Adjusting entries are usually required at the end of every accounting period for the financial statements to reflect the accrual basis of accounting. The adjusting entries makes certain that revenues are reported on the income statement when they are earned, and expenses are reported on the income statement when they best match the revenues or expire. (When the money is received or paid is not relevant for reporting revenues and expenses.) Adjusting entries are often grouped into three categories: accruals, deferrals, and other.
An accrual adjusting entry can involve revenues or expenses. A service company that has earned fees, but has not yet recorded the transaction, will accrue revenue. This is done with a debit to the asset Accounts Receivable and a credit to Service Revenues. An adjusting entry to accrue expense is needed when a company has received a service or goods from a vendor, but the expense and the liability is not yet recorded. Gas, electricity, water, telephone, wages, interest, and repairs are examples of expenses that will likely require an accrual adjusting entry. The accrual adjusting entry for these items normally include a debit to an expense and a credit to a liability account.
A deferral adjusting entry for revenues is necessary when a company has received money from a customer before it has been earned. The money received will be recorded in the Cash account at the time it is received, but the amount that has not yet been earned must be reported as a liability such as Unearned Fees, Unearned Revenues, or Customer Deposits. As the unearned amount is earned, an adjusting entry will debit the liability account and will credit a revenue account such as Service Revenues.
A deferral adjusting entry for expenses is necessary if a payment overlaps accounting periods. For example, if a company prepays a six-month insurance premium and the company issues monthly financial statements, then a deferral adjusting entry will be necessary. The purpose of a deferral adjusting entry for this situation is (1) to report Insurance Expense for the insurance cost that has expired during the accounting period, and (2) to report the amount of insurance cost that has not yet expired on the balance sheet as the asset Prepaid Insurance, or Prepaid Expenses.
Examples of other adjusting entries include depreciation and the allowance for doubtful accounts. The adjusting entry for depreciation involve a debit to Depreciation Expense and a credit to Accumulated Depreciation. The adjusting entry for doubtful accounts usually means a debit to Bad Debts Expense and a credit to Allowance for Doubtful Accounts.
A common characteristic of adjusting entries is they involve one balance sheet account and one income statement account.
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Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. He is the sole author of all the materials on AccountingCoach.com. Read more about the author.