Adjusting Entries
Adjusting Entries
Introduction to Adjusting Entries
Adjusting entries are accounting
journal entries that convert a company's accounting records to the accrual
basis of accounting. An adjusting journal entry is typically made just prior to
issuing a company's financial statements.
To demonstrate the need for an
accounting adjusting entry let's assume that a company borrowed money from its
bank on December 1, 2015 and that the company's accounting period ends on
December 31. The bank loan specifies that the first interest payment on the
loan will be due on March 1, 2016. This means that the company's accounting
records as of December 31 do not contain any payment to the bank for the
interest the company incurred from December 1 through December 31. (Of course
the loan is costing the company interest expense every day, but the actual
payment for the interest will not occur until March 1.) For the company's
December income statement to accurately report the company's profitability, it
must include all of the company's December expenses—not just the expenses that
were paid. Similarly, for the company's balance sheet on December 31 to be
accurate, it must report a liability for the interest owed as of the balance
sheet date. An adjusting entry is needed so that December's interest expense is
included on December's income statement and the interest due as of December 31
is included on the December 31 balance sheet. The adjusting entry will debit
Interest Expense and credit Interest Payable for the amount of interest from
December 1 to December 31.
Another situation requiring an
adjusting journal entry arises when an amount has already been recorded in the
company's accounting records, but the amount is for more than the current
accounting period. To illustrate let's assume that on December 1, 2015 the
company paid its insurance agent $2,400 for insurance protection during the
period of December 1, 2015 through May 31, 2016. The $2,400 transaction was
recorded in the accounting records on December 1, but the amount represents six
months of coverage and expense. By December 31, one month of the insurance
coverage and cost have been used up or expired. Hence the income statement for
December should report just one month of insurance cost of $400 ($2,400 divided
by 6 months) in the account Insurance Expense. The balance sheet dated December
31 should report the cost of five months of the insurance coverage that has not
yet been used up. (The cost not used up is referred to as the asset Prepaid
Insurance. The cost that is used up is referred to as the expired cost Insurance
Expense.) This means that the balance sheet dated December 31 should report
five months of insurance cost or $2,000 ($400 per month times 5 months) in the
asset account Prepaid Insurance. Since it is unlikely that the $2,400
transaction on December 1 was recorded this way, an adjusting entry will be
needed at December 31, 2015 to get the income statement and balance sheet to
report this accurately.
The two examples of adjusting
entries have focused on expenses, but adjusting entries also involve revenues. This
will be discussed later when we prepare adjusting journal entries.
For now we want to highlight some
important points.
There are two scenarios where
adjusting journal entries are needed before the financial statements are
issued:
Nothing has been entered in the
accounting records for certain expenses or revenues, but those expenses and/or
revenues did occur and must be included in the current period's income
statement and balance sheet.
Something has already been entered
in the accounting records, but the amount needs to be divided up between two or
more accounting periods.
Adjusting entries almost always
involve a
balance sheet account (Interest
Payable, Prepaid Insurance, Accounts Receivable, etc.) and an
income statement account (Interest
Expense, Insurance Expense, Service Revenues, etc.)
For a step-by-step presentation of
adjusting entries, see our visual tutorial Adjusting Entries which is available
in
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