Adjusting Entries: Definition, Types and Examples

Contents

Key Takeaways

  • Adjusting entries are special journal entries that are posted to adjust certain ledger accounts at the end of the period to ensure that business transactions are recorded according to accrual accounting.
  • The different types of adjusting entries are accrued income, accrued expense, deferred income, prepaid expense, bad debts, and depreciation.

Overview of the Accounting Cycle

Preparing adjusting entries and the adjusted trial balance are the fifth and sixth steps in the accounting cycle of the business. The Accounting Cycle refers to the steps that a company takes to prepare financial statements.

Below are the steps in the accounting cycle, done in the following order:

  1. Gathering of business source documents
  2. Analyzing and journalizing business transactions
  3. Posting journalized transactions to the ledger
  4. Preparing an unadjusted trial balance
  5. Journalizing and posting adjusting entries
  6. Preparing an adjusted trial balance
  7. Preparing the financial statements
  8. Journalizing and posting closing entries
  9. Preparing a post-closing trial balance
  10. Journalizing and posting reversing entries

Definition of Adjusting Entries

The preparation and recording of adjusting entries is an important step that you need to take before preparing the financial statements of your company.

What are adjusting entries?

Adjusting Entries are special journal entries that adjust the amounts of certain ledger accounts to accurately report income and expenses during the period.

Timing is an important factor when recording business transactions. It influences the reliability of the information that is presented in your company’s financial statements.

Let’s assume that your company sells yearly magazine subscriptions of $120. At the start of the year, you charge your subscribers $120 that covers 12 months of magazines that are issued to them monthly.

When you receive the subscription fee from your subscriber, would you immediately recognize the entire $120 as income on the first month? Or should you recognize only the earned portion of that amount as you issue the magazines each month?

To better understand the concept of adjusting entries, let’s briefly go through some important principles and assumptions below.

  1. Time period assumption
  2. Accrual accounting
  3. Matching principle

Time period assumption

Since accounting views a company as an entity that operates indefinitely, the time period assumption requires it to divide its business operations into equal time intervals called accounting periods. An Accounting Period is the time frame that is covered in a financial statement, e.g. monthly, quarterly, semi-annual, and annual.

If you look at the financial statements of a company, you’ll notice that the accounting period is indicated below the name of the financial statement. For example, the income statement may state the phrase “for the year ended December 31, 20xx” which indicates that the report covers the operations throughout that specific year starting from January and ending in December.

Timely information is essential to every stakeholder that relies on your financial statements to make economic decisions. The time period assumption ensures that accounting information is reported and made available to these stakeholders at regular intervals.

However, timing the recording of transactions is a challenge for accountants since they need to determine which accounting period should some income and expense items be reported. This is why this assumption also requires an understanding of the accrual principle.

Accrual accounting

There are two methods of accounting that may be used when recognizing and recording income and expenses, i.e. cash basis accounting and accrual accounting. These two methods differ mainly at the point in time at which income and expense is recognized and recorded.

Cash basis accounting recognizes income and expenses when cash is received or paid, respectively. This means that when cash is received from a customer, you need to recognize a revenue in the accounting books, regardless if your product or service was already received by your customer. Likewise, when you pay cash for a product or service, you’ll immediately record an expense, regardless if that product or services was already delivered to you.

Accrual accounting, on the other hand, recognizes income and expenses when they are earned or incurred, regardless of when cash is received or paid. This means that revenue is not recorded just because you have received a cash payment from your customer.

In the example above, when you received $120 on January from a customer as their payment for monthly magazine subscriptions, the entire amount should not be recorded as revenue on January alone. Instead, the amount of $120 is divided across twelve months and a revenue of $10 is recognized for each month that you issue a magazine to your customer.

Another example is when you pay $2,400 for a twelve-month insurance coverage of your employees. The entire payment of $2,400 should not be recognized immediately as expense when you paid the amount in advance. Instead, the amount is divided into twelve months and an insurance expense of $200 is recognized as a portion of the prepayment is applied each month.

The goal of accrual accounting is to record income and expenses in the period where the real economic transaction occurred rather than when cash is exchanged.

Matching principle

Connected to accrual accounting is the matching principle where expenses should be matched to the related revenues that they help generate during a period. This principle exists since it is assumed that the generation of a revenue has a cost that is always associated with it.

