Even when the books appear to be ready and up to date, accountants often need to examine them one more time to determine the need for adjusting entries. This is a vital step in every accounting cycle, as without it, the balances will not be accurate, and thus will not comply with accrual accounting principles—read on to see everything to watch out for regarding the manner.
Adjusting Entries: Why Is It Necessary?
Before the financial statements are published, adjusting entries is a must for the books to be full and compliant with accrual accounting.
The following three examples detail the necessity of adjusting entries:
At the end of the accounting period, not all of a company's financial transactions will be handled by accounting software, like Wafeq, so delays might occur.
For instance, the power bill for December could not be received until January 10. The electric utility checks the meters on January 1 in order to determine how much energy was really utilized in December, which accounts for the 10-day delay. The utility must then compile the bill and send it to the business via mail.
On occasion, a bill is paid in the current accounting period, but the amount is actually a cost for a number of subsequent accounting periods. The cost of insurance for the company's vehicles, for instance, maybe SAR 12,000 and cover the six-month period beginning on January 1 and ending on June 30.
The cost must be postponed if the business must pay the SAR 12,000 in advance at the end of December in order for SAR 2,000 to show up on each of the monthly income statements from January through June.
When a corporation buys equipment to be utilized in the business, something similar to Situation 2 happens. Assume that the machinery is purchased, paid for, and put to use on May 1.
However, 10 years of usage is anticipated for the equipment. The straight-line technique requires SAR 2,000 to be shown on the income statement each month for 120 months if the equipment cost is SAR 240,000, and it will have no salvage value.
These three scenarios demonstrate the necessity of adjusting entries in accounting in order to provide accurate financial statements.
Read more in detail about Accrual Basis Accounting.
How To Adjust Entries In Practice
Some procedures that must be followed while adjusting entries are:
- You must specify the two or more affected accounts.
- A balance sheet account will be one of the accounts.
- The second account will be used for an income statement.
- Before adjusting entries, you must determine the quantities.
- Both the accounts and the adjustment will be entered in the general journal.
- You must specify which accounts will be credited and debited.
Various Types Of Adjusting Entries
Adjusting entries can be arranged into five groups.
1. Accrued Income
A company must disclose all the sales (and associated receivables) it has generated over the course of an accounting period in accordance with the accrual method of accounting.
A company may have received payments from clients for services rendered, but the revenues and receivables are not yet shown in the accounting records. If so, the financial statements must contain an accrual-type adjusting item to reflect the revenues and associated receivables.
The accrual-type adjusted entry will look like this if a company has SAR 10,000 in sales but does not record it as of the end of the accounting period:
Accrued Receivables 10,000
Service Revenues 10,000
2. Accrued Costs
According to the accrual method of accounting, a company's financial statements must include all expenditures (and associated payables) made within an accounting period. For instance, even if a supplier's invoice hasn't arrived yet, a firm must nevertheless record an expenditure that has already been incurred.
Let's use the example of a corporation that employed a worker from a temporary staffing firm on December 27. The business anticipates getting an invoice on January 2 and paying it on January 9.
Given that the charge and the payable happened in December, the business must accumulate the charge and obligation as of December 31 with the adjusted entry listed below:
Temporary Help Expense 400
Accrued Liabilities 400
3. Deferred Income
The accrual method of accounting requires that money received before it is earned be deferred to a liability account until it is.
Assume that on December 10, Wasslak Company will receive SAR 8,000 in payment for services that will be rendered later. The amount of SAR 8,000 that has been earned as of December 31 must be determined by Wasslak before it can release its December financial results.
The only sum that may be included in December's revenues is what has already been earned. On the balance sheet as of December 31, the sum that was unearned must be shown as a liability.
If SAR 6,000 has been earned, SAR 6,000 must be recorded in the Service Revenues account. The last SAR 2,000 that is unearned will be carried over to the next accounting period. A SAR 2,000 credit to a liability account, like Deferred Revenues or Unearned Revenues, will serve as proof of the deferral.
The manner in which the receipt of SAR 8,000 was recorded on December 10 will determine the adjusted entry for this deferral. The December 31 entry will be as follows if the receipt of SAR 8,000 was recorded with a credit to Service Revenues (and a debit to Cash):
Service Revenues 2,000
Deferred Revenues 2,000
The entry on December 31 would be the following if the whole receipt of SAR 8,000 had been credited to Deferred Revenues on December 10 (along with a debit to Cash):
Deferred Revenues 6,000
Service Revenues 6,000
4. Deferred Costs
Any payments for future costs must be put on hold in an asset account until they are used up or expire under the accrual method of accounting.
For the sake of illustration, let's imagine that a new business pays SAR 12,000 on December 27 for the insurance on its cars for the duration of the six-month period starting January 1. The business should have an asset of SAR 12,000 in either prepaid expenses or insurance for the period of December 27 to December 31.
The business must make the following adjusted entry to lower the asset account in each of the months of January through June:
Insurance Expense 2,000 Prepaid Insurance 2,000
5. Depreciation Expense
Fixed assets, also known as plant assets, are utilized in the business and are subject to depreciation. Buildings, machinery, equipment, cars, furniture, and other built assets utilized in a business with a useful life of more than a year are examples of fixed assets. The land is not devalued, though.
The cost of the item is divided into expenses for the accounting periods in which it is used (less any anticipated salvage value). Therefore, office equipment with a five-year useful life and no salvage value will result in a monthly depreciation charge equal to one-sixth of the equipment's cost.
A building with a 25-year useful life and no salvage value will incur monthly depreciation costs equal to 1/300 of the structure's original cost.
As we can see, adjusting entries is an absolutely necessary step in the accounting process. Without it, balances would not represent reality accurately, and financial statements would often appear better, or worse than they actually are.
If you’d like to find out more about entries, and accounts in general, check out one of our related articles now—see you there!
Did you know?
Wafeq uses an accrual accounting method to manage your transactions which is fully compliant with Tax Authorities.