subject: Adjustments in Accrual Accounting [print this page] Adjusting entries are a crucial part of accrual basis accounting because you must get all of your revenues and expense recorded in the proper accounting period. If a company were to have revenues or expenses unaccounted for at the end of the period, it would affect all of your financial statements dramatically. Because of that, it is important for companies to make sure they have everything recorded in the proper year. Adjustments can be made for a number of reasons.
First, if a company recieves a full payment in advance and only provides a portion of the service, they must record the revenues earned in the proper year. For example, if a company recieves $1000 for two months of consulting work and the accounting year ends in the middle of the two months, the company must recognize one month of consulting revenues earned in the first year. That would require an adjusting entry debiting unearned consulting revenue for $500 and crediting consulting revenue for $500. Keep in mind there has already been an account set up for unearned consulting revenue with a credit balance of $1000 when they cash was recieved. Because the company has not yet earned the other half of their revenue, they cannot record it as a revenue until the service is preformed.
In the same respect, a companys accounting period may end in the middle of the week and therefore they must expense the salaries that their employees earned in the proper period. For example, a company pays 3 workers $100 a day each and the accounting year ends 2 days into the week. They must expense two days of salaries in the correct period. Therefore they would make an entry debiting salaries expense for $600 (3 employees x $100 x 2 days) and credit salaries payable for $600. Although the salaries may not be paid until the next year, the company must reckognize the expense in order to prepare proper financial statements.
Another way a company could need to make an adjustment is if they have paid for something and only recieved a portion of their purchase. The most common example is a company prepaying insurance. At the end of the accounting period they must identify exactly how much of the insurance that they have used and expense it. If a company prepaid a year of insurance for $1200 dollars on October 1, and the year ends December 31, they must account for the insurance they have used and expense it. In order to do so the company would simply debit insurance expense for $300 ($1200/12 months x 3 months) and credit prepaid insurance for $300. For these entries there should already be a prepaid insurance account with a $1200 debit balance. You must record it in the proper year in order to reduce your prepaid to the proper amount and expense the insurance already used.
The last basic way a company would need to make adjustments is if they own equiptment, buildings, or land that is depreciating in value. If your assets only have a certain useful life, the company must expense the depreciation at the end of each accounting period. a common example of this is when a company buys a piece of equiptment for $24000 with a useful life of 2 years it would depreciate $1000 dollars a month ($24000/24 months). At the end of each accounting period the company must expense the depreciation. If the company purchased the equiptment on June 1, and the accounting period ended December 31, they would have to expense $6000. In order to do that they would make an entry debiting depreciation expense for $6000 and crediting accumulated depreciation. The same method applies with buildings, land, and any other asset with a depreciating value.
Although each adjusting entry is different the reasoning behind each is the same. Without these adjustments companies would have financial statements that are not stated correctly. Although this is just the surface level of adjustment entries in accounting, the concept remains the same into higher level accounting and in the real world.