For example, let’s assume that you purchased cup sealing machines amounting to $1,000, which your business will use to seal the plastic cups of bubble teas that you sell to your customers. If you expect to use these machines for 5 years, their costs should be systematically spread out and recognized as expense over the periods for which they are expected to provide benefits. Immediately recognizing the full costs of the machines as expense on the period they were purchased is not in accordance with accrual accounting and will violate the matching principle.

With the above principles and assumptions out of the way, let’s take a look at some of the reasons why we need to record adjusting entries.

Purpose and Types of Adjusting Entries

Adjusting entries play an essential role in accurate financial reporting. Here are the main reasons why they are important:

  1. Adjusting entries ensure that all your business transactions are being accounted for using the accrual method. This allows the proper reporting of all income earned and all expenses incurred during the accounting period.
  2. Adjusting entries ensure that all assets during the period are completely reported. This includes accounting for any accrued income, prepayments, uncollectible amounts, and depreciation.
  3. Adjusting entries ensure that all liabilities during the period are also fully reported. This includes accounting for any accrued expenses and unearned income.

The following are the common types of adjusting entries:

  1. Accrued income
  2. Accrued expense
  3. Deferred income or Unearned income
  4. Prepaid expense
  5. Bad debts or Doubtful accounts
  6. Depreciation

Accrued Income

What is accrued income?

Accrued Income, also called Accrued Revenue, represents income that is already earned but not yet received. It is accounted for as an asset of the business.

The adjusting entry for the recognition of earned but unrecorded income for which no cash has been received yet is:

Since accrual accounting reports revenue in the current period that it is earned even if the collection of cash will still be made in a future date, an adjusting entry to record a receivable, which is an asset, and an income should be made at the end of the current period.

One example of accrued income is related to unpaid rent that was already earned.

Accrued Rent

Accrued rent income is recognized when the period covered by the rental payment has already passed even if no cash payment was still made by the customer. In this case, rent income was already earned which should trigger the recognition of a receivable.

To illustrate, let’s assume that your company leases out apartment spaces for $1,000 per month. The amount covers the entire month from the first day to the last day.

For example, on June 1, 2023, you already have 10 tenants that will pay their rental payments on July 5, 2023. Before you prepare the financial statements for the month of June 2023, you need to post an adjusting entry as shown below to recognize accrued rent income for the month.

By the end of June 2023, you have already earned $10,000 which is the amount of monthly rent per tenant multiplied by 10 tenants. The above adjusting entry recognizes the rent income you’ve already earned and sets up a receivable account for it.

When July 5 arrives, the journal entry for the collection of rent would be:

If you fail to record accrued rent income on June 30, it will affect your company’s financial statements as follows:

Another example of accrued income is related to interest that you’ve already earned even if no payment was still made by the payor. The adjusting entry for this is:

Accrued Expense

What is accrued expense?

Accrued Expense represents expense that is already incurred but not yet paid. It is accounted for as a liability of the business.

The adjusting entry for the recognition of expenses that have already accrued but you haven’t paid yet is:

Under accrual accounting, any expenses that your company has incurred during the period will be recognized in the same period even if you haven’t paid it yet. A liability to pay it arises, hence the recording of a payable at the end of the period.

An example of accrued expense is related to payroll.

To illustrate, let’s assume that the amount of salaries you have to pay your employees covering the period June 16 to 30, 2023 is $12,000. Payment will be made on the 5th day of the following period, in this case July 5, 2023. The adjusting entry to record accrued payroll is:

Before preparing your financial statements for June 2023, you need to post the above adjusting entry to recognize the payroll expense for that period and to set up the related liability. Upon payment of employees salaries on July 5, the entry will already be:

Failing to record accrued payroll on June 30 will result in the following:

  • Statement of financial position – liabilities will be understated by $12,000
  • Income statement – expenses will be understated by $12,000 while net income will be overstated by the same amount.

Another example of an accrued expense is related to the interest on the loan that you have to pay after the related payment becomes due. The adjusting entry for this is:

Deferred Income

What is deferred income?

Deferred Income, also called Deferred Revenue and Unearned Income, represents income that is already received but not yet earned. It is accounted for as a liability of the business.

