Rebekiah has taught college accounting and has a master's in both management and business.
Accounting is a multi-step process. In this lesson, we will discuss adjusting entries. You will learn what they are, why they are important, and see examples.
What Are Account Adjustments?
The accounting cycle is like a circle. It begins with transaction analysis and ends with closing the books. Each and every step in between is vital to the process. There are eight general steps to the accounting cycle. Today, we're going to talk about the sixth step in the cycle - adjustments to accounts.
Account adjustments, also known as adjusting entries, are entries that are made in the general journal at the end of an accounting period to bring account balances up-to-date. Unlike entries made to the general journal that are a result of business transactions, account adjustments are a result of internal events. Internal events are those events that have occurred in the business that don't involve an exchange of goods or services with another entity.
Types of Account Adjustments
There are four types of account adjustments found in the accounting industry. They are accrued revenues, accrued expenses, deferred revenues and deferred expenses. Pay attention; this can get a little tricky.
An accrued revenue is one that occurs when a sale is made or services are performed in one accounting period but payment is not received until a later period. An accrued expense is an expense that has occurred in one accounting period but won't be paid until another period. A deferred revenue is money that has been paid in advance for a service that will be performed later. A deferred expense is an expense that has been paid in advance and will be expensed out at a later date.
Adjusting Entry Examples
Now that we have gotten the terminology out of the way, let's look at an example to help you understand the entire concept. Alex is the owner of Alex's Furniture Emporium with a fleet of six company vehicles. He buys and sells fine furniture from all over the world. He also builds a few pieces on a commissioned basis. Because Alex has such a unique clientele and spends a great deal of time traveling, he has to rely on his office staff to ensure that his business runs smoothly.
Four months ago, Alex was paid $2,000 to build a one of a kind hall tree. He will deliver the finished piece of furniture to the customer this week. He also sold a hand-carved bed from Denmark to a customer for $7,500. The customer purchased the bed with a 90-day-same-as-cash payment plan.
Payroll checks are issued on the 1st and the 15th of each month. Since every employee is salaried, the payroll expense remains the same at $5,200 per pay period. Because Alex travels so much, he makes sure to pay his building rent, which is $2,000 a month, and vehicle insurance, which is $700 a month, at the beginning of each year.
The books for Alex's Furniture Emporium are closed quarterly. What are the appropriate adjusting entries for the first quarter? The first thing we need to do is to look at the transactions.
Alex was paid $2,000 two months ago to build a piece of furniture that he has completed this month.
He sold a bed for $7,500 to a customer and will be paid for the bed in 90 days.
Payroll is $5,200 every two weeks. The last paycheck for the current period will not be paid until the beginning of the next period.
Alex pays his rent and insurance a year in advance.
Now, the next thing we need to do is make the adjusting entries. Alex got paid for something four months ago that was not delivered until this month. This created a deferred revenue. Because he is delivering the product now and it was paid for it in a prior period, then we have to make the following entry:
March 31, 2013 - unearned revenue is debited $2,000 and revenue is credited $2,000.
This entry shows that the unearned revenue account is decreased, and the revenue account is increased by the same dollar amount to record money that's now been earned.
Alex selling the bed on account created an accrued revenue. In order to properly record this in the journal, you'd make the following entry:
March 31, 2013 - accounts receivable is debited $7,500 and revenue is credited $7,500.
This entry shows that the balance in accounts receivable increased due to the sell on account, and the revenue balance also increased.
The next thing that you see is the payroll that is outstanding. Since payroll has been earned but not paid out at Alex's Furniture Emporium, the journal entry to record this is as follows:
March 31, 2013 - salaries expense is debited $5,200 and salaries payable is credited $5,200.
This entry increases both the expense and payable account balances.
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The last two transactions that need an adjusting entry are for the prepaid rent and insurance expense accounts. We call them prepaid because they're paid in full and will be expensed out during the course of the year. Alex's rent is $2,000 per month. Since his books are closed quarterly, which is every three months, then the amount of rent that is expensed is $6,000 ($2,000 * 3 months). The adjusting entry for this expense looks like this:
March 31, 2013 - rent expense is debited $6,000; prepaid rent is credited $6,000.
The insurance expense is done exactly the same. Since his insurance expense is $700 a month, the amount reported in the adjusting entry will be $2,100 (the $700 a month * 3). The entry will look like this:
March 31, 2013 - insurance expense is debited $2,100; prepaid insurance is credited $2,100.
Since both of these entries are due to prepaid expenses, it's important to remember that when making the adjusting entry, the debit always goes to the expense account and the credit always goes to the prepaid account.
Account Adjustments and the Financial Statements
Why do we even bother to make account adjustments? It just seems like more work, but really, what's the point? The point is very simple and very important.
Whenever an accounting period is about to close, we need to make sure that the balances in the accounts are correct. Because the ending balance in one period is the beginning balance in the next, one simple mistake will throw everything off. The account balances are where the information reported on financial statements comes from.
If they aren't right, then the information on the financial statements won't be right. Even though errors may seem minute and simple to the person preparing the financial statements, the information reported on the financial statements is heavily relied on by both current and potential investors and creditors.
Account adjustments are entries made in the general journal at the end of an accounting period to bring account balances up-to-date. They are the result of internal events, which are events that occur within a business that don't involve an exchange of goods or services with another entity. Not every account will need an adjusting entry. There are four types of accounts that will need to be adjusted. They are accrued revenues, accrued expenses, deferred revenues and deferred expenses.
Accrued revenues are money earned in one accounting period but not received until another. Accrued expenses are expenses that are incurred in one accounting period but not paid until another. Deferred revenues are money that a business has been paid in advance for a service that will be provided later. Deferred expenses are expenses that have been paid in advance and will be expensed out at a later date.
No matter what the type of account adjustment is that needs to be made, the main purpose of the adjustment is to ensure that account balances are correct for the end of the period reporting. The same balances that end a period are also the ones that open the next period. So, errors in account balances can and do cause information on the financial statements to be incorrect. In a world where financial data is heavily relied upon, it is the job of the accounting professional to ensure that financial statement data is true and correct.
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