What Are Adjusting Journal Entries? Experts Guide

There are accounting principles that must be upheld in order to comply with regulations. Luckily, financial automation solutions make this feat easy to accomplish as the software systems are able to handle massive amounts of data in a timely manner, all while minimising errors. When it comes to adjusting journal entries it requires utmost attention to detail. So, here we will answer, “What are adjusting journal entries?” and share how automation solutions can make these simpler to manage.

Coming Up

1. What are Adjusting Journal Entries?

2. What is the Purpose of Adjusting Journal Entries?

3. What are the 3 Types of Adjusting Journal Entries?

4. Why are Adjusting Journal Entries Important?

5. What are Examples of Adjusting Journal Entries?

6. How Do Adjusting Journal Entries Fit with the Financial Close Process?

7. What is Adjusting Journal Entries and Accrual Accounting?

8. What Accounts Require Adjusting Journal Entries?

9. The Bottom Line

What are Adjusting Journal Entries?

Adjusting journal entries is a journal entry that is typically made at the end of the accounting period to recognise an income or expense during that period when it was incurred.

Adjusting journal entries exist because of accrual accounting, which is based on the revenue recognition principle. This means that journal entries need to be made in the period in which the revenue was earned, not in the period that cash was received.

Adjusting journal entries are very important because they impact financial statements. Revenue and expense accounts are affected on the income statement, and the balance sheet is adjusted based on whether the entry is an asset or liability.

These adjustments make their way to the general ledger. As such, every entry matters because it can and will likely affect business decisions, so it’s of importance to make adjusting journal entries in a timely manner and accurately.

What is the Purpose of Adjusting Journal Entries?

Adjust entries exist so that business activities are recorded when they actually take place. For example, without an adjusting journal entry, your business’ books will show that you pay for an expense before you reap the value of the expense (or in other words, actually incur the expense). Or, you may show that you have revenue before you have the money to use.

Without adjusting journal entries, your business’ income and expenses will be mismatched, so you run the risk of tracking revenue incorrectly. Of course, this can heavily affect business decisions, as well as how you pay your taxes. So, it’s no wonder why you’d want your journal entries, and in turn, your financial statements to be correct.

That’s why most companies are turning to financial automation solutions to help track their finances and input journal entries. With automation solutions, you can free up your team’s time to focus on high-level tasks like strategic planning and analysis that will increase value for your business.

At the same time, the automation solution will accurately and quickly take care of all the work that would otherwise take a lot of manual time and run the risk of human error.

What are the 3 Types of Adjusting Journal Entries?

To better understand adjusting journal entries, we can categorise the three main types.

Let’s take a look at what these include:

1. Accruals

Accruals refer to revenue and expenses that haven’t yet been made (received or paid). For example, think about rent. You occupy your office space for the entire month before you have to pay rent for it at the end of the month. Therefore, you are accruing an expense.

2. Deferrals

Deferrals are revenues and expenses that are made in advance, so they haven’t yet been used (or recorded). For example, you may have unearned revenue, which is an account for money received on goods that have not yet been delivered. This happens a lot in retail situations, as customers  may pay in advance for a piece of furniture, but delivery is still 4-6 weeks out.

3. Estimates

Estimates exist as adjusting entries for non-cash items, such as depreciation. These are items that don’t have exact values. When it comes to depreciation, accountants need to estimate a depreciation schedule based on the expected life of the product, as well as its residual value (what it will be worth after use). Depreciation expenses are typically recorded at the end of the month.

Why are Adjusting Journal Entries Important?

Adjusting journal entries are vital in making sure that business transactions are being recorded properly in time.

They help to keep track of receivables and payables, as well as to ensure that you have the right profit and loss amount at the end of the fiscal year.

Without adjusting journal entries, the financial health of your business will be skewed and distorted, which could lead you to believe that you have more or less revenue or expenses than you actually have.

What are Examples of Adjusting Journal Entries?

To better understand and answer, “What are adjusting journal entries?” it helps to look at some common examples.

• A company ships goods based on credit, but the sales invoice wasn’t processed at the end of the accounting period.
  

