An adjusting journal entry is used at the end of an accounting period to properly record transactions that have taken place but haven’t yet been recorded. This type of ledger entry is also used to correct any mistakes made during the accounting cycle.
Journal entry adjustments help ensure that your company’s financial statements and cash flow are accurately reflected, which helps you understand your financial position better.
This article covers journal entry adjustments and how they can help with accrual accounting.
- What is an adjusting journal entry?
- The importance of adjusting journal entries
- The 3 main types of adjusting journal entries
- A practical example of an adjusting journal entry
What is an adjusting journal entry?
Adjusting journal entries are made in a company’s general ledger at the end of an accounting period—typically affecting income statement accounts (expenses or revenue) and balance sheet accounts (liabilities or assets).
Note, however, that journal entry adjustments are mainly used by companies using the accrual accounting method, which recognizes revenue and expenses when they occur rather than when cash exchanges hands.
Whenever a transaction takes place in one accounting period and transitions to the next period, an adjusting journal entry is needed to account for this transaction properly. The method is a lot more time-consuming than cash accounting, a bookkeeping method that records revenue and expenses only when they’re actually received or paid, not when they’re incurred.
How does accrual accounting differ from cash accounting?
With cash accounting, transactions are recorded as they happen. Individuals and small businesses commonly use this method since it involves the simplest accounting. Many start-up companies often begin operations using the cash accounting method and transition to the accrual accounting method as they grow.
The accrual accounting method is the most commonly used and shows a more accurate view of a company’s long-term profitability than the cash accounting method. It combines two accounting principles: The revenue recognition principle requires revenue to be recognized in the period it’s earned. The matching principle requires expenses to be recognized in the same accounting period as the associated revenue.
When is an adjusting journal entry needed?
Consider a simple example illustrating when an adjusting journal entry is needed: A marketing agency starts a project in one period but doesn’t invoice their client until the project is completed in four months. The agency will need to make an adjusting journal entry at the end of every month to recognize revenue for one-fourth of the amount that will be invoiced at the end of the four months.
Adjusting journal entries is often complicated and time-consuming. Hiring a bookkeeper can ensure that your books are up-to-date and accurately reflect your company’s financial position. Upwork makes it easy to hire qualified bookkeepers so you have more time to dedicate ontward your business instead of your books.
The importance of adjusting journal entries
Many companies make or receive payments during a different accounting period from the time when they actually deliver the goods or services they provide.
So, the revenue recognition principle requires businesses to record revenue and expenses when they’re earned and realized, even if the period wasn’t necessarily when they collected or will collect the cash. Adjusting journal entries are necessary to ensure that revenue and expenses are recorded during their earned and incurred periods.
Without this timely recognition, it’s difficult to estimate the true profit or loss at the end of the period—distorting the financial health of the business.
Adjusting journal entries can also be used to correct any accounting mistakes at the end of an accounting period. Journal entries track how money moves within a business, such as between accounts, and how it enters and exits the business. If a mistake was made during the accounting period, an adjusting journal entry is needed to correct the error. This helps align revenue and expenses at the end of every accounting period.
The 3 main types of adjusting journal entries
While the volume of financial transactions of a business determines how many adjustments are needed at the end of a period, the types of adjusting journal entries fall into three main categories:
Accruals refer to accrued revenue and expenses. Deferrals are deferred revenue or expenses that have been prepaid. Estimates refer to the non-cash expenses of a company that don’t involve an actual exchange of money.
Accruals are journal entries used to record revenue and expenses that haven’t yet been received or paid. The revenue was earned, or the expense was incurred, in one accounting period, but the transaction took place in a different accounting period.
For example, let’s say a photographer completes a wedding photo shoot in February but won’t get paid until the final product is delivered. The photographer’s financial statements for February need to reflect the work that has been completed for the month, even though they won’t get paid until March. The expense was incurred even though cash hasn’t yet been exchanged.
Accrued revenue is recorded by debiting accounts receivable and crediting the revenue account. The adjusting journal entry will credit accounts receivable and debit the cash account once that money is received. The revenue was earned and recognized earlier, so an adjusting journal entry is needed to properly recognize the cash that has now been received.
An accrued expense is recorded by debiting the expense account and crediting accounts payable. The adjusting journal entry will debit accounts payable and credit the cash account once the payment is made.
Deferrals refer to revenue and expenses that have been recorded and have been received or incurred but haven’t yet been earned or used. Unearned revenue, such as receiving payment for a service not yet delivered, requires a deferral journal entry.
A prepaid expense is first recorded as an asset and later expensed using an adjusting journal entry. The adjusting journal entry for prepaid expenses includes debiting the expense account and crediting the prepaid expense account.
Deferred revenue is money that a customer pays for a product or service they haven’t received yet, such as a yearly membership or subscription fee. When that money is received, it needs to be recorded as a liability since it hasn’t been earned yet.
Once the product or service is delivered and the money is fully earned, the adjusting journal entry requires debiting the deferred revenue account and crediting the revenue account.
Accountants have to make estimates whenever the exact value of an item isn’t known. This helps the company create a more accurate financial picture and track its revenue and expenses better. Estimate journal entries record non-cash items, such as allowances for doubtful accounts and depreciation expenses.
Since no actual cash exchange is involved, these expenses are merely estimates. Adjusting journal entries to record depreciation expenses include debiting the depreciation expense account and crediting the accumulated depreciation account.
Other non-cash expenses include amortization, depletion, asset impairments, and stock-based compensation.
A practical example of an adjusting journal entry
Let’s say you own a plumbing business. In March, you bill a customer $2,000 for a plumbing service that you performed. The customer pays you the following month.
In March, you record the $2,000 as accounts receivable since you already delivered the service and expected to receive the revenue. Accounts receivable is an asset account on the balance sheet and, therefore, gets debited. Revenue gets credited with $2,000.
You’ll then record the money as a cash deposit in your bank account in April when the customer finally pays you by performing an adjusting journal entry.
An adjusting journal entry helps you amend the first journal entry without going back to that journal entry to erase and redo it. First, make an adjusting journal entry to move the revenue from accounts receivable since you’ve now received the money. Accounts receivable gets credited with $2,000, and cash gets debited with $2,000.
Get help with your bookkeeping
Keeping track of your company’s financials to get an accurate picture of your cash flow is crucial for the health of your business. Good bookkeeping can help you make better-informed business decisions, which is often the difference between success and failure.
However, doing proper bookkeeping can be time-consuming and overwhelming. Hiring a freelance bookkeeper can lift some of this weight from your shoulders. Find qualified bookkeepers on Upwork to handle your company’s books so that you can keep your focus on running your business.
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