subject: Adjusting Entries [print this page] Keeping track of a company's expenses and revenues for a certain accounting period can be more complex than normal when payments are received in advance of future services, or vice versa. Thus, there is a need for adjusting journal entries to make certain that revenues and expenses are recorded in the proper accounting period. It is necessary that all revenue and expense accounts are accurate so that all of the accounts on the income statement are not overstated or understated. The accuracy of the income statement is basically the reason adjusting entries are needed.
Situations where adjusting entries are needed include prepayments for goods or services that are provided. For example, if an insurance company agrees to provide coverage to a customer for a period of one year and that customer pays $120 for his/her one year of coverage in advance on December 1,2009, an adjusting entry is needed to allocate the revenue earned by the insurance company in the proper accounting period. The company receives all of the payment in advance of the service provided, but it cannot include the entire payment in the 2009 revenue account on the income statement. Initially, the company would perform a simple double entry to increase their cash account, an asset, and to also increase their unearned revenue account, a liability, for the $120 that the customer paid in advance. Then, on December 31, 2009, to account for the coverage provided to the customer for the month of December, the insurance company would perform an adjusting entry that increases their revenue account, part of equity, and decreases their unearned revenue account, in the amount of $10 (price of one month of coverage if one year costs $120). This makes certain that the company allocates the right amount of revenue in the right accounting periods. Another example where an adjusting entry is needed would be providing goods or services in advance of receiving payment for them. In this case, when the company provides the goods or services, a journal entry is recorded that increases their receivables account, an asset, and increases their revenue account, part of equity, for the same amount. Then when the payment is received, the company's cash account is increased and their receivables account is decreased for the amount of the payment. This way, the revenue is recorded when the goods or services were provided and the income statement is in turn accurate, even if the payment was received in a different accounting period.
Those were two examples of adjusting entries dealing with revenue accounts. Adjusting entries are also required for expenses that are prepaid, or for expenses that are incurred, but not yet paid. Prepaid expenses are recorded by creating a journal entry at the time of payment that decreases the cash account, again, an asset, and increases a prepaid expense account, also an asset. Then, as the expense is incurred, an adjusting entry is recorded that decreases that same prepaid expense account and increases their actual expense account, a liability. When an expense is incurred but not yet paid for, a journal entry is recorded where the company's payables account increases and their expense account also increases. The adjusting entry when the expense is actually paid for includes a decrease in the payables account and a decrease in the cash account. The importance of making sure that these expenses are recorded in the accounting period that they are incurred is to keep the expense accounts on the income statement accurate.
Basically, adjusting entries are required for the accuracy of the bottom line of the income statement. Anytime a revenue or expense account is not accurate, the income statement will not be accurate either because the income statement is made up of the company's revenue and expense accounts. The accuracy of the income statement is very important; not only for tax purposes, but also for a company's management to analyze and evaluate the performance of the company to better make decisions that are in the best interest of the company. With the income statement being such an important piece of a company's financial records, taking steps to ensure that all of its components are accurate is vital. Such is the importance of using adjusting entries to make the expense and revenue accounts accurate.
