses whereby the payment does not occur at the same time as delivery.
What are the types of adjusting journal entries?
The main two types are accruals and deferrals. Accruals refer to payments or expenses on credit that are still owed, while deferrals refer to prepayments where the products have not yet been delivered.
What is the difference between cash accounting and accrual accounting?
The primary distinction between cash and accrual accounting is in the timing of when expenses and revenues are recognized. With cash accounting, this occurs only when money is received for goods or services. Accrual accounting instead allows for a lag between payment and product (e.g., with purchases made on credit).
Who needs to make adjusting journal entries?
Companies that use accrual accounting and find themselves in a position where one accounting period transitions to the next must see if any open transactions exist. If so, adjusting journal entries must be made accordingly.