As a small business owner reviewing the documents your accountant has asked you to review, you’ve probably wondered:
What are all these “adjusting entries?”
No, your accountant is making up for a mistake they made last financial period.
In fact, adjusting journal entries are a routine part of financial accounting, helping businesses maintain alignment with two core accounting principles: the revenue recognition principle and the matching principle.
In this article, we’ll explain what those principles mean and how they relate to adjusting entries. We’ll then dive further into adjusting journal entries, exploring different types, providing examples, and discussing how and when to make journal entry adjustments.
What are adjusting entries?
Adjusting journal entries are entries in a company’s general ledger record at the end of an accounting period to recognize any previously unrecorded income or expenses for the period.
They are generally used to reflect transactions that start in one accounting period and end in another, such as receiving a bill from a supplier in one month that you don’t have to pay for until the following month.
They can also be used to correct mistakes made in the previous accounting period, though its not what adjusting entries are specifically designed for.
What is the purpose of adjusting journal entries?
So, why do we use adjusting entries?
In accounting, we have fixed financial periods, such as a month or a quarter.
But business doesn’t start and stop at the end of each month. Consider, for example, an invoice sent on the 15th of June. Your customer might not pay that bill until into early July, depending, of course, on your payment terms.
The cash hasn’t hit your account yet, so there is no ledger entry for that revenue. But from an accounting perspective — assuming your business uses the accrual basis rather than the cash basis — that revenue has been earned.
That’s because, under the accrual method, the revenue recognition principle applies, which means that revenue must be recorded in the period for which it was earned, which is not necessarily the same as paid.
That’s one core reason for adjusting journal entries. Another example is to reflect how revenue is earned for long-term projects.
Say, for example, that your company is a web design agency undertaking a large project that’s expected to take six months to complete. The client pays 20% up front, with the remainder being due on completion.
From the perspective of the accrual method and the respective GAAP (Generally Accepted Accounting Principles), getting 20% of the revenue now and 80% in six months isn’t an accurate representation of how you earned the revenue.
Rather, your company earned that revenue incrementally over the six-month period. Here, adjusting journal entries would be required at the end of each month, each of which reflecting one-sixth of the total revenue you’ll receive for the project.
Types of accounting adjustments
There are four main kinds of journal adjustments accountants make.
1. Accruals
Accruals are used for transactions that have occurred but where cash hasn’t yet changed hands.
An accrued expense, for example, reflects a bill you’ve received but not yet paid. Accrued revenue, on the other hand, reflects invoices you’ve sent to customers for which you’re still waiting on payment.
2. Deferrals
Deferrals are the opposite of accruals. They are used to reflect cash transactions that have already taken place but which need to be recognized in future accounting periods.
A deferred expense entry is used when you pay for expenses in advance, such as buying an annual software subscription. A deferred revenue entry is used when you receive payment from a customer in advance of performing the work or providing the services.
3. Estimates
Estimates are adjusting journal entries that are generally used for non-cash transactions in order to accurately reflect the value of your company’s assets and liabilities on the balance sheet.
For instance, your accountant may notice that a given percentage of raw materials on hand becomes unusable — fresh produce that goes off, for example — and must be written often. So, they use an adjusting entry to change the accuracy of the inventory value on your balance sheet.
4. Depreciation
Depreciation technically falls under the estimates umbrella, but since it's so common in financial accounting, it's worth discussing it specifically.
Deprecation is the practice of expensing the value of a capital asset over the period of its useful life to align with the matching principle.
For example, say you pay $20,000 for a new company car. You’re not going to get all of the value from the vehicle in the month that you buy it. It's going to be used to generate revenue over an extended period of time (the asset’s useful life) — 8 years, say.
To reflect this, your accountant will add deprecation journal entries ($2,000 each year, say) to align with GAAP.
How to make adjusting entries
When you make an adjusting journal entry, you must follow the standard rules of double-entry accounting.
That is, you must change the balance of at least two general ledger accounts with matching total amounts of debit and credit entries.
For example, if you have completed work for a client but haven’t yet billed for it, you’ll want to add an adjusting entry for accrued revenue.
You’ll debit the Accounts Receivable account and credit the Accrued Revenue account.
When to make journal entry accounting adjustments
Adjusting journal entries are a standard part of the accounting cycle.
The majority of the adjustments accountants make are related to periodicity — the fact that financial records are divided into distinct blocks of time but that, in practice, business transactions often extend across those time portions.
For that reason, most accountants will make their adjusting entries after creating the unadjusted trial balance each month (or other financial period).
The principal drivers for making accounting adjustments are accruals and deferrals — when you have incurred an expense or made revenue, but the cash that represents that income or expense has not yet entered or exited your account.
Adjusting journal entry example
Here’s a simple example of a typical adjusting entry.
In March, you completed a project for a client and billed them for $4,000. You have established payment terms of Net 60 Days with that client, meaning they won’t pay you until May.
Though the money hasn’t hit your account yet, you’ll still record that revenue in March to align with the accrual accounting principle. To do so, you’ll have to use an adjusting journal entry, debiting Accounts Receivable and crediting Accrued Revenue.
Make managing journal adjustments easy
Adjusting journal entries are a common and completely natural aspect of financial accounting.
They arise from the fact that we divide business financials up into distinct time periods — months, for example — but that actual business transcends these arbitrary time periods.
Often, you incur an expense in one month but pay for it in another, meaning a journal adjustment is required.
As your company scales, this is only going to happen more often, meaning you’ll want an effective and efficient way to enter and manage journal adjustments.
BILL’s financial operations platform is stacked with helpful features for managing business finances, from accounts payable automation to automated forecasting, not to mention dozens of integrations with popular accounting tools
FAQ
Why are adjusting journal entries important?
Adjusting journal entries are important as they help you ensure that your company financials abide by the matching and revenue recognition principles, two principles that make up the basis of accrual accounting.
The reason they are required is because financial statements dive the time up into arbitrary periods (months, years, quarters), but real-life business doesn’t fit neatly within those parameters.
Who needs to make adjusting entries?
Any business that uses the accrual accounting basis instead of the cash accounting basis will need to make adjusting entries in their general ledger.
What is the difference between cash accounting and accrual accounting?
Cash accounting and accrual accounting are two distinct accounting methods that define when revenue and expenses are recognized.
Under the cash method, revenue and expenses are recognized in the period in which the cash flows into or out of the company bank account.
Under the accrual method, revenue and expenses are recognized in the period in which they were (revenue) or incurred (expenses), regardless of whether you have received or made payment.
What accounts are affected by an adjusting entry?
The answer to this question depends on the kind of adjusting journal entry you’re creating. An adjusting journal entry for an accrued expense will involve different accounts than one for accrued income, for example.
In general, however, these are the accounts that are typically impacted by adjusting entries:
- Accrued revenue
- Deferred revenue
- Accounts receivable
- Accounts payable
- Accrued expenses
- Prepaid expenses
- Asset accounts
- Equity accounts
