Why are adjusting entries necessary? A simple, yet best advice

By Kishana Citadelle
Published: 12/22/21
definition backgroundWhy are adjusting entries necessary? A simple, yet best advice

No matter the business, you must take the step of adjusting entries into consideration to create accurate financial statements.

So why are adjusting entries necessary? They occur at the end of an accounting period to properly count your income and expenses that have not yet been recorded in the accounting ledger.

What are adjusting entries?

First, you need to know where adjusting entries occur, and that is in journal entries that record the cash flow of a company. Adjusting entries are changes made to previously recorded journal entries to make sure that the numbers match with the correct accounting periods.

For example, you’ve done some work for a client and decide to charge them $2,000 for the services you’ve done in September. You receive the payment the next month, in October.

That money is recorded as accounts receivable in September, as you’re expected to get paid but have yet to receive the income. Then, in October, you record the money as cash deposited in your bank account.

So, to make an adjusting entry of this

Types of adjusting entries

There are different types of adjusting entries that are accruals, deferrals, and estimates.

1. Accruals

Accruals stand for revenues and expenses not yet received or paid, nor recorded in an accounting transaction.

2. Deferrals

Deferrals involve revenues and expenses that have been paid or received in advance and recorded but have yet to be earned or used. Whereas unearned revenues concern money that was received for goods but that remains to be delivered.

3. Estimates

Estimates record non-cash items like depreciation expense, inventory, etc. at the end of a product life cycle.

Why are adjusting entries necessary?

Adjusting entries are necessary because they ensure that your business activities are correctly recorded and that you are not paying for expenses before they happen. Simply put, that your financial statements provide accurate data.

How does adjusting entries work?

There are steps to adjusting entries and those are:

Step 1: Recording accrued revenue

If you perform a service but have not invoiced your customer, the amount of the revenue earned will need to be recorded as accrued revenue. Let us give an example: You own a car repair shop. You bill your clients for a month of services at the beginning of the following month.

Your bill for letting us say July is $4,000, but since you won’t be billing your clients until August 1, you’ll have to adjust the entry to amass the $4,000 you’ve earned in July.

DATE ACCOUNT DEBIT CREDIT
7-31-20 Account Receivable $4,000
Accrued Revenue $4,000

In addition, if you decide to bill the clients in August, your entry would be:

DATE ACCOUNT DEBIT CREDIT
6-31-20 Accrued Revenue $4,000
Revenue $4,000

Step 2: Recording accrued expenses

Payroll or paycheck is one of the primary expenses that need an adjusting entry at the end of the month. That is to say, any working hours for the month not yet paid until the next month should be represented as expenses. Here is how it will be presented in the journal entry below:

DATE ACCOUNT DEBIT CREDIT
7-31-20 Wages & Salaries Expense $10,000
Wages & Salaries Payable $10,000
DATE ACCOUNT DEBIT CREDIT
8-10-20 Wages & Salaries Expense $10,000
Wages & Salaries Payable $10,000

Step 3: Recording deferred revenue

This entry concerns payment received from customers in advance. This advance payment will have to be deferred until it is earned. For example, you offer your car repair services and one of the customers decides to pay $2,000 in advance for the 4 months their car will have to stay in the shop.

However, since you have not earned the revenue, it has to be deferred. The journal entry can be found below: 

DATE ACCOUNT DEBIT CREDIT
7-31-20 Cash $2,000
Deferred Revenue $2,000

For those two months, you’ll need to record $500 in revenue until the balance of the deferred revenue is 0.

DATE ACCOUNT DEBIT CREDIT
7-31-20 Deferred Revenue $500
Service Revenue $500

Step 4: Recording prepaid expenses

They are recorded like deferred revenue. It is if you decide to pay something in advance like your office rent for the rest of the year. Since your rent is $12,000, you will have to record the $1,000 for the rent expenses.

DATE ACCOUNT DEBIT CREDIT
7-31-20 Prepaid Rent $12,000
Cash $12,000
DATE ACCOUNT DEBIT CREDIT
7-31-20

Rent Expense

$1,000
Prepaid Rent $1,000

And so on for the adjusting entries which give you a correct representation of your business’s financial position and health. 

Hopefully, you won't panic or feel lost in your accounting errors.

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