3.3 Recording Adjusting Entries
What are Adjusting Entries?
Adjusting journal entries (AJE) are recorded on certain accounts in the unadjusted trial balance at the end of the accounting period but prior to preparation of the financial statements to:
- Recognize revenue in the period earned (the revenue principle),
- Recognize expenses in the period incurred (the matching principle), and
- Bring related asset and liability accounts to proper balances.
Note: the trial balance we covered previously is the unadjusted trial balance.
Cash is never affected by an adjusting journal entry. This is because an adjusting entry is being made at the financial closing period rather than when cash is exchanged.
Types of Adjustments
There are 3 main types of adjusting entries:
1. Deferrals (cash has already been exchanged):
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- When a company receives (pays) cash in advance of providing (receiving) the related good/service that has been paid for.
- This adjusting journal entry results in the recognition of a portion of deferred revenue (expense) earned (incurred) in the period.
2. Accruals (cash has not yet been exchanged):
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- When a company delivers (receives) a good/service in advance of it being billed and paid for.
- This adjusting journal entry results in the accrual of the related revenue (expense) in the period in which the good/service is actually provided (received).
3. Depreciation (amount expensed to account for usage of a capital asset)
1. Deferral Adjusting Journal Entries
Deferrals occur when a business has paid or received cash in advance of revenue/ expense recognition.
There are two types of deferred adjusting entries:
A. Deferred (Prepaid) Expenses: A deferred expense is a transaction where cash is exchanged prior to expense recognition. Since cash is paid before the expense has “incurred” an asset is recognized.
These are generally expenses that a company pays for in advance of actually using the benefit (often known as prepaid expenses). At the time of the transaction, because this will provide future benefit to the company, it is recorded as an asset, thereby “deferring” the expense until the benefit is realized.
The portion of the total benefit used by the end of a financial year is recorded as an expense at the end of the period. The adjusting journal entry ensures that assets and expenses are appropriately reflected in the financial statements.
An example of a deferred expense:
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- Prepaid rent: when the organization pays the annual rent in advance at the beginning of the year, it is recorded as an asset and expensed as the year goes by.
B. Deferred (Unearned) Revenues: A deferred/unearned revenue is a transaction where cash is exchanged prior to revenue recognition. Since cash is received before the revenue is “earned” a liability is recognized.
Many businesses collect cash from customers before “earning” the revenues through services rendered or goods delivered. Since the revenue has not yet been earned, this is a liability that must be recognized, often called “unearned revenues.”
The portion of the total revenues earned in terms of services rendered or goods delivered is then recorded as revenue at the end of the period with this adjusting entry. This adjusting entry ensures that liabilities and revenues are appropriately reflected in the financial statements.
Note that one company’s unearned revenue is another company’s prepaid expense (i.e., the deferral of revenue by one company will result in the deferral of an expense by another company).
An example of deferred (unearned) revenue:
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- A business prepays office rent for the next three months to the landlord (another company), resulting in a prepaid expense. The landlord recognizes this amount as unearned revenue.
2. Accrual Adjusting Journal Entries
Accruals occur when a business has incurred an expense or earned revenue but not exchanged cash.
There are two types of accrual adjusting entries:
A. Accrued Expenses: An accrued expense is a transaction where cash is exchanged after the expense is recognized. Since the expense has been “incurred” a liability must be recognized.
Businesses often incur expenses before receiving the bills. For example, utility bills are received after electricity is consumed. Unbilled/unpaid expenses are called accrued expenses.
At the end of each accounting period, an adjusting journal entry is required to record accrued expenses. This AJE ensures that related expenses and liabilities are properly reflected in the financial statements.
An example of an accrued expense:
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- Accrued salaries: many companies have fixed dates on which salaries are paid, such as biweekly, twice a month, etc. If the payment day falls on a weekend, then the salary might be paid the following Monday. As a result, the company must record an accrued expense for unpaid salaries expense.
B. Accrued Revenues: accrued revenues are transactions where cash is exchanged after revenue is recognized. Since the revenue is “earned,” an asset for the amount receivable is recognized.
Businesses often earn revenue before they bill their customer for the services/goods. These unbilled/uncollected revenues are called accrued revenues.
At the end of each accounting period, an adjusting journal entry is required to record accrued revenues. This adjusting journal entry ensures that related revenues and assets are properly reflected in the financial statements.
An example of accrued revenues:
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- Accrued revenues: an audit firm conducts its work and audits clients prior to invoicing the client. Once the work is completed, revenue has accrued when unbilled/uncollected from clients.
3. Depreciation of Property, Plant, and Equipment (PP&E)
Property, plant, and equipment (PP&E) (e.g., buildings, machinery, and furniture) are long-term tangible assets that provide benefits to a company over their useful life (i.e., they are long-term deferred expenses).
These assets are used up during each accounting period to generate revenue. The part of the PP&E’s historical (original) cost consumed during the accounting period to generate revenue should be expensed in that period (matching principle).
This is called depreciation: allocation of PP&E’s historical cost to expense over its estimated useful life. We will cover the methods to calculate the depreciation in greater detail in a later unit.
PP&E assets are reported at their carrying amount or net book value on the balance sheet. This is computed as the historical cost of the PP&E less the “accumulated depreciation.”
An accumulated depreciation account is a contra asset account.
A contra account has 2 characteristics:
1. It has a companion asset account.
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- For example, computer equipment would be the companion account for accumulated depreciation: computer equipment
2. Its normal balance is opposite that of the companion account.
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- For example, computer equipment is an asset account with a debit normal balance and accumulated depreciation: computer equipment is a contra asset account with a credit normal balance.
An accumulated depreciation account accumulates all the depreciation recorded on the asset, and thus, its balance increases over the life of its companion asset account.
Depreciation (expense) is the amount of depreciation recorded for the current period.
Summary of the Adjustment Process
- Both deferred and accrued revenue increase the revenue account at the end of the period.
- Both deferred and accrued expense increase the expense account at the end of the period.
- Every adjusting journal entry affects one account on the balance sheet (asset or liability) and one account on the income statement (revenue or expense).
- Adjusting journal entries (AJE) never adjust cash (i.e., AJE has NO cash effect).
- In the case of deferred revenue/expense, cash is already recorded during the period.
- In the case of accrued revenue/expense, cash will be recorded in the next period.
(Harrison et al., 2018, p. 123–124)
The Adjusted Trial Balance
At the end of the period, after all the AJEs are journalized and posted, the adjusted trial balance is prepared. The adjusted trial balance helps the preparation of the financial statements.
(Harrison et al., 2018, p. 126)