Many companies use a subscription business model where they receive cash payments in advance from customers for services or products that they’ll still have to deliver in the future. For example, a website builder company may collect an annual fee upfront from subscribers who want to use their services for an entire year.

Under accrual accounting, advanced cash payments from customers are not yet considered as earned revenue until delivery of services or products are made. There are two methods of recording income with this type of transaction:

  1. Liability method
  2. Income method

Liability Method

Under the liability method, a liability or deferred income account is immediately credited upon receipt of the advance cash payment. For example, let’s assume that your company received a total of $24,000 payment from the beginning of January 2023 from customers who subscribed to one of your packages covering one year of software services.

The entry to record the advanced collection of subscription payments from customers will be:

This entry represents your obligation to render software services in exchange of the advanced subscription payments that you have received from your customers. As you provide services each month, you recognize revenue from the earned portion of the advanced subscription payments by posting an adjusting entry at the end of each month until the full subscription amounts are earned and the entire deferred revenue liability is converted to revenue.

By the end of January 2023 before you prepare your financial statements for the month, your adjusting entry to record the earned portion of the subscription fee will be as follows:

The amount was computed by dividing $24,000 by 12 months, which is the number of months covered by the service. The resulting amount of $2,000 will be the subscription revenue that you have earned for the delivery of software services for the month of January 2023.

If you don’t adjust for the earned portion of the advanced subscription payments, the effects on your financial statements will be as follows:

  • Statement of financial position – liabilities will be overstated by the amount of earned revenue.
  • Income statement – revenue and net income will both be understated by the same amount as the earned portion.

Income Method

When you’re using the income method, you’ll immediately credit the subscription revenue account instead of a liability account upon receipt of the customers’ advance cash payments. The entry would be:

Since the above entry immediately recognized the entire payment as revenue, your adjusting entry at the end of January 2023 should adjust for the unearned portion of the subscription payments received from the customers. The adjusting entry should be:

The above amount of $22,000 was computed as follows:

Unable to make this adjustments will result to the following effects in your financial statements:

  • Statement of financial position – liabilities will be understated by the amount of the unearned portion.
  • Income statement – both revenue and net income will be overstated by the amount of the unearned portion.

Whether you use the liability method or the income method in recording advance customer payments, the balances of the accounts involved should still be the same after adjustments were made.

Prepaid Expense

What is prepaid expense?

Prepaid Expense represents expense that is already paid but not yet incurred. It is accounted for as an asset of the business.

There are certain expenses that a business has to pay upfront in exchange for receiving benefits in the future. These expenses, called prepaid expenses, are considered assets since they are advances made by the company to the provider of goods and services, therefore the company does not have to pay for them anymore at a later date.

Some common prepaid expenses are prepaid office supplies, prepaid insurance, prepaid rent, and prepaid subscriptions. For example, in a prepaid subscription plan, the business makes a single payment upfront for goods or services that will be delivered to them repeatedly over a period of time that is covered under their contract with the provider.

Under the matching principle, advanced cash payments made by a business for goods and services cannot be expensed immediately until the actual value has been received. Therefore, the payment should be initially recorded as an asset and then expensed when incurred over a period of time to properly match with the benefits as they were received.

There are two methods of recording expenses under prepayments:

  1. Asset method
  2. Expense method

Asset Method

Under the asset method, the advance cash payment will immediately be debited to a prepaid asset account. For example, let’s assume that your company purchases a 12-month insurance coverage plan and pays an upfront fee of $60,000.

The entry to record the insurance premium payment using the asset method will be:

As you end the accounting period each month, you need to prepare an adjusting entry to transfer the expired portion of the prepaid insurance to an expense account. To compute for the expired portion each month, divide $60,000 by 12 months to get $5,000 which is the monthly insurance expense.

The adjusting entry at the end of each month will be:

Failure to record an adjusting entry for the expired portion of the insurance will result to the following:

  • Statement of financial position – assets will be overstated by the amount of the expired insurance.
  • Income statement – expenses will be understated while net income will be overstated by the amount of the expired portion.

Expense Method

Alternatively, you may use the expense method in recording prepaid insurance. Under this method, the advance payment will immediately be debited to the insurance expense account as follows:

The above entry recognized the entire amount of the insurance payment as an expense, therefore, your adjusting entry to transfer the unexpired portion of the insurance at the end of the first month will be:

Not posting the above adjusting entry will result in the following:

  • Statement of financial position – assets will be understated by the amount of the unexpired insurance.
  • Income statement – expenses will be overstated while net income will be understated by the amount of unexpired insurance.

