• Explain the need for adjusting journal entries
• Describe the adjustment process

 

What Is an Adjusting Entry?

Adjusting entries reflect economic activity that has taken place but has not yet been recorded because it is either more convenient to wait until the end of the period to record the activity or because no source document concerning that activity has yet come to the accountant’s attention. Periodic reporting and the matching principle may also periodically require adjusting entries. Remember, the matching principle indicates that expenses have to be matched with revenues as long as it is reasonable to do so. To follow this principle, adjusting journal entries are made at the end of an accounting period or any time financial statements are prepared so that we have matching revenues and expenses.

Adjusting entries are made during the accounting cycle after the unadjusted trial balance and before the company prepares its financial statements, bringing the amounts in the general ledger accounts to their proper balances.

Each adjusting entry has a dual purpose:

1. to make the income statement report the appropriate revenue or expense
2. to make the balance sheet report the appropriate asset or liability

Thus, every adjusting entry affects at least one income statement account and one balance sheet account.

Adjusting entries fall into two broad classes: accrued (meaning to grow or accumulate) items and deferred (meaning to postpone or delay) items. The entries can be further divided into accrued revenue, accrued expenses, unearned revenue, and prepaid expenses, a division we will examine further in the next lessons.

The adjusting entries for a given accounting period are entered in the general journal and posted to the appropriate ledger accounts (note: these are the same ledger accounts used to post your other journal entries).

Three Adjusting Entry Rules

1. Adjusting entries will almost never include cash. The purpose of adjusting entries is to make the accounting records accurately reflect the matching principle—match revenue and expense of the operating period. There are some rare cases where cash needs to be adjusted, but ideally, that adjusting should have all been done prior to running the unadjusted trial balance.
2. Debits always equal credits (as usual).
3. The adjusting entry will have one balance sheet account (asset, liability, or equity) and one income statement account (revenue or expense) in the journal entry. Remember, the goal of the adjusting entry is to match the revenue and expense of the accounting period. Adjusting entries between balance sheet accounts only, or between income statement accounts only, are usually called reclassifications.

Steps of the Adjusting Process

We can break down steps five and six of the accounting cycle into a bit more detail.

1. Print out the unadjusted trial balance.
2. Analyze each account.
3. Look for anything that is missing.
4. Make adjusting journal entries.
5. Post the adjusting journal entries.

This is a systematic way to prepare and post adjusting journal entries that accountants have been using for about 500 years.

Let’s dig into each step.

Step 1: Print Out the Unadjusted Trial Balance

The unadjusted trial balance comes right out of your bookkeeping system. Debits will equal credits (unless something is terribly wrong with your system). However, you have no idea if everything is recorded correctly. This is actually where our accountant brains really get to work.

Step 2: Analyze Each Account

Start at the top with the checking account balance or whatever is the first account on the trial balance. If it’s petty cash, then you should have a petty cash count at the end of the period that matches what is shown on the trial balance (which is the ledger balance). If they match, fine. If they don’t, you have to do some research and find out which one is right, and then make a correction.

Step 3: Look for Anything That Is Missing

As you move down the unadjusted trial balance, look for documentation to back up each line item. For instance, if you get to accounts receivable, you should have a list of all customers that owe you money, and it should exactly agree to the trial balance, which comes from the ledger.

The list of customers, called a subsidiary ledger, should have been updated with the same information that updated the general ledger, so if a customer bought something on account, the general ledger (accounts receivable) was increased (by a debit in this case) and the subsidiary ledger was increased by the same amount.

The difference between a subsidiary ledger and a general ledger is that the subsidiary ledger is organized by customer and shows what each customer owes (charges less payments) and the general ledger is just a list by date of what everybody owes. It would be a lot of work to sort through the general ledger to find all the transactions for one particular customer, so we track that as we go. Conducting a search with the subsidiary ledger means we have two things:

1. A way to instantly tell how much a customer owes us.
2. A list agreeing with the general ledger account with the details we need to verify it.

The total of the subsidiary ledger must always agree with the general ledger account balance because both ledgers are just two ways of looking at the same thing. We call the general ledger account a “control” account because we can check our subsidiary ledger against it to make sure they both contain the same exact information.

Back to adjusting journal entries—if you find, by investigation (asking questions, doing research) that there is a customer out there who has not been billed yet, and so doesn’t show up in the control account (or the subsidiary ledger), you have to accrue (add) that revenue by creating and posting a journal entry.

Step 4: Make Adjusting Journal Entries

Every time you find an error, an asset, or a liability (or equity account) that needs to be adjusted, you make an adjusting journal entry and you carefully document why you made it. Those entries are usually dated as of the end of the period (e.g., 12/31/20XX) and if they are numbered, many accountants use the prefix AJE (e.g., AJE1, AJE2, AJE3, etc.).

Step 5: Post the Adjusting Journal Entries

This process is just the same process you use when recording transactions during the period: analyze, journalize, and post.

In the next section, we’ll discuss how to tell the difference between a deferral and an accrual, and why that matters.