As we know that the Financial Statements are prepared at the end of the period on the basis of the trial balance. However, some adjustments are usually needed to prepare a correct and up-to-date financial statements. The adjustments are generally required because of the multi-period items (revenue and expense items that relate to more than one accounting period) and accrued items (revenue and expense items that have been earned or incurred in a given period, but not yet entered into the accounting records). These changes are not recorded by the regular operational journal entries of the entity, so an adjusting process is needed to cause the accounts to appropriately reflect those changes. Hence, adjusting entries are passed to record the required changes. This is consistent with the revenue and expense recognition rules.
Adjusting entries are journal entries recorded at the end of an accounting period to alter the ending balances in various general ledger accounts. These adjustments are made to align the reported results and financial position of a business with the requirements of an accounting framework, such as GAAP. This generally involves the matching of revenues to expenses of the appropriate accounting periods under the matching principle and the accrual concept of accounting.
The use of adjusting journal entries is a key part of the period closing processing, as noted in the accounting cycle, where a preliminary trial balance is converted into a final trial balance. The transactions which are recorded using adjusting entries are not spontaneous but are spread over a period of time. It is generally not possible to create financial statements that are fully in compliance with accounting standards without the use of adjusting entries.
Note: Not all journal entries recorded at the end of an accounting period are adjusting entries. For example, an entry to record a purchase on the last day of a period is not an adjusting entry. An adjusting entry always involves either income or expense account.
Accruals- To record a revenue or expense that has not yet been recorded through a standard accounting transaction, i.e. Outstanding expenses or accrued incomes.
Accounting Treatment: (i) Accrued expenses have not yet been paid for, so they are recorded in a payable account. (ii) Accrued income which has been earned but it has not been received yet, so they are recorded in a receivable account.
Deferrals- To defer a revenue or expense that has been recorded, but which has not yet been earned or used, i.e. Advance incomes or prepaid expenses.
Accounting Treatment: (i) When this cash is paid in advance for expenses, it is recorded under prepaid expense as an asset. (ii) A company receiving the cash for benefits yet to be delivered will have to record the amount in an unearned revenue liability account.
Estimates (Non- cash items)- To estimate the amount of a reserve, such as the allowance for doubtful debts, depreciation, inventory obsolescence reserve, etc.
Accounting Treatment: When the exact amount of an expense cannot be determined, a reserve is created using estimates to cover the risk of these foreseen expenses under liabilities.
Note: Adjusting entries effect both P&L account and Balance Sheet.
Since adjusting entries so frequently involve accruals and deferrals, it is required to set up reversing entries for these entries. This means that the computer system automatically creates an exactly opposite journal entry at the beginning of the next accounting period. By doing so, the effect of an adjusting entry is eliminated when viewed over two accounting periods.
1) Accrued expenses– Accrued expenses are goods or services that have been availed by the entity but have not yet paid for.
E.g. Rent expenses, if a company is operating in a premises for long time and has a good and credible relationship with the owner for the premises, the entity might hold on to the rent expenses for a few month in unfavourable situations like lack of liquidity/ cash. This means the company is utilizing the premises but doesn’t actually get to pay for it immediately. This transaction is recorded as a accrued or outstanding expenses until the expenses are paid off. The same is true at the end of an accounting period. All expenses that are incurred are recorded, even a part of it or whole of it isn’t paid yet.
M/S Hannah Pharmas is operating in a premises which costs $1,500 per month for rent expenses. Due to delay in collection of payment from the customers, the entity could not pay its rent expenses for the last 2 month before 31st December,2017. The entry for this in the books will be-
For November and December: Rent Expense A/c Dr. $1,500
To Outstanding Rent A/c Cr. $1,500
Then whenever the payment is made (partly or wholly), the following entry will be passed in the books-
For payment made in 2018: Outstanding Rent A/c Dr. $2,000
(suppose for $2,000) To Cash A/c Cr. $2,000
Also, the Balance Sheet as of 31st December, 2017 will show a Outstanding expenses of $3,000 under the Liabilities side.
2) Accrued incomes– Accrued incomes are goods or services that have been sold/ provided by the entity to its customers but have not yet received the payment for the same.
E.g. Goods sold on credit, this is a very common thing for a trader to sell goods on credit, especially if he is a bulk seller. This means the company is selling its product, generating profits but doesn’t actually get paid for it immediately. This transaction is recorded as a accrued income until the payment is received. The same is true at the end of an accounting period. All revenues incurred in the accounting period are recorded, even a part of it or whole of it isn’t received yet.