• A company provides service to a customer that will be paid next month, so it will exist in the accrued revenue account. Once it’s paid, it will become an adjusting entry that will be credited as revenue.
  

• A company pays rent on a quarterly basis for $15,000. So, the rent expense is divided into 3, for $5,000 each month to be recorded as a rent expense (debit) and prepaid rent (credit). When the prepaid rent is paid, it is converted as an adjusting entry into an expense.
  

• A company purchases a piece of equipment for $20,000 that has a depreciation schedule of 10 years (for $2,000 a year). Depreciation is recorded as a depreciation expense for $2,000 in the debit column, and accumulated depreciation as a credit. At the end of the month, the adjusting journal entry is made for $2,000.

How Do Adjusting Journal Entries Fit with the Financial Close Process?

Adjusting journal entries is a main component of the financial close process. At the end of each accounting period, it is up to your financial team to identify all prepaid and accrued expenses, as well as unearned and accrued revenue so they can make the necessary adjusting journal entries.

There’s no doubt that this is a time-consuming and tedious process. And, if one item is missed, it can throw off your financial statements entirely. We have also yet to mention that adjusting journal entries may be made to rectify mistakes that have been made during the account reconciliation process.

Accountants then need to make the adjusting journal entry, and make note of their reasoning for doing so with supporting documentation. In the event of an audit, this documentation will be necessary to explain the updates made.

With a financial automation solution, you can reduce the chance of having to make adjusting journal entries to correct mistakes because the system collects, transforms, and inputs data accurately every time.

Plus, the software can execute account reconciliation so that your team no longer has to spend days or weeks pulling together all the data and statements required to do so. In turn, your financial close process is streamlined, accurate, and entirely documented with easy to run audit trails, should you have any need.

What is Adjusting Journal Entries and Accrual Accounting?

Accrual accounting makes it so revenues and costs are reported in the same accounting period to uphold the matching principle. It also makes it so revenues and expenses are recorded in the actual period that they are incurred.

But, when it comes to real life, revenues could be earned in one period, and costs show up as expenses in another. Therefore, the timing throws off the matching. The difference between cash flow and transaction timing is the reason for adjusting entries. Adjusting journal entries make it possible to record revenue and expense or cash payments when they take place.

You can probably already see how this can become complicated, especially as the amount of transactions increases within your business. That’s why a financial automation solution is so handy because it will properly track and upkeep your journal entries and remove the chance of anything slipping through the cracks.

What Accounts Require Adjusting Journal Entries?

Adjusting journal entries will end up affecting five accounts.

These include:

• Accrued Revenues: For a service that is performed at one time, but billed in another period, the adjusting journal entry is made to reflect the revenue in the month that the service was performed.
  

• Accrued Expenses: A common example of an accrued expense is wages that are paid to employees. The employee performs their work throughout the month (accruing the expense) which gets processed at the end of the month and then paid out in the next month’s accounting period. As such, the adjusting journal entry will debit the wages expense and credit wages payable.

• Unearned Revenue: When a payment is made for goods or services that will be delivered in the future, it is recorded as unearned revenue. The cost of the item is unearned revenue and when the goods arrives, the company will make an adjusting entry for the month the order was made to debit unearned revenue and credit the revenue account.
  

• Prepaid Expenses: If assets are paid for and used up gradually (i.e. office supplies), then they are a prepaid expense.. When the supplies are bought and used, the adjusting entry debits office supply expenses and credits repaid office supplies.
  

• Depreciation: Depreciation is associating a cost of an asset over its lifespan. So, companies have to determine the accumulated depreciation and spread it out of the life of the asset.

The Bottom Line

Let’s take it back from the top when we began with the question of: “What is an adjusting journal entry?” The definition of an adjusting journal entry probably wasn’t new to you, nor is the practice of knowing how adjusting journal entries are prepared.

The good news that despite the complications that adjusting journal entries and accrual accounting can create, financial automation solutions are here to remove the burden from your finance team’s shoulders.

Financial automation solutions take care of collecting, transforming, and storing data, as well as executing account reconciliation processes and preparing financial statements for your company’s financial close procedure.