Whichever method you use in recording the insurance payment, either would still result in similar account balances after posting the above adjusting entries.

Bad Debts

What is bad debt?

Bad Debt represents receivables from customers that may be proven as uncollectible. It is also called Doubtful Account or Uncollectible Account.

In order to increase sales, many businesses extend credit to customers. The amounts owed by these customers are recorded in individual ledger accounts under the accounts receivable control account.

However, companies are aware of the inherent risks of extending credit to customers. This is the reason why they would estimate the amount that they deem to be uncollectible or no longer recoverable from their customers. This amount, which is considered as bad debt is an expense of the business and should eventually be written off.

The concept of bad debts is in accordance with the matching principle wherein the estimated uncollectible accounts should be expensed in the same period as the related sales were made. This practice of recognizing bad debts is a normal business practice and is part of the operating expenses of a company.

Methods for Calculating and Recording Bad Debts

The amount of bad debts are usually estimated by applying a percentage that is determined from bad debt history. Even though you could specifically identify each customer accounts that are uncollectible, doing so could take a lot of time which is the reason why estimating bad debts is the more practical approach.

There are three methods that you may use to estimate the amount of bad debts:

  1. Percentage of credit sales – the amount of bad debt is calculated by multiplying credit sales for the period by a percentage rate based on past bad debt to credit sales ratio.
  2. Percentage of outstanding accounts receivable – this method estimates bad debts as a percentage of the accounts receivable balance instead of the credit sales.
  3. Accounts receivable aging – bad debt is calculated by preparing a schedule of the outstanding receivables and grouping them according to the age of their invoices. The total balance of each group is then multiplied by a different percentage rate that is applicable only to the group. The older the receivable group is, the higher their percentage rate because of the higher risk of default.

The percentage rates that are used in the methods above can be based on your company’s historical data related to bad debts. In addition to historical data, you may also utilize industry averages in estimating bad debts.

Recording bad debts in the books also involves two methods:

  1. Direct write-off method
  2. Allowance method

Direct write-off method

Under the direct write-off method, bad debts are recorded only when you are certain that you could no longer collect from the customer anymore with any legal means available. This is a simpler approach than the allowance method that small businesses could use.

For example, you’ve determined that the receivable from customer A amounting to $100 is already worthless and uncollectible. The adjusting entry to record it would be:

While this method is simpler and more straightforward, it is not in accordance with the matching principle since bad debts is not recognized in the period that the actual sales took place. In addition, it does not present the correct net realizable value of the accounts receivable.

Allowance method

In contrast with the direct write-off method, the allowance method is the approach that is more aligned with the matching principle since it properly matches expenses with the revenue for the period. It also uses the estimation methods that we have discussed above.

Under this method, an estimate of bad debts is charged to the Allowance for Doubtful Accounts, which is a contra-asset account that is deducted from accounts receivable to obtain the net realizable value (NRV). The accounts receivable net realizable value of is the amount that you expect to receive from your customers after accounting for possible bad debts.

The difference between the allowance method and the direct write-off method is that the former is more conservative by recognizing bad debts expense in advance even if the accounts are not yet reasonably proven as uncollectible and the loss is only probable. The latter, on the other hand, only recognizes bad debts when it is proven that the amount could no longer be recovered.

For example, based on past experience, you’ve determined that 5% of credit sales during a period becomes uncollectible. With this knowledge, you’ve decided to provide a 5% allowance for bad debts at the same period as the sale was made.

Let’s assume that for the month of April 2022, you recorded credit sales amounting to $100,000. The entry to record bad debts at the end of this month would be:

The above amount of $5,000 was computed by multiplying credit sales of $100,000 with the 5% historical bad debt rate. The total allowance for doubtful accounts will be deducted from total accounts receivable to get the net realizable value.

Continuing with this example, let’s assume that the following month, you have determined that $1,000 can no longer be collected. The entry to write off this amount will be:

This entry directly reduces both accounts receivable and the allowance for doubtful accounts since it is already proven that the amount can no longer be recovered. Bad debts expense is not recorded anymore since it was already recorded in advance on previous periods.

