5 Types of Adjusting Journal Entries (With Examples)
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An adjusting journal entry is an entry companies make to assign the correct amount of expenses and revenue to each accounting period. Accrual accounting requires businesses to record their revenue and expenses in the period they accrued or incurred them, regardless of when the payment occurred. Understanding how to use the various types of journal entries can help you accurately adjust a company's income and expenses to reflect its financial position. In this article, we explain what adjusting journal entries are, list their types with examples, state the benefits of creating them, and provide answers to frequently asked questions.
What are adjusting journal entries?
Businesses typically use adjusting journal entries for accrual accounting. They're entries in an organization's ledger at the end of an accounting period. Companies make these journal entries to correct their accounts before preparing a financial statement. They commonly use adjusting entries to match their revenue and expenses with the period in which they occurred. You can also refer to an adjusting journal entry as a financial report that corrects a company's mistakes in its previous accounting period. Adjusting entries usually include a balance sheet and an income statement.
The balance sheet generally shows the company's liability or assets, while the income statement shows its revenue or expenses. A business's periodic reporting and matching principle often necessitate adjusting entries. The matching principle requires a company to match its revenue with costs when it's reasonable to do so. When a company receives payment on a different date on which it incurs or earns an expense or revenue, it creates an adjusting entry to record it in the appropriate period.
5 types of adjusting entries
Depending on the number of financial transactions, a business can make several adjusting entries. Each entry can directly impact an organization's revenue and expense accounts. The following are five common types of adjusting entries that a business may use:
1. Deferred revenue
Deferred revenue often refers to advance payments a company receives before delivering goods or services. Subscriptions, gift cards, and yearly memberships are examples of this revenue type. When a company receives these payments, it records them as a liability because it hasn't yet rendered the goods or services. This liability turns into revenue once the customer receives the product or service.
Most professional firms that work on a retainer, such as certified public accounting and law firms, usually have deferred revenue. As a company provides the services and earns the income, it creates an adjusting entry that increases its revenue account and reduces its unearned revenue.
Example: Express Production Inc. sends a down payment of $1,500 to Handmade Bags for 500 bags. It pays Handmade Bags on February 25 after confirming that Handmade Bags can begin production on April 10. They record the following adjusting journal entry for February 25:
Debit cash: $1,500
Credit deferred sales revenue: $1,500
Then, on April 10, when Handmade Bags begins production, it can move the payment from deferred revenue to consulting revenue:
Debit deferred revenue: $1,500
Credit consulting revenue: $1,500
2. Accrued revenue
Accrued revenue occurs when a company makes a sale and collects payment at a later date. It's essential that a company makes an accrued revenue journal adjustment whenever it generates income in one period but doesn't recognize it until later. This type of adjusting entry is common in service-related businesses. A typical example of accrued revenue is credit sales. A company can create an adjusting entry to record accrued revenue by crediting its revenue account and debiting its accounts receivable. The accounts receivable typically shows the amount that customers owe a business.
Example: Towel Firm delivered services to a hostel on June 30 and sent an invoice for $3,500. It received payment from the hostel on August 2. It records the following adjusting journal entry for June 30:
Debit account receivable: $3,500
Credit revenue: $3,500
Then, when it receives payment on August 2:
Credit account receivable: $3,500
Debit revenue: $3,500
3. Accrued expenses
Accrued expenses refer to costs that a business hasn't paid yet. For example, it may be the rent that an organization pays at the end of the month, even though it occupied the space from the beginning of the month. Adjusting entries to record an accrued expense increases the expense account corresponding to a company's expense. An example of this expense is the salary employees receive at the end of the month.
Example: Sarah owns a store and pays her employee $600 per month. The employee's pay date was September 25, but they worked for three additional days in September. Sarah doesn't include this in the payroll for September 25. Sarah then pays the employee on October 16. She records the adjusting entry for September 25:
Credit accrued expenses: $600
Debit employee wages: $600
On October 16, when she pays the invoice:
Debit accrued expenses: $600
Credit employee wages: $600
4. Prepaid expenses
Prepaid expenses are similar to deferred revenue, but in this case, a company pays for a product or service, such as rent, upfront. The company records its expenses in the appropriate period. For example, if a firm prepays its rent in December for the entire year, it's essential to record the monthly cost for the next 12 months. This enables it to account for its rental payment properly. It's crucial that the company records its prepaid expenses because it enables it to balance its high rental expense.
Example: Ponytail Shop rents a new location for its business and prepays $12,000 in January for a year's worth of rent. In January, it records the entry as:
Debit prepaid rent expenses: $12,000
Credit cash: $12,000
Then, in January, it records the December portion of the prepaid rent:
Debit rent expense: $1,000
Credit prepaid rent: $1,000
5. Depreciation expense
It's important that a company records its depreciation expenses and accumulated depreciation to expense the useful life of its assets properly. When a business depreciates an asset, it makes a single payment and disperses the expenses over multiple accounting periods. Companies usually do this for large purchases, such as buildings, vehicles, and equipment. The way a company records depreciation depends on the method it uses. Most businesses typically choose the straight-line method to depreciate fixed assets because it's the easiest method to track.
Example: A factory purchases equipment for $3,000 with a useful life of six years and a salvage value of $1,200. It depreciates the asset for six years, making the monthly depreciation $25 per month. The factory records the depreciation in a journal entry:
Debit depreciation expense: $25
Credit accumulated depreciation: $25
What are the benefits of an adjusting entry?
An adjusting journal entry helps a business track its receivables and payables. It's also essential in reconciling transactions a company hasn't closed. The adjusting journal entry also offers a company an accurate record of its financial health. Keeping this entry prevents businesses from overstating their net income or owners' equity and understating their expenses and liabilities. If a company reviews its documents and finds errors in its income statements or balance sheets, this entry enables it to make corrections quickly.
Frequently asked questions about adjusting entries
Here are the answers to commonly asked questions about adjusting journal entries:
Which businesses require an adjusting entry?
Businesses typically require adjusting entries if they use accrual accounting. If a company's accounting period often transits into the next one, it's crucial it makes this entry to record its open transactions. The adjusting entry is also vital for organizations with an incorrect balance sheet or profit and loss statement.
What is the difference between accrual and cash accounting?
The main difference between accrual and cash accounting is when a company recognizes its expenses and revenue. The accrual method generally focuses on anticipated revenue and costs, while the cash method immediately recognizes income and expenses when they occur. Publicly traded companies usually use the accrual method because it enables them to smoothen their earnings over time. Meanwhile, tracking cash flow is easier with the cash method.
Who can make an adjusting entry?
If a business uses the accrual accounting system, it's essential that its accountant makes the journal entries before publishing a monthly financial statement. A bookkeeper can also help the firm create adjusting journal entries. If a business doesn't have a bookkeeper, it can contract a bookkeeping team to make entries.
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