Why are Adjusting Entries Necessary? A Simple, Yet Best Advice

No matter the business, you must take the step of adjusting entries into consideration to create accurate financial statements.

So why are adjusting entries necessary? 🤔

They occur at the end of an accounting period to properly count your income and expenses that have not yet been recorded in the accounting ledger.

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What are Adjusting Entries?

A Quick Definition

First, you need to know where adjusting entries occur, and that is in journal entries that record the cash flow of a company.

Adjusting entries are changes made to previously recorded journal entries to make sure that the numbers match with the correct accounting periods.

👉 For example, you’ve done some work for a client and decide to charge them $2,000 for the services you’ve done in September. You receive the payment the next month, in October.

That money is recorded as accounts receivable in September, as you’re expected to get paid but have yet to receive the income.

Then, in October, you record the money as cash deposited in your bank account.

The 3 Types of Adjusting Entries

There are different types of adjusting entries that are accruals, deferrals, and estimates.

1. Accruals

Accruals stand for revenues and expenses not yet received or paid, nor recorded in an accounting transaction.

2. Deferrals

Deferrals involve revenues and expenses that have been paid or received in advance and recorded but have yet to be earned or used. Whereas unearned revenues concern money that was received for goods, but that remains to be delivered.

3. Estimates

Estimates record non-cash items like depreciation expense, inventory, etc. at the end of a product life cycle.

Why are Adjustments Needed at the End of an Accounting Period?

To ensure your financial statements accurately reflect your income and expenses, adjustments are typically made on an accrual basis. As such, you will need to get it done at the end of the accounting period.

This means revenues and expenses are recorded when they are earned or incurred, rather than when cash is exchanged. This approach provides a more precise and comprehensive view of your financial performance.

Why is it Necessary to Record Adjustment Entries in the Actual System of Accounting?

Adjustment entries are essential in accounting to ensure the accuracy and integrity of financial statements.

Accrual Accounting Compliance

Accrual accounting requires recognizing revenues and expenses when they are earned or incurred, not when cash is exchanged.

Adjustment entries ensure that:

• Revenues earned but not yet received are recorded.
• Expenses incurred but not yet paid are captured.

Matching Principle

The matching principle dictates that expenses should be recorded in the same period as the revenues they help generate. Adjustment entries ensure that:

• Expenses align with the revenues they generate, providing a clear picture of profitability.

Accurate Financial Statements

For financial statements to be reliable, they must reflect all financial activities accurately.

Adjustment entries correct discrepancies or omissions, providing a true financial position.

Periodic Reporting

Businesses often prepare financial statements periodically.

Thus, adjustment entries help in:

• Closing books accurately at the end of each period.
• Ensuring interim reports reflect up-to-date financial information.

Compliance with Accounting Standards

Adjustment entries ensure compliance with accounting standards like GAAP or IFRS by maintaining consistency and transparency across reporting periods.

4 Steps To Adjust Entries?

Step 1: Recording Accrued Revenue

If you perform a service but have not invoiced your customer yet, the amount of the revenue earned will need to be recorded as accrued revenue.

👉 For example, let’s imagine that you own a car repair shop. You bill your clients for a month of services at the beginning of the following month.

Thus, your bill for July is $4,000, but since you won’t be billing your clients until August 1, you’ll have to adjust the entry to amass the $4,000 you earned in July.

In addition, if you decide to bill the clients in August, your entry would be:

DATE	ACCOUNT	DEBIT	CREDIT
6-31-20	Accrued Revenue	$4,000
	Revenue		$4,000

Step 2: Recording Accrued Expenses

Payroll or paycheck is one of the primary expenses that need an adjusting entry at the end of the month.

That is to say, any working hours for the month not yet paid until the next month should be represented as expenses.

Here is how it will be presented in the journal entry below:

DATE	ACCOUNT	DEBIT	CREDIT
7-31-20	Wages & Salaries Expense	$10,000
	Wages & Salaries Payable		$10,000

DATE	ACCOUNT	DEBIT	CREDIT
8-10-20	Wages & Salaries Expense	$10,000
	Wages & Salaries Payable		$10,000

Step 3: Recording Deferred Revenue

Deferred revenue concerns payment received from customers in advance. This advance payment will have to be deferred until it is earned.

👉 For example, you offer car repair services and one of the customers decides to pay $2,000 in advance for the 4 months their car will have to stay at the shop.

However, since you have not earned the revenue, it has to be deferred.

The journal entry can be found below:

DATE	ACCOUNT	DEBIT	CREDIT
7-31-20	Cash	$2,000
	Deferred Revenue		$2,000

For those two months, you’ll need to record $500 in revenue until the balance of the deferred revenue is 0.

DATE	ACCOUNT	DEBIT	CREDIT
7-31-20	Deferred Revenue	$500
	Service Revenue		$500

Step 4: Recording Prepaid Expenses

Prepaid expenses are recorded like deferred revenue.

👉 For example, you decided to pay your office rent in advance, for the rest of the year. Since your rent is $12,000, you will have to record the $1,000 for the rent expenses.

DATE	ACCOUNT	DEBIT	CREDIT
7-31-20	Prepaid Rent	$12,000
	Cash		$12,000

DATE	ACCOUNT	DEBIT	CREDIT
7-31-20	Rent Expense	$1,000
	Prepaid Rent		$1,000

And so on for the adjusting entries which give you a correct representation of your business’s financial position and health. 

Hopefully, you won't panic or feel lost in your accounting errors.

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What You Should Remember about Adjusting Entries

Adjusting entries is essential for maintaining the accuracy and reliability of financial statements.

It ensures that all revenues and expenses are recorded in the appropriate accounting period, reflecting the true financial position of your business.

Accurate financial statements are crucial for informed decision-making and maintaining stakeholder trust, highlighting the importance of regular and precise adjusting entries.