Adjusting Journal Entry

What is an 'Adjusting Journal Entry'

An adjusting journal entry is an entry in financial reporting that occurs at the end of a reporting 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.

An adjusting journal entry is also known as a balance day adjustment.

BREAKING DOWN 'Adjusting Journal Entry'

The purpose of adjusting entries is to show when the money actually changed hands and to convert real-time entries to entries that reflect the accrual accounting system. An adjusting journal entry involves an income statement account (revenue or expense) along with a balance sheet account (asset or liability), and typically relates to the accounts for accrued expenses, accrued revenue, prepaid expenses, and unearned revenue. The entries are made in accordance with the matching principle to match revenue and expenses in the period in which they occur. The adjustments made in journals are carried over to the account ledgers and accounting worksheet in the next accounting cycle step.

A common characteristic of an adjusting entry is that it will involve one income statement account and one balance sheet account. Income statement accounts that may need to be adjusted include interest expense, insurance expense, depreciation expense, and service revenue. Balance sheet accounts that may be adjusted at the end of a reporting period include accounts receivable, interest payable, accumulated depreciation, and prepaid insurance.

In summary, adjusting journal entries are most commonly of three types – accruals, deferrals, and estimates. Accruals are revenues and expenses that have not been received and paid, respectively, and have not yet been recorded through a standard accounting transaction. Deferrals refer to revenues and expenses that have been received and paid in advance, respectively, and have been recorded, but have not yet been earned or used. Estimates are adjusting entries that record non-cash items, such as depreciation expense, allowance for doubtful accounts, or the inventory obsolescence reserve.

For example, a company that has its fiscal year ending December 31, takes out a loan from the bank on December 1. The terms of the loan indicate that the 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 fact that the company is not expected to make any interest payments until March does not mean that it doesn’t accrue interest for the months of December, January, and February. Since the firm is set to release its financial statements in January, an adjusting entry is needed to accurately reflect the accrued expenses and interest 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 owed 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.

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.