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A Complete Guide to Adjusting Entries
Accounting Stuff
Overview
This video provides a comprehensive guide to adjusting entries in accounting, explaining their necessity under the accrual basis of accounting. It details four main types of adjusting entries: prepaid expenses, deferred revenue, accrued expenses, and accrued revenue. The explanation focuses on how these entries ensure that revenues and expenses are recognized in the correct accounting period, regardless of when cash is exchanged, aligning financial statements with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). Practical examples illustrate the process of making these adjustments to accurately reflect a business's financial performance and position.
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Chapters
- Adjusting entries are journal entries made at the end of an accounting period to align a business's financial records with the accrual method of accounting.
- The accrual basis of accounting recognizes revenue when earned and expenses when incurred, irrespective of cash flow.
- Financial statements must adhere to GAAP or IFRS, both of which mandate the accrual basis.
- Adjusting entries are necessary when the cash transaction (payment or invoice) and the earning/incurring of the revenue/expense occur in different accounting periods.
Understanding adjusting entries is crucial because they ensure financial statements accurately represent a company's financial health by matching revenues with the expenses incurred to generate them in the correct period.
If a business pays for a year's insurance in advance, adjusting entries are needed to spread that expense over the 12 months it's consumed, rather than expensing it all in the month of payment.
- Prepaid expenses are costs paid in advance for goods or services that will be consumed or used in future accounting periods.
- Initially, the full payment is recorded as an asset (prepaid expense) on the balance sheet.
- At the end of each accounting period, an adjusting entry is made to recognize the portion of the expense that has been incurred (used up) by debiting the expense account and crediting the prepaid expense asset account.
- This process continues until the entire prepaid amount has been expensed over the periods it benefits.
Properly accounting for prepaid expenses ensures that costs are matched to the periods in which the related benefits are received, preventing overstatement of expenses in the initial period and understating them in subsequent periods.
Paying $2,400 for car insurance on December 15th, 2018, for the entire year 2019. Initially, this $2,400 is recorded as a prepaid expense (asset). Each month in 2019, an adjusting entry debits $200 to insurance expense and credits $200 to prepaid expenses.
- Deferred revenue (also called unearned or prepaid revenue) is cash received in advance for goods or services that have not yet been provided.
- Upon receiving payment, the cash is debited, and the amount is credited to a liability account (deferred revenue) on the balance sheet, as the service has not yet been earned.
- As the goods or services are provided, an adjusting entry is made to recognize the earned portion of the revenue by debiting the deferred revenue liability and crediting the revenue account.
- This ensures revenue is recognized only when earned, not when cash is received.
Accounting for deferred revenue correctly prevents overstating revenue and profit in the period cash is received, ensuring that income is only recognized when the obligation to provide goods or services has been fulfilled.
A customer pays $800 in June for a round-trip flight in July and August. The $800 is initially recorded as deferred revenue (liability). In July, $400 is recognized as earned revenue (debiting deferred revenue, crediting revenue), and the remaining $400 is recognized in August.
- Accrued expenses are costs that have been incurred but not yet paid or recorded.
- These expenses relate to goods or services already received or consumed in an accounting period, but the invoice has not yet arrived or payment has not been made.
- An adjusting entry is made at the end of the period to recognize the expense (debiting the expense account) and record it as a liability (crediting accrued expenses).
- When the invoice is eventually received and paid, a subsequent entry will debit the accrued expense liability and accounts payable, and credit cash.
Accruing expenses ensures that all costs incurred during an accounting period are recognized, providing a true picture of profitability by matching expenses to the revenues they helped generate.
An office uses $50 worth of water in November, but the quarterly bill covering November, December, and January won't arrive until January. At the end of November, an adjusting entry debits $50 to utilities expense and credits $50 to accrued expenses.
- Accrued revenue (or unbilled revenue) is revenue that has been earned but not yet billed or received.
- This occurs when a business has provided goods or services in an accounting period but has not yet issued an invoice to the customer.
- An adjusting entry is made to recognize the earned revenue (crediting the revenue account) and record it as an asset (debiting accrued revenue).
- When the invoice is later issued, the accrued revenue asset is reduced (credited), and accounts receivable is increased (debited).
Recognizing accrued revenue ensures that all income earned during a period is reported, even if the invoicing and cash collection happen later, providing an accurate measure of performance.
A web developer completes a website design for $500 in June but doesn't issue the invoice until mid-July. At the end of June, an adjusting entry debits $500 to accrued revenue (asset) and credits $500 to service revenue.
Key takeaways
- Adjusting entries are essential for adhering to the accrual basis of accounting, ensuring revenues and expenses are recognized in the correct period.
- Prepaid expenses are assets that become expenses over time as they are consumed.
- Deferred revenue is a liability that becomes revenue as goods or services are delivered.
- Accrued expenses are liabilities representing costs incurred but not yet paid or recorded.
- Accrued revenue is an asset representing income earned but not yet billed or received.
- The core principle behind adjusting entries is matching: matching expenses to the revenues they help generate and ensuring all revenues and expenses are recorded in the period they occur.
- Without adjusting entries, financial statements would inaccurately reflect a company's financial performance and position, potentially misleading stakeholders.
Key terms
Adjusting EntriesAccrual Basis of AccountingGAAP (Generally Accepted Accounting Principles)IFRS (International Financial Reporting Standards)Prepaid ExpensesDeferred RevenueUnearned RevenueAccrued ExpensesAccrued RevenueBalance SheetIncome StatementAssetLiabilityRevenueExpense
Test your understanding
- Why are adjusting entries necessary under the accrual basis of accounting?
- How does an adjusting entry for a prepaid expense differ from an entry for an accrued expense?
- What is the accounting treatment for deferred revenue, and how does it change as the service is provided?
- Explain the purpose of an adjusting entry for accrued revenue.
- How do adjusting entries ensure that financial statements accurately reflect a business's financial performance and position?