However, let’s assume that after writing off the $1,000, your customer miraculously decided to pay and settle their debt. The entries would be as follows:

Failing to make adjustments for bad debts expense will result in the following:

  • Statement of financial position – assets will be overstated by the amount of bad debts.
  • Income statement – expenses will be understated while net income will be overstated by the amount of bad debts.

If you notice that you have unreasonably large amounts of bad debts from customers, it’s time for you to check the creditworthiness of your customers and assess if you should still consider providing credit to those with a track record of not making timely payments. Not doing so will negatively impact your company’s cash flow, which could result in less available cash.

Depreciation

What is depreciation?

Depreciation represents the portion of an asset’s cost that is charged to expense over a period of time that it provides utility to an entity.

Most companies acquire fixed assets for their operations and with the intent to help their business generate revenues. Fixed assets, also known as property, plant and equipment, are tangible assets that usually require a relatively large capital outlay and are expected to be used over a long period of time.

Examples of fixed assets are vehicles, equipment, machinery, furniture, buildings, and land. They usually have a useful life of more than a year and are classified as non-current assets in the statement of financial position or balance sheet.

However, fixed assets, excluding land, experience a decline in their utility value over time as they are being used in the business and subjected to continuous wear and tear. Utility value is the ability of an asset to serve its purpose in the business.

Since fixed assets are capital expenditures that are expected to be used over several periods or years, their costs cannot be immediately expensed from the time they are acquired. Instead, companies allocate the cost of the asset to expense over their useful life through depreciation.

Methods For Calculating Depreciation Expense

Depreciation is one of the largest expense that a business could have. The following are some of the methods used to compute depreciation:

  1. Straight-line method – the simplest and most commonly used method in calculating depreciation. Using this method, the cost of the asset is spread out evenly over the expected life of the asset, thus resulting in equal amounts of depreciation expense.
  2. Double declining method – this method is used for assets that have their most utility or usefulness in their early years of life. The amount of depreciation expense during the asset’s earlier years are higher compared to its later years.
  3. Sum-of-the-years’ digits method – this method is an accelerated method of computing depreciation wherein the amount is higher in the asset’s initial years of usage and lower in later years, which is similar to the double declining method. This can be used for an asset that usually lose most of its economic value towards the earlier years of its useful life such as the case of a vehicle.
  4. Units of production method – this method is used for assets such as production machinery where the useful life is more appropriately measured using the output the asset produces rather than with passage of time.

To illustrate how depreciation expense is computed, let’s use the straight-line method in our example for easier understanding.

Let’s assume that on January 1, 2023, your company purchased a delivery truck for $60,000 which it expects to use for five years. To compute for the annual depreciation using the straight-line method, simply divide the cost of $60,000 by the truck’s estimated useful life of 5 years. This would yield equal yearly depreciation expense of $12,000 which you will be recording at the end of each year for 5 years.

If you’re preparing the monthly financial statements of your company, you may compute for the monthly depreciation by dividing $60,000 by 60 months which is the total number of months covered by the truck’s 5-year useful life. The resulting monthly depreciation expense would be $1,000.

Recording Depreciation Expense

Continuing with the example above, the following is the adjusting journal entry to record the depreciation expense at the end of the first month which is January 31, 2023.

The accumulated depreciation account is a contra-asset account that reduces the cost of fixed assets and is shown as a deduction from fixed assets in the statement of financial position.

The balance of the accumulated depreciation account contains the cumulative amounts charged to depreciation expenses over time. This balance is reduced when a particular asset is disposed.

When you don’t make the necessary adjustments for depreciation expense, it could result in the following:

  • Statement of financial position – assets, specifically fixed assets, will be overstated by the depreciated portion of the asset’s cost.
  • Income statement – expenses will be understated while net income will be overstated by the amount of depreciation.

Review Questions

  1. What is the purpose of adjusting entries?
  2. What happens to your financial statements when you fail to record for the expired portion of a prepayment when using the asset method?
  3. What is the effect in the income statement for not recording bad debts during a period?
  4. What happens to the statement of financial position if accrued expenses are not recorded?
  5. What is the effect in the income statement if you recorded the full amount of advance payments from your customers as revenue without  making subsequent adjustments for the amount of unearned revenue?

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