Adjusting Entries – Classification, Adjusting and Example

What Is an Adjusting Journal Entry?

Adjusting journal entries is a common practice in the accounting profession. The purpose of an adjusting journal entry is to record income and expenses recognized at the time but not correctly recorded on main materials such as books, forms, and other records maintained by the accounting department.

Accounting clerks frequently adjust entries if the amount reported by an individual does not match up with what was recorded in the books or other records kept by the company.

Understanding Adjusting Journal Entries

Adjusting entries are used to convert cash transactions into accrual-basis reporting. Accrual accounting is closely related to the cash basis of accounting and is based on the revenue recognition principle; it records revenue when earned rather than when officially collected.

An adjusting journal entry involves the classification of certain accounts into the income statement and the balance sheet. It is characterized by an increase or decrease in an income statement account and a related account classified as an asset or liability in the balance sheet.

Accounts used to record expenses like interest, insurance, depreciation, and revenues may require adjustments upon review. Adjustments are made by the matching principle to match expenses to the related revenue in the same accounting period. Journal entries are used to move balances from the individual subsidiary ledgers into the general ledger. These adjustments are consolidated and carried through to the financial statements.

Adjusting entries are the incremental results of accruals, deferrals, and estimates. Accruals adjustments are the principal of a business. They aren’t just about balance sheets. When a company generates revenues, it generally tallies those up against its expenses to produce a profit. But some expenses shift from month to month or year to year, sometimes dramatically. That means accruals adjustments must be made in some units—usually to include interest on debt or pay down long-term liabilities.

Deferral adjustments adjust estimated revenue and expense recognition during which estimated cash flows differed from actual cash flows. They result from accounting practices that recognize cash payments made in advance of anticipated revenues or expenses, even though those payments may not have been made when the statement is produced. 

An essential purpose of adjusting journal entries is to prevent overstating estimates or understating actual expenditure or income. It is more likely that reliable sources will be consulted to clarify or revise estimates rather than assumptions being made based on informal negotiation or assumption.

Why make adjusting entries?

As a business owner, you need to ensure your books accurately reflect your transactions. But if you don’t make adjusting entries, your books may show you paying for expenses before you’ve incurred them and collecting revenue you haven’t yet earned.

If your accounting entries aren’t properly balanced, you may not accurately picture how your business is performing. The figures on your financial statements will be incorrect, and you could end up paying more in taxes than necessary.

Adjusting journal entries are one method of depreciating assets. They’re useful for tax deduction purposes, and they ensure that your books balance.

Who needs to make adjusting entries?

If you do your accounting but record sales and purchases using the accrual method of accounting, you’ll have to make adjusting entries.

If your tax return is simple and you follow the cash basis system, you might not need to adjust entries.

A good accountant should be able to handle any adjusting entries on time easily.

Classification of Adjusting journal entries

They are classified into 4 different types

1. Accrued Revenues

Accrued revenues are a type of income that you will receive in the future, even though it is not yet recorded as profit on your books.

It can include revenues from emails you have sent out or the sales of products you have sold but not yet booked into your sales ledger. But this kind of income does not usually appear as a separate line item in your quarterly or monthly audit report.

2. Accrued Expense

Accrued expenses are money that has come due but hasn’t been paid for yet. Said differently, an expense is earned once and is paid once for all purposes except replacement cost. So when a purchase is made, whether it be a meal or a repair, these are paid that has already been accounted for as earned expenses.

3. Deferred Revenue

This type of deferred revenue occurs when an individual purchases a product or service with funds that have yet to be earned by the business. Examples of this include income from tips, training courses, consulting services, or data processing fees.

4. Deferred Expense

Deferred expense is money that is not necessarily spent immediately but can be used to buy later. It tends to be money used for things we don’t need right now but could use the money if circumstances change.

For example, you borrowed money to go on a trip, but a better alternative would be saving up and buying the ticket.

Adjusting Entry Best Practices

The company should regularly evaluate the need for each key accounting entry to ensure that the financial results are accurate. The company should develop a template in the accounting software for each major type of entry.

The templates should be reviewed regularly to ensure that they apply, as business conditions can change over time. Businesses should review their standard list of entries to determine whether adjustments are needed because of changes in the business.

Always follow accounting standards for entering journal entries. A company should review adjustments at the end of each accounting period and construct journal entry templates in the business’s accounting software.

Example of Adjusting Entries

To avoid having the loan balance accrue interest through the reporting period that starts on March 1, Marraider adjusts the entry so that the unpaid balance on March 1 is less than the total of the loans outstanding at the end of December.

For example, if there are $100,000 outstanding on December 31, but $84,000 is paid off by January 31, there will be no outstanding balance on March 1, and the company will not have to pay an additional interest charge for 3 months.

Key Takeaways

  • Adjusting entries are used to convert cash transactions into accrual-basis reporting.
  • Adjustments are made by the matching principle to match expenses to the related revenue in the same accounting period.
  • Adjusting journal entries are one method of depreciating assets. They’re useful for tax deduction purposes, and they ensure that your books balance.
  • Adjusting entries are the incremental results of accruals, deferrals, and estimates.
  • Adjusting journal entries are classified into Accrued Revenue, Accrued Expense, Deferred Revenue, Deferred Expense