M/S Hannah Pharmas sold 10 cartoons of medicines to a retailer for $1,000 each cartoon. The retailer made the payment for 7 cartoons before the period end and the rest he has promised to make by January 31st, 2018. The entry for this in the books will be-
CashA/c Dr. $7,000
Accrued Income A/c Dr. $3,000
To SalesA/c Cr. $10,000
Then whenever the payment is made (partly or wholly), the following entry will be passed in the books-
For payment made in 2018: Cash A/c Dr. $3,000
(suppose for the entire $3,000) To Accrued Income A/c Cr. $3,000
Also, the Balance Sheet as of 31st December, 2017 will show a Accrued Income of $3,000 under the Assets side.
2) Prepaid expenses– Prepaid expenses are goods or services that have been paid for by a company but have not been consumed yet.
E.g. Insurance Insurance is usually paid in advance for atleast six months. This means the company pays for the insurance but doesn’t actually get the full benefit of the insurance contract until the end of the six-month period. This transaction is recorded as a prepaid expenses until the expenses are incurred. The same is true at the end of an accounting period. Only expenses that are incurred are recorded, the rest are booked as prepaid expenses.
M/S Hannah Pharmas pays $8,400 on October 15th,2017 for the insurance on its vehicles for the six-month period beginning November 1st,2017. The entry for this in the books will be-
For October: Prepaid Insurance A/c Dr. $8400
To Cash A/c Cr. $8,400
Then from each month from November,2017 to April, 2018, the following entry will be passed in the books-
From November to April: Insurance Premium A/c Dr. $1400
(every moth end) To Prepaid Insurance A/c Cr. $1,400
Also, the Balance Sheet as of 31st December, 2017 will show a Prepaid expenses of $5,600 [1400*4 months] under the Asset side.
3) Advance Income– Advance income is goods that have not yet been sold or services that have not yet been provided by the entity but the payment for it has been received from the customer.
E.g. In case of an event management company, the company always takes a major portion of it’s charges for the event in advance from the customer as an assurance that the deal is finalized. It also needs fund to further outsource other service providers like florist or caterer. This means the company is getting the payment for the services/ product it has not yet delivered/ sold. This transaction is recorded as a advance income until the services/goods are delivered. The same is true at the end of an accounting period. All payments received in lieu of any product that the company is yet to deliver are recorded as advance income.
M/S Hannah Pharmas has got an order for delivering all the supplies and equipments for a new clinic that is going to open in its locality. The advance payment for $6,800 has been made immediately and the rest will be made once the products are delivered. The entry for this in the books will be-
For November and December: Cash A/c Dr. $6,800
To Advance Income A/c Cr. $6,800
Then whenever the products will be delivered, the following entry will be passed in the books-
For supplies delivered in 2017: Advance Income A/c Dr. $2,700
(suppose for $2,700) To Sales A/c Cr. $2,700
Also, the Balance Sheet as of 31st December, 2017 will show an Advance Income of $4,100 under the Liabilities side.
4) Depreciation or bad debts provision- Depreciation is associated with fixed assets that are used in the business like buildings, machinery, equipment, vehicles, furniture, except land (land is not considered a depreciable asset). Depreciation is also provided for other constructed assets used in a business and having a useful life of more than one year.
In the case of depreciation, a reserve called Accumulated Depreciation is created and each year the depreciation charged for the period is transferred to the Accumulated Depreciation Account. At the time of sale of that fixed assets, the total amount of accumulated depreciation is deducted from the asset’s value to determine the profit or loss for the sale of fixed asset.
E.g. M/s Hannah Pharmas records the $1,200 of depreciation associated with its fixed assets during each month. The asset was purchased on 1st March, 2017. The entry for this in the books will be-
Depreciation expense A/c Dr. $12,000 [1200*10 months]
ToAccumulated depreciation A/c Cr. $12,000
It’s a common practice for companies to provide services or sell goods for cash or on credit. Allowing credit tends to encourage more sales. However, businesses that allow credit are faced with the risk that their receivables may not be collected. Thus, the entity needs to create a reserve/ provision for any such possible losses and to represent Accounts in the balance sheet at net realizable value, i.e. the most probable amount that the company will be able to collect.
In the case of depreciation, a reserve called Provision for bad and doubtful debts is created and the estimated portion of the Accounts Receivable that the company will not be able to collect is transferred to the Provision for bad and doubtful debts Account.
The estimates are often based on the company's past experiences. To recognize doubtful accounts or bad debts, an adjusting entry must be made at the end of the period.
E.g. M/s Hannah Pharmas had made a sale of goods to a customer for $3,000 10 months back. Even after multiple reminders, the customer has only paid $1,200 and rest is still due to be received. The market image of that customer is also not credible. The entry for this in the books will be-
Bad Debts Expense A/c Dr. $1,800
ToAllowance for Bad Debts A/c Cr. $1,800
In case the estimated bad debt is recovered partly or completely, the following entry will be passed-
Cash A/c Dr. $1,800
To Bad Debts Recovered A/c Cr. $1,800