Meaning of Adjusting Entries
Adjusting Entries are journal entries passed at the end of an accounting period to ensure that income and expenses are recorded in the accounting period in which they actually occur, irrespective of when cash is received or paid.
These entries are prepared under the Accrual Basis of Accounting and are based on the Revenue Recognition Principle and the Matching Principle.
Adjusting entries are also known as Balance Day Adjustments because they are generally made on the balance sheet date (year-end) before preparing the financial statements.
Need for Adjusting Entries
Adjusting entries are required because, under accrual accounting, cash transactions and accounting recognition may occur in different accounting periods.
The objectives of adjusting entries are to:
- Record all earned revenues.
- Record all incurred expenses.
- Match revenues with related expenses.
- Present the correct financial position.
- Prepare accurate financial statements.
Accounting Principles Behind Adjusting Entries
1. Revenue Recognition Principle
According to the Revenue Recognition Principle, revenue should be recognized when it is earned, not necessarily when cash is received.
Example:
- Service provided today but payment received next month → Revenue is recognized today.
2. Matching Principle
According to the Matching Principle, expenses must be recognized in the same accounting period as the revenues they help generate.
This ensures that the profit for the accounting period is correctly calculated.
Types of Adjusting Entries
Adjusting entries are broadly classified into Prepayments (Deferrals), Accruals, Estimates, and Inventory Adjustments.
1. Prepayments (Deferrals)
Meaning
Prepayments arise when cash is paid or received before the related expense is incurred or revenue is earned.
They are called Deferrals because recognition of the expense or revenue is postponed to a future accounting period.
Prepayments are of two types:
(a) Prepaid Expenses
Prepaid Expenses are expenses paid in advance and initially recorded as assets because their benefits will be received in future periods.
Examples include:
- Rent paid in advance
- Insurance premium paid in advance
- Office supplies purchased in advance
As time passes or the asset is consumed, an adjusting entry transfers the appropriate amount from Asset to Expense.
(b) Unearned Revenue
Unearned Revenue is cash received before goods are delivered or services are performed.
Initially, it is recorded as a Liability because the business still owes goods or services to the customer.
As the goods are delivered or services are provided, the liability decreases and revenue is recognized through an adjusting entry.
Example – Unearned Revenue
A magazine company receives $12 as an annual subscription fee in advance.
Initial Entry
| Particulars | Debit | Credit |
|---|---|---|
| Cash | $12 | |
| Unearned Revenue | $12 |
After one month, $1 becomes earned revenue.
Adjusting Entry
| Particulars | Debit | Credit |
|---|---|---|
| Unearned Revenue | $1 | |
| Revenue | $1 |
After one month:
- Unearned Revenue = $11
- Revenue Recognized = $1
2. Accruals
Meaning
Accruals arise when revenue is earned or expenses are incurred before cash is received or paid.
(a) Accrued Revenue
Accrued Revenue refers to revenue that has been earned but has not yet been received or recorded.
When recognized, it is recorded as a Receivable (Asset).
Examples:
- Interest earned
- Rent receivable
- Commission receivable
(b) Accrued Expenses
Accrued Expenses are expenses incurred but not yet paid or recorded.
These expenses are recorded as Liabilities (Payables) until payment is made.
Common examples include:
- Interest payable
- Salary payable
- Rent payable
- Taxes payable
3. Estimates
Meaning
Sometimes the exact amount of an expense cannot be determined at the end of the accounting period.
In such cases, businesses record the expense based on a reasonable estimate.
Examples
- Depreciation on Fixed Assets
- Bad Debt Expense
These estimates help present a true and fair view of the financial statements.
4. Inventory Adjustment
In a Periodic Inventory System, an adjusting entry is required at the end of the accounting period to determine the Cost of Goods Sold (COGS).
This adjustment helps calculate the correct gross profit and closing inventory.
However, this adjusting entry is not required under a Perpetual Inventory System, because inventory records are continuously updated after every transaction.
Classification of Adjusting Entries
| Category | Meaning | Initial Recording |
|---|---|---|
| Prepaid Expenses | Cash paid before expense is incurred | Asset |
| Unearned Revenue | Cash received before revenue is earned | Liability |
| Accrued Expenses | Expense incurred but not yet paid | Liability |
| Accrued Revenue | Revenue earned but not yet received | Asset |
| Estimates | Estimated expenses like depreciation and bad debts | Expense Adjustment |
| Inventory Adjustment | Adjustment to determine COGS under periodic inventory | Year-end Adjustment |
Difference Between Prepayments and Accruals
| Basis | Prepayments (Deferrals) | Accruals |
|---|---|---|
| Cash Flow | Cash paid/received first | Cash paid/received later |
| Recognition | Expense/Revenue recognized later | Expense/Revenue recognized first |
| Examples | Prepaid Rent, Unearned Revenue | Salary Payable, Interest Receivable |
Key Points
- Adjusting Entries are passed at the end of the accounting period.
- They are also called Balance Day Adjustments.
- Based on the Accrual Basis of Accounting.
- Supported by the Revenue Recognition Principle and Matching Principle.
- Prepaid Expenses are initially recorded as Assets.
- Unearned Revenue is initially recorded as a Liability.
- Accrued Revenue is recorded as a Receivable (Asset).
- Accrued Expenses are recorded as Payables (Liabilities).
- Depreciation and Bad Debt Expense are examples of Estimated Adjustments.
- Inventory Adjustment is required only under the Periodic Inventory System.
- No inventory adjustment is required under the Perpetual Inventory System for determining COGS at year-end.
Quick Revision Summary
| Type | Remember |
|---|---|
| Adjusting Entries | End-of-period journal entries |
| Revenue Recognition Principle | Revenue recognized when earned |
| Matching Principle | Match expenses with related revenues |
| Prepaid Expense | Asset → Expense |
| Unearned Revenue | Liability → Revenue |
| Accrued Revenue | Revenue earned but cash not received |
| Accrued Expense | Expense incurred but cash not paid |
| Estimates | Depreciation, Bad Debts |
| Inventory Adjustment | Required in Periodic Inventory System only |