Adjusting Entries - Adjusting entries are journal entries recorded at the end of an accounting period to alter the ending

balances in various general ledger accounts. These adjustments are made to more closely align the reported results and
financial position of a business with the requirements of an accounting framework, such as GAAP or IFRS. This generally
involves the matching of revenues to expenses under the matching principle, and so impacts reported revenue and
expense levels.

The use of adjusting journal entries is a key part of the period closing processing, as noted in the accounting cycle, where you
convert a preliminary trial balance into a final trial balance. It is usually not possible to create financial statements that are fully in
compliance with accounting standards without the use of adjusting entries.

An adjusting entry can used for any type of accounting transaction; here are some of the more common ones:

To record depreciation and amortization for the period

To record an allowance for doubtful accounts
To record a reserve for obsolete inventory
To record a reserve for sales returns
To record the impairment of an asset
To record an asset retirement obligation
To record a warranty reserve
To record any accrued revenue
To record previously billed but unearned revenue as a liability
To record any accrued expenses
To record any previously paid but unused expenditures as prepaid expenses
To adjust cash balances for any reconciling items noted in the bank reconciliation

As shown in the preceding list, adjusting entries are most commonly of three types, which are:

Accruals. To record a revenue or expense that has not yet been recorded through a standard accounting transaction.
Deferrals. To defer a revenue or expense that has been recorded, but which has not yet been earned or used.
Estimates. To estimate the amount of a reserve, such as the allowance for doubtful accounts or the inventory
obsolescence reserve.

When you record an accrual, deferral, or estimate journal entry, it usually impacts an asset or liability account. For example, if
you accrue an expense, this also increases a liability account. Or, if you defer revenue recognition to a later period, this also
increases a liability account. Thus, adjusting entries impact the balance sheet, not just the income statement.

Since adjusting entries so frequently involve accruals and deferrals, it is customary to set up these entries as reversing entries.
This means that the computer system automatically creates an exactly opposite journal entry at the beginning of the next
accounting period. By doing so, the effect of an adjusting entry is eliminated when viewed over two accounting periods.

A company usually has a standard set of potential adjusting entries, for which it should evaluate the need at the end of every
accounting period. You should have a list of these entries in the standard closing checklist. Also, consider constructing a journal
entry template for each adjusting entry in the accounting software, so there is no need to reconstruct them every month.

Adjusting Entry Examples

Depreciation: Arnold Corporation records the $12,000 of depreciation associated with its fixed assets during the month. The
entry is:

Debit Credit

Depreciation expense 12,000

Accumulated depreciation 12,000

Allowance for bad debts: Arnold Corporation adds $5,000 to its allowance for doubtful accounts. The entry is:
 Debit Credit

Bad debts expense 5,000

Allowance for doubtful accounts 5,000

Accrued revenue: Arnold Corporation accrues $50,000 of earned but unbilled revenue. The entry is:

Debit Credit

Accounts receivable - accrued 50,000

Sales 50,000

Billed but unearned revenue: Arnold Corporation bills a customer for $10,000, but has not yet earned the revenue, so it creates
an adjusting entry to record the billed amount as a liability. The entry is:

Debit Credit

Sales 10,000

Unearned sales (liability) 10,000

Accrued expenses: A supplier is late in sending Arnold Corporation a materials-related invoice for $22,000, so the company
accrues the expense. The entry is:

Debit Credit

Cost of goods sold (expense) 22,000

Accrued expenses (liability) 22,000

Prepaid assets: Arnold Corporation pays $30,000 toward the next month's rent. The company records this as a prepaid
expense. The entry is:

Debit Credit

Prepaid expenses (asset) 30,000

Rent expense 30,000

Adjusting Entries

To make sure that the expenses of an accounting period are matched with the revenues, entries are made at the end of an accounting
period to adjust the account balances accordingly. There are two types of adjusting entries:

1. The amount of an asset that is used up during the accounting period is transferred to a corresponding expense account.

2. The amount of a liability that has been earned during the accounting period is transferred to the corresponding revenue account.

The accounts that are affected by adjusting entries are called mixed accounts. That means that these accounts have both a balance
sheet portion and an income statement portion. To report net income accurately, the income statement portion must be removed by an
adjusting entry.
Example: Transfer an Asset to an Expense

Previously we learned that on February 1 Phils Photography purchased a one-year insurance policy for $1200. The journal entry on
Feb. 1 was:

DR Prepaid-Insurance $1200
CR Cash $1200

At the end of February, one months insurance has been used. The monthly portion of insurance is $100, therefore $100 must be
removed from the asset account Pre-paid Insurance and transferred to the expense account Insurance Expense. This adjusting entry
will match the expenses incurred in February with the revenues received in February.

Adjusting entry:
DR Insurance Expense $100
CR Pre-Paid Insurance $100
To record insurance expense for February.

The balance in the Pre-paid Insurance account is now $1100 and each month another $100 will be removed until it is time to purchase
next years policy.

Example: Transfer a Liability to a Revenue

When on July 1 Pauls Computing entered into a 6-month network service contract for $2400 and received an $800 advance payment
the following journal entry was made:

DR Cash $800
CR Unearned Revenue $800

At the end of July 1 month of revenue from that contract was earned. Each month Pauls Computing earns $400 from the contract,
therefore $400 must be removed from the liability account of Unearned Revenue and transferred to earned Revenue account.

Adjusting entry:
DR Unearned Revenue $400
CR Revenue $400

The balance in the Unearned Revenue account is now $400. At the end of August, the remaining $400 will be transferred and future
payments for the contracted service can be recorded directly into the Revenue account.

The adjusting entries require additional steps in the Accounting Process:

Analyze the account balances and prepare adjusting entries

Post the Adjusting entries to the Ledger accounts
Prepare an Adjusted Trial Balance to prove that the Debits and Credits still match