Adjusting Entries in Journal

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What are Adjusting Entries in Journal?

Adjusting Entries in Journal is the journal entry done by the company at the end of any accounting period based on the accrual concept of accounting, as companies are required to adjust the balances of their different ledger accounts at the accounting period end to meet the requirement of the standards set by the various authorities.

Adjusting entries (also known as accounting adjustments) are journal entries generally made at the end of a particular accounting period/reporting period to record the transactions in that accounting period but have not been recognized or recorded.

These Accounting Adjustments are made to correctly allocate the income and expenses of a Company in the same period in which the transactions related to income and expenses took place.
Adjusting entries are mostly made just before the release of the Company's financials. The Company's reported financials comply with the relevant framework of international accounting standards such as IFRS and GAAP.
These entries are made at the end of an accounting period so that the company's reported numbers are in line with the concept of the revenue recognition principle and the matching principle of accrual-based accounting.

What are Adjusting Entries in Journal?

Example

Taking an adjusting entries example of a company named ABC Corporation, which availed of long-term debt funding to implement its expansion plan. The financial reporting period for the Company is January 2018 to December 2018 (January to December cycle).

The debt funding terms by lenders to the company are such that it has to make the interest payments for debt on the 15^th of every month. The company’s interest payment on the debt from 15^th December 2018 to 15^th January 2019 will be due on 15^th January 2019. Therefore Company's records will not have any entries for payment of interest to the bank for interest expense of 15 days of December.
However, the company’s reported numbers at the end of December 2018 must contain the interest of 15 days for December 2018 to correctly represent the expenses incurred by the Company for the accounting period of January 2018 to December 2018. Therefore, the Company needs to adjust journal entries as below to include the 15 days’ interest expense in the reported number for the accounting period of January 2018-December 2018.
Adjusting journal entries will involve adjustments in the interest expense account in the income statement and the interest payable account in a balance sheet. The interest expense account in the income statement will have a debit entry for 15 days' interest expense (of December month). The interest payable account in the balance sheet will have a credit entry for the same amount.

Classification of Accounting Adjustments

Most of the adjusting journal entries made for accounting adjustments can be broadly classified under two major heads, i.e., deferral and accruals. Deferrals include those transactions wherein a company pays or receives cash before consumption (either by a company or its clients). The accounting adjustments for prepaid expenses and unearned revenues come under deferrals. Accruals include those transactions wherein a company pays or receives cash after the consumption (either by a company or its clients). The adjusting journal entries for accrued expenses and accrued revenues come under accruals.

#1 - Accrued Revenue

Accrued revenue is a transaction wherein a company renders its goods and services to customers but receives the payment with a certain time delay. Suppose a company makes a sale for USD 100 million in an accounting period but receives only 80% of the payment for the sales made in the same accounting year. In this scenario, the accounting adjustments are made as a credit in the revenue account by USD 100 million and a debit entry of USD 20 million (100*20%) to accounts receivable in a balance sheet.

#2 - Unearned Revenue

When a Company receives the payment in advance for its goods or services to be rendered in the future, such amount the company refers to unearned revenue. Construction companies are a classic example of such transactions wherein they generally receive an advance from the client to start the work. They receive advance payments even before they start the construction work. Suppose the company received the advance payment for the work in December 2018 and is planning to start the work in January 2019. The Company will adjust journal entries in December 2019 to credit the revenue account and debit the unearned revenue account.

#3 - Accrued Expenses

Accrued expenses are incurred and recorded by a company in an accounting period; expenses are not paid. These unpaid expenses are recorded in the payables account on the Company's balance sheet. The most common example of payables is wage payables to employees, interest expense payable to banks, or payables to suppliers of raw materials. The adjusting journal entries for payables are made by way of a debit entry in the respective expense account in the income statement and by credit entry in the payables account in the company's balance sheet.

#4 - Prepaid Expenses

Prepaid Expenses are classified as assets on a balance sheet. It arises when a company pays for consumables/services in advance, but it uses these consumables /services over time. One common example of prepaid expense is the subscription fee paid by a company to a research company to avail of its services (research reports, industry research, outlook on various industries). In such transactions, the company pays the subscription fee upfront. However, a company will use the services of the research company over the accounting period. Once used/consumed, the prepaid expenses become an expense and are recorded in the income statement. The unused portion of such prepaid expenses will remain in the prepaid expense account.

Conclusion

The basic premise before adjusting journal entries in the income statement and balance sheet is to make the reported financial statements in line with the concept of accrual-based accounting, i.e., conformance of the revenue recognition principle and matching principle in the reported financials. The accounting adjustments help incorrectly allocate the income, expenses, assets, and liabilities, thus resulting in correct reported financials.