Adjusting entries are often categorized into three types:
Accruals or accrual adjusting entries are prepared at the end of an accounting period to report amounts that have occurred in the current accounting period but were not yet entered into the general ledger accounts. An example is a retail store's emergency plumbing repair on December 31, the last day of its accounting period. The repair occurred in the December accounting period but the bill will not be received until the January accounting period. As of December 31, the retailer needs an accrual adjusting entry so that its December financial statements will report the expense and the liability. Also on December 31, the plumbing company will need an accrual adjusting entry so that its financial statements will report the revenues and the receivables that were earned in December.
Deferrals or deferral adjusting entries are prepared at the end of an accounting period to defer expenses and/or revenues that have already been recorded in the general ledger accounts. The reason is that some of the recorded amounts will actually be used up and/or earned in a future accounting period. An example is a retailer's payment of $1,200 for six months of property insurance that was paid in advance. For instance, if the payment was made on December 1 for protection during the upcoming period of December 1 through May 31, the retailer's December's income statement should report Insurance Expense of $200 (the expired 1/6 of the $1,200) and the December 31 balance sheet should report Prepaid Insurance of $1,000 (a current asset that represents the unexpired 5/6 of $1,200). The amount used in the deferral adjusting entry should be whatever is necessary to get the proper amounts to appear on the financial statements. The insurance company must also make a deferral adjusting entry so that its December revenues will include only the $200 that was earned. Its December 31 balance sheet should show the unearned $1,000 as the current liability Deferred Premiums.
Other adjusting entries will likely include:
- Depreciation of assets used in a business. This is done with a debit to Depreciation Expense and a credit to Accumulated Depreciation.
- Reporting bad debts expense pertaining to accounts receivable. This is done by either debiting Bad Debts Expense and crediting Allowance for Doubtful Accounts, or by writing off an account with a debit to Bad Debts Expense and crediting Accounts Receivable.
The adjusting entries are required in order to have a company's financial statements comply with the accrual method of accounting. A common characteristic of all adjusting entries is they involve a balance sheet account and an income statement account.