Today, let me share my takeaways from the latest session of the Corporate Financial Accounting course with you. The topic is “Adjusting Entries”
WHAT ARE ADJUSTING ENTRIES?
Adjusting entries are changes to journal entries already recorded. The entries usually occur at the end of an accounting period. This oftentimes alters the ending balances in the various ledger accounts.
These entries also refer to financial reporting that corrects mistakes made previously in the accounting period.
WHY MAKE ADJUSTING ENTRIES?
We use adjusting entries to properly account for the transactions that occur in a particular accounting period.
When you start a transaction in one accounting period and end in a later period, you require an adjusting journal entry to properly account for the transaction.
In other words, time is the key driver of adjusting entries.
We need to understand some basic timing concepts in accounting before I go into some examples.
1. Accrual-basis accounting: Under the accrual basis, companies record transactions in the periods in which the events occur. This is against the cash basis that records transactions only when you receive cash is or paid out
2. Accounting time period: These are generally a month, a quarter, or a year. An accounting time that is one year in length is a fiscal year.
3. Revenue recognition principle: This principle requires that companies recognize revenue in the accounting period in which it is earned. You earn revenue when you performed the service.
4. Expense recognition principle: This is usually tied to the revenue recognition principle. It is often referred to as the matching principle. It dictates that efforts (expenses) be matched with results (revenues).
Adjusting entries ensure that we follow the revenue recognition and expense recognition principles.
The company will analyse each account in the trial balance to determine whether it is complete and up to date for financial statement purposes.
Example of an adjusting entry
Here let us look at an example of an adjusting entry:
In March 2022, you charged your customer a fee of N50,000 for a service rendered to him. However, the customer did not pay you immediately. He paid in April 2022.
We can see from the above example that, the transaction occurred in one accounting period (March) and received payment in another accounting period (April).
In March, we are to record the above transaction in the accounts receivable as income we are expecting to receive. The corresponding entry will go to the Revenue account as shown below:
Then, in April when we receive the cash, we will record the money as cash and adjusted the account receivable.
I will like you to note that, in making an adjusting entry, you do not literally go back and change a journal entry. Instead, you make a new entry amending the old one.
Let us say the customer in the above example asked for a discount before making the payment in April. You obliged and you gave a discount of 5%.
We will need to pass an adjusting entry at the end of April to show the current figure after the discount.
Note that, after these adjustments, the Account receivable balance will be zero at the end of April 2022.
In summary, adjusting journal entries are necessary to avoid overstating or understating your net income at the end of a given accounting period.
Thanks for reading.