What are Adjustment Entries?
Adjusting entries are the entries that are made on the last day of an accounting period. This is done so that a company's financial statements go in accordance with the accrual method of accounting. In simple words, the adjusting entries are needed in a company for the following reasons:
Income statement records the revenues which were earned during the accounting period.
Balance sheet reports the receivables who has a right to receive at the end of the accounting period.
Income statement reports the expenses and losses to incur during the accounting period.
Balance sheet records the liabilities which has incurred as of a particular accounting period.
Types of Adjustment Entries
Primarily the types of the adjusting entries are discussed in the given sections:
Accrued Revenues
These entries help a business in reporting all the revenues, which it had earned during the accounting period. There might arise a case when a company has already provided a service, but did not receive the payment yet. So, the accrual type of adjusting entries are shown in the financial statements to account for such as these revenues.
Accrued Expenses
Like the accrued income or the revenue, a company only should record the expenses which it incurs. A business should also report an expense even if it does not incur its expenses. For example, a company assigns a worker on a contract basis. The company is expecting to get an invoice on January 3rd and remit the payment on January 8th. However, the services of the worker were availed in the month of December itself. Therefore, the company needs to account the expenses and liability as of December 31st.
Deferred Expense
Deferred expenses are the payment paid in the present for the future expenses. One must also refer these payments as the deferred expense until the expenses expire or the company avails the service. Like, a company pays Rs.10000 on December 25 towards a machine insurance for the six-month period starting January 1. This means the insurance is actually prepaid for a period between the December 25th and December 31.
Depreciation Expense
It is in relation to the use of the fixed asset in the business, a company depreciates an asset at a certain rate which has a useful life for more than a year. Through the depreciation period, the company allocates this cost of the asset as an expense in the accounting periods where the company uses the asset. Example, a machine costing Rs.50000 with no salvage value and useful life of 20 years will result in a monthly depreciation expense of Rs.50000/240 (20*12).
Deferred Revenue
If the company receives any amount in advance before earning, the company should mention the same as a liability in the current accounting period. Like, a company gets an advance of Rs.5000 for offering a service which will offer at a later date. As on December 31st, the company should analyse the portion of the service which it has already delivered. The portion will come as income, and the balance will be the deferred revenue.
Importance of Adjustment Entries
Adjusting Entries helps in the following cases:
The income statement of the company only records the revenues which the company earns during the accounting period.
Receivables in the balance sheet reflects the accurate amount which the company has the right to receive at the end of an accounting period.
Income statement encompasses the expenses and losses which a company incurs during the accounting period.
Balance sheet also consists of the liabilities which the company incurs as of the end of the accounting period.
This also helps in calculating the exact revenues and expenses.
Updating the financial statements can be done through these entries.
To fix an error, adjustment entries are passed easily.
FAQs on Adjustment Entries in Accounting: Explained
1. What are adjustment entries in accounting?
Adjustment entries are special journal entries recorded at the end of an accounting period. Their main purpose is to accurately match a company's revenues and expenses to the correct period, ensuring the financial statements reflect the true financial position under the accrual basis of accounting.
2. Why are adjustment entries so important for preparing financial statements?
Adjustment entries are crucial because they uphold the matching principle of accounting. This principle states that all expenses incurred to generate revenue must be recorded in the same period as that revenue. Without these entries, a company's profit or loss for the period would be incorrect, and its assets and liabilities would be misstated on the Balance Sheet.
3. What are the main types of adjustment entries students need to know?
The most common adjustment entries you will encounter in Class 11 and 12 accountancy are:
- Outstanding Expenses: Expenses that have been incurred but not yet paid.
- Prepaid Expenses: Expenses paid in advance, where the benefit will be received in a future period.
- Accrued Income: Income that has been earned but not yet received.
- Unearned Income: Income received in advance for a service or product that is yet to be delivered.
- Depreciation on Assets: The systematic allocation of the cost of a tangible asset over its useful life.
- Provision for Doubtful Debts: An estimated amount set aside for potential losses from customers who may not pay their dues.
4. Could you explain an adjustment entry with a simple example?
Certainly. Imagine a company pays an annual insurance premium of ₹12,000 on April 1st for the full year. At the end of the financial year on March 31st, the entire ₹12,000 has been used up. However, if the company closes its books on December 31st, only 9 months of insurance have been used (₹9,000). The remaining 3 months (₹3,000) is a prepaid expense. The adjustment entry would be made to show ₹9,000 as an expense for the current year and ₹3,000 as an asset (prepaid insurance) on the Balance Sheet.
5. How do adjustment entries affect the final accounts?
Adjustment entries have a dual effect on the final accounts. They simultaneously impact both the Income Statement (or Trading and Profit & Loss Account) and the Balance Sheet. For example, recording an outstanding salary increases the salary expense in the Profit & Loss Account (reducing profit) and also creates a liability (outstanding salary) on the Balance Sheet.
6. What is the difference between an adjustment entry and a correcting entry?
This is a common point of confusion. An adjustment entry is a normal part of the accounting cycle, made to account for revenues and expenses in the correct period (like for prepaid rent). A correcting entry, on the other hand, is made to fix a mistake that was made in the books of accounts, such as posting a transaction to the wrong account or for the wrong amount.
7. When are adjustment entries usually recorded in the accounting process?
Adjustment entries are typically recorded at the very end of an accounting period, after a trial balance has been prepared but before the final financial statements (like the Income Statement and Balance Sheet) are created. This ensures that the final reports are accurate and comply with accounting principles.
