Every successful business is based on accurate financial records. Not all financial transactions are however recorded at the point of time that they impact the finances of a company. There are revenues that are earned prior to receiving payment and expenses that are incurred prior to payment. This is where it is necessary to make adjustments in journal entries in accounting.
Adjusting journal entries make sure that financial statements are a true reflection of financial position of a company at the end of an accounting period. They assist businesses to adhere to the accrual basis of accounting, enhance reporting accuracy and ensure adherence to accounting standards.
Here you will find out what are the adjustments of journal entries, why they are important, the various types of journal entries, and how businesses make proper adjustments.
What Are Adjusting Journal Entries?
Adjusting journal entries are entries in the accounting records that are made at the end of an accounting period to correct revenues and expenses that have not been recorded completely.
These entries make sure that the financial transactions are recorded during the period in which they are recorded, irrespective of the receipt or payment of cash. Through these adjustments, companies are able to prepare financial statements that are true to their income, expenses, assets, and liabilities.
In contrast to daily journal entries, adjusting entries are usually prepared prior to the completion of financial statements.
Why Are Adjusting Journal Entries Important?
Financial statements can give a false impression of the financial health of a company without making adjustments. The revenue might be overstated or understated, expenses might not be in the appropriate accounting period and profits might be misleading.
Adjusting journal entries help businesses:
- Compare the revenues and expenses.
- Enhance the quality of financial statements.
- Comply with accrual accounting principles.
- Make credible reports to investors and lenders.
- Promote improved business decisions and financial planning.
Proper adjustments enable the management to assess the performance of the business.
When Are Adjusting Journal Entries Made?
Adjustment of journal entries are normally made at the close of an accounting period, i.e. monthly, quarterly or annually.
Accountants look into transactions before preparing financial statements to determine revenues that have been earned but not recorded and expenses that have been incurred but not yet recognized. These changes make the books complete prior to the end of the accounting period.
Adjustments to entries are a normal aspect of financial reporting in businesses that use accrual accounting.
Types of Adjusting Journal Entries
There are a number of adjusting entries that are common in accounting. They all have a different role in proper financial reporting.
Accrued Revenue
Accrued revenue is the amount of revenue that has been earned but is yet to be received or recorded.
An illustrative case is when a consulting firm finishes a project in December but bills the customer in January. The revenue is in December since it is during this month that the service was rendered.
Recording accrued revenue makes income to be recognized during the right accounting period.
Accrued Expenses
Accrued expenses refer to costs that a business has incurred yet it has not paid them.
Examples are salaries of employees, utilities, interest, or professional service fees that are current but will be paid in the future.
Documenting these costs is a way of ensuring that they are balanced with the revenue that they assisted in creating.
Deferred Revenue
Deferred revenue is a case where a company is paid in advance of delivery of goods or services.
The payment is first recorded as a liability since the company has not yet delivered the promised product or service to the customer. Adjusting entries recognize portions of the deferred revenue as earned income as the work is completed.
This will help businesses not to record revenue too soon.
Prepaid Expenses
Some of the expenses that businesses pay in advance include insurance, rent or software subscriptions.
In the case of payment, the full amount is not an expense when the benefit is carried over to further accounting periods. Rather, the entries are adjusted over time as the cost is incurred but the benefit is consumed over time.
This approach gives a better depiction of the operating costs.
Depreciation
Equipment, vehicles and office furniture are long-term assets that depreciate.
Instead of entering the entire cost as an expense at the time of purchase, businesses depreciate the cost of the asset over the useful life of the asset.
Frequent depreciation revaluations make sure that the financial statements capture the remaining value of the asset and the cost of using the asset.
How to Prepare Adjusting Journal Entries
The preparation of adjusting entries starts with the review of the trial balance and the determination of transactions which need to be updated prior to the preparation of financial statements.
The second thing to do is to decide the accounts that require correction and to compute the right amount. Once the journal entries have been made, accountants consider the new balances to make sure that revenues and expenses are realized in the correct accounting period.
Lastly, a modified trial balance is made and then the financial statements of the company are compiled.
A systematic procedure will minimize mistakes and enhance the accuracy of reporting.
Common Examples of Adjusting Entries
Knowledge of real-life scenarios facilitates the application of journal entries.
When the employees receive salaries at the end of the month but the payroll is prepared in the next month, then the salary costs have to be incurred before the month ends.
In the same way, when a business pays insurance premiums annually, the amount paid in advance should be only charged as an expense in the current month, and the rest of the amount should remain as a prepaid asset.
Businesses also change the monthly depreciation to reflect the continued use of equipment and other long-term assets.
Such regular changes make financial reports accurate during the year.
Common Mistakes to Avoid
Most accounting errors are made when adjusting entries are not taken into consideration or computed in the wrong way.
Among the errors that are likely to occur is the failure to record the accrued expenses prior to the preparation of financial statements. Businesses can also record revenue prematurely or not decrease prepaid assets as they are used up.
Other mistakes are wrong depreciation calculations, irregular adjustment schedules and not checking supporting documentation prior to entering entries.
Best Practices for Accurate Adjusting Entries
Consistency and good internal processes are essential in maintaining accurate adjusting journal entries. Companies are advised to have a routine closing process at the end of every month, account reconciliation, and documentation of all adjustments.
The process can also be made easier with the help of good accounting software that automates the process of implementing changes and minimizes human mistakes.
In the case of expanding companies, professional accountants or CFO services may be used to further enhance the accuracy of reporting and adherence to accounting standards.
How Technology Is Improving Adjusting Journal Entries
The accounting software that is available today has greatly enhanced the manner in which businesses prepare adjusting journal entries. The cloud-based platforms are able to automatically monitor recurring transactions, depreciation, identify prepaid expenses, and create reminders of adjustments.
Automation saves on the manual labor and enhances consistency and accuracy in reporting. Finance teams will be able to waste less time on data entry and more time on analyzing the financial performance and assisting in strategic decision-making.
With the further implementation of digital accounting systems by businesses, it has become quicker, more dependable, and simpler to adjust journal entries.
