In our previous article, we’ve discussed about the preparation of a trial balance. After the trial balance is prepared, we need to ensure that our accounting records are accurate and our financial reports will be fairly presented. Adjusting journal entries (AJE) are necessarily made at the end of the accounting period to update accounts to their correct balances. Adjusting entries are recorded as journal entries just like regular transactions. They are then posted to the general ledger just like any other journal entries to correct the ledger account balances. The adjusted ledger balances are eventually reflected in the adjusted trial balance. In this post, we will discuss how to make adjusting journal entries.
Adjusting journal entries are usually prepared to adjust revenues and expenses to the accounting period in which they actually occurred. If you are using the accrual accounting system, where economic events are recognized by matching revenues to expenses (matching principle) at the time the transactions actually occur regardless of whether the payment is made or received, you will usually adjust your accounts’ ending balances to reflect accruals and prepayments. The following are the 7 types of adjusting entries.
1. Accrued revenues. Accrued revenues are revenues already earned during the accounting period but not yet received as at the end of reporting period. Below are the common examples of accrued revenues.
a. Service revenue rendered to client during the accounting period, but not yet paid by client as at the end of that period.
b. Rent revenue earned during the accounting period, but not yet received as at the end of that period.
c. Accounts receivable from customers for the sale of goods as at the end of reporting period.
Accrued revenues are usually recorded as a debit to a receivable account and a credit to revenue account.
2. Accrued expenses. Accrued expenses are expenses already incurred, but not yet paid as at the end of reporting period. The common examples of these expenses are the following:
a. Employees’ salaries for December 2011, but still unpaid as of December 31, 2011.
b. Utility expenses (e.g., telephone, water and power) for December 2011 but are still to be paid on January 2012.
c. Accrued interest expense. Loan interest incurred for the accounting period, but will be paid in the next accounting period.
d. Taxes, licenses and government fees incurred but still payable as at the end of reporting period.
Accrued expenses are recorded as adjusting entries at the end of accounting period by debiting an expense account and crediting a liability account.
3. Unearned revenues. Also known as “deferred revenues”, are revenues already received in cash during the period, but not yet earned as at the end of reporting period. Some examples of unearned revenues are the following:
a. Advance rental payments for the next accounting period, but already received in cash during the period.
b. School fees received during the period, but are pertaining to next accounting or school period.
c. Advance interest received from clients during the period, but will be earned in the next period.
4. Prepaid expenses. Also called “deferred expenses”, are your expenses that are already paid in cash during the period, but not yet incurred or actually spent as at the reporting period. Below are some of the common examples of prepaid expenses:
a. Advance payment you’ve paid in cash to your lessor for office space rental covering the next accounting period.
b. Unexpired portion of insurance paid as at the end of the balance sheet date covering the next accounting period.
c. Unused supplies as at the end of the balance sheet date or reporting period.
5. Estimation. Some expenses are recognized based on estimation. These expenses include depreciation, amortization and bad debt expense. They are recognized by using generally accepted estimation method, such as straight-line depreciation method for computing depreciation or amortization expense and allowance method for recognizing bad debts.
Depreciation is the decrease in value of a fixed asset, such as property, plant and equipment over its useful life or during its use for generating revenue. It is usually calculated periodically at the end of the accounting period, which may be monthly, quarterly or annually. It is also computed to determine the asset’s accumulated depreciation and net carrying value at the end of accounting period. Accumulated depreciation is a contra-asset account that is deducted to an asset’s cost value to determine its carrying value. Depreciation is recognized at the end of the accounting period by recording a journal entry with a debit to depreciation expense and a credit to accumulated depreciation.
6. Change in accounting estimate – is an adjustment of the carrying amount of an asset or liability, or related expense, resulting from reassessing the expected future benefits and obligations associated with that asset or liability (IAS 8). An example of change in accounting estimate is the change of the useful life of a long-term asset used for computing depreciation.
7. Prior period errors – are omissions from, and misstatements in, an entity’s financial statements for one or more prior periods arising from a failure to use, or misuse of, reliable information that was available and could reasonably be expected to have been obtained and taken into account in preparing those statements. Such errors result from mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretations of facts, and fraud (IAS 8). The following are examples of prior period errors.
a. Business transactions that were omitted or not recorded during the year 2010 and prior years if you are reporting or presenting a 2011 financial statements.
b. Transactions that were recorded more than once or erroneously recorded during the prior years of your reported financial statements.
c. Prior period errors committed because of incorrect applications of accounting policies.
To learn more about recording adjusting journal entries, please stay tuned for our next post which will show some examples of AJEs from the sample transactions we have illustrated in our previous articles.
Update: We have just published the said examples of adjusting journal entries here.