Let's revisit the accounting cycle. Notice that step five relates to adjusting journal entries.
So question. Why adjust account balances? Why do they need adjustment?
Adjusting entries are necessary because the unadjusted trial balance may not contain up to date and complete data as you've learned when you studied the unadjusted trial balance.
Adjusting entries update asset and libiliity accounts as well as revenue and expense accounts. Without this adjustment our financial statements could mislead investors and creditors. Finally, adjusting entries help ensure that the revenue recognition and matching principles are followed. Failure to record adjusting entries results in overstatement and understatements.
When we make adjusting entries there are two main types of sub-categories.
One is deferrals and the other is accruals.
One type of deferral is prepaid expenses. This means that cash is paid before the expense is incurred. Some common examples of adjusting entries for prepaid expenses are prepaid rent, supplies and depreciation.
Another type of deferral is unearned revenue. This means a cash is received before revenue is earned. Some common examples of adjusting entries for unearned revenues are unearned rent revenue, season ticket revenue, and airline ticket revenue.
An example of an accrual is accrued revenues. This means that cash is received after revenue is earned. Some common examples of adjusting entries for accrued revenues are service revenue and interest revenue.
Another type of accrual is accrued expenses. This means that cash is paid after the expense is incurred. Companies tend to have a lot of accrued expenses as this is the most common type of adjusting entry. Some common examples of adjusting entries for accrued expenses or salary expense and interest expense.
Finally, let's look at some characteristics of an adjusting entry and how they differ from a regular journal entry made in the ordinary course of business.
The first is that there is no underlying business event that causes an adjusting entry to happen. They happen most often because of the passage of time or that information isn't available in the period we need it.
They are recorded at the end of the accounting period. So adjusting journal entries will be dated at the end of the month.
They will always include one income statement account and one balance sheet account. Again this requires some critical thinking but you can usually figure out the accounts affected by an adjusting entry by remembering this.
They should never ever include the cash account .At some point you are going to be really tempted to use the cash account when doing an adjusting entry. Please don't, it is certainly wrong. Now I will say that there is an exception to this and that is when we're doing adjusting entries from the bank reconciliation.
They are required every time a company prepares financial statements.