Adjusting Entry Definition
An adjusting entry is a journal entry you make in your accounting records at the end of an accounting period. It updates the balances of your accounts to reflect the true financial status of your business.
You might need to make adjusting entries for several reasons, such as to record expenses that have occurred but haven’t been paid for yet (like utilities or salaries), or for revenue recognition.
Adjusting Entry Example
Let’s walk through an example of making an adjusting entry for an accrued expense.
Imagine it’s the end of December, and you own a coffee shop. You’ve used electricity all month to keep the lights on and the espresso machines running, but you won’t collect your accounts receivable until January.
Even though you haven’t paid it yet, you still need to account for that expense in December because that’s when you used the electricity. This is where an adjusting entry comes in.
Here’s how you do it:
Determine the expense: First, estimate how much the electricity cost you for December. Let’s say you estimate the bill will be $300.
Make the adjusting entry: To record this accrued expense, you would make an adjusting entry in your accounting records at the end of December. The entry would look something like this:
- Debit (increase) Utilities Expense account by $300. This reflects that you’ve incurred an expense of using electricity.
- Credit (increase) Utilities Payable account by $300. This shows that you owe money for the electricity used, even though you haven’t paid it yet.
This entry does two things: It recognizes the expense of electricity in December, when you actually use it, and it acknowledges that you have a liability, or an obligation to pay, that you’ll settle in the future.
By making a closing entry, you ensure your financial statements for December accurately reflect the costs of running your coffee shop.
Trial Balance vs. Normal Balances
Understanding the difference between a trial balance and a normal balance is key to managing your business’s finances effectively.
Think of a trial balance as a list you make, at the end of an accounting period, that shows every account from your general ledger with the total debits and credits recorded. An adjusted trial balance helps check that the sum of all debits equals the sum of all credits. This ensures that your accounting entry follows the double entry system correctly, where every debit entry has a corresponding balance sheet credit entry. It’s like making sure both sides of the scale are even. If they match, it suggests your transactions are recorded correctly. If they don’t, it’s a signal that there might be errors needing correction.
Normal balances refer to the side (debit or credit) where an account increases. Each type of account has a “normal” side that reflects its increase. For assets and expenses, the normal balance is a debit, meaning these accounts increase on the debit side. For liabilities, equity, and revenue, the normal balance is a credit, meaning they increase on the credit side. Understanding the normal balance is crucial for correctly recording transactions. For instance, when you earn revenue, you increase the revenue account by crediting it, adhering to its normal balance being a credit.
Types of Adjusting Journal Entry
Adjusting journal entries come in a few different types, each serving a unique purpose in your financial accounting records. Let’s explore these types so you can understand how to use them to keep your financial statements up-to-date.
- Accrued Revenue: This is money you’ve earned but haven’t received yet. Imagine you completed a project in December, but your client will pay you in January. You use an accrued revenue entry to record the income statement in December because that’s when you earned it, ensuring your earnings are matched with the right period.
- Accrued Expenses: These are expenses you’ve incurred but haven’t paid for yet. If you used electricity all month but the bill won’t arrive until next month, you still need to recognize that expense. An accrued expense entry lets you record the cost in the month when you used the electricity, not when you paid for it.
- Deferred Revenue: Sometimes called an unearned revenue, these are payments you received for goods or services you haven’t delivered yet. If someone pays you in December for a job, you’ll do in January, you record this payment as a liability (because it’s money you owe in services) until the job is done. Then, you adjust the entry to show the revenue when you actually perform the work.
- Prepaid Expenses: A prepaid expense is a payment you’ve made in advance for items or services you’ll use. If you pay your insurance for the entire year in January, you don’t recognize the entire expense in January. Instead, you make an adjusting entry each month to expense part of that prepaid amount, spreading the cost over the period you’re insured.
- Depreciation Expense: This type applies to assets like equipment or vehicles that lose value. You use depreciation to spread the cost of the asset over its useful life. Each period, you record an adjusting entry to account for the asset’s accumulated depreciation, reflecting its decreasing value and the expense of using it.
Importance of Adjusting Entry
Adjusting journal entries are crucial for a few key reasons, and understanding them will help you manage your business’s finances more accurately.
- Accuracy: It ensures your financial statement is accurate. By making these adjustments, you’re making sure that your income and expenses are recorded in the correct period. This is vital for understanding how much cash flow you have and spent in a specific timeframe.
- Compliance: Adjusting entries helps you comply with accrual accounting. This accounting method records income when it’s earned and expenses when they’re incurred, regardless of when money actually changes hands. This is not just about following rules; it helps you see a clearer, more comprehensive picture of your financial situation, which cash accounting can’t always provide.
- Decisions: They help make informed business decisions. Accurate financial statements are like a compass for your business, guiding your decisions about spending, investing, and growing. If your financial statements are off because they don’t include adjusting entries, you might decide based on incomplete or misleading information. For instance, if you don’t account for all your expenses, you might think you have more profit than you actually do, leading to overspending.
- Tax: Adjusting entries prepares you for tax time. By ensuring that your financial records accurately reflect your business’s income and expenses, you’re also making sure that you’re reporting your taxes correctly. This can help you avoid overpaying or underpaying your taxes and prevent potential issues with tax authorities.