Adjusting entries: A simple introduction

Adjusting entries are modifications made to a company’s accounting records at the end of an accounting period to reflect the timing of revenues and expenses accurately. As a business owner, understanding adjusting entries is crucial for you to ensure your financial statements accurately reflect your company’s financial health, aiding in better decision-making and compliance with accounting standards.

As a small business owner, you probably find yourself juggling multiple roles, just like John, who runs a busy retail store in Austin. Between managing inventory, assisting customers, and ensuring his team is motivated, John barely has time to breathe. 

And when it comes to handling the store’s finances, things can get particularly challenging.

While John loves the hustle of his business, one thing he dreads is the end-of-month financial close. He often wonders why his books never seem to match up perfectly, and he’s puzzled by the discrepancies that appear when comparing cash flow with recorded transactions.

Adjusting entries play a crucial role here. They bridge the gap between cash and accrual accounting, making sure your financial statements accurately show what’s really going on with your business’s finances, including the true profit or loss for the period.

In this blog, we’ll explore what adjusting entries are and why they’re essential for your business.

What are adjusting entries?

In the accounting cycle, adjusting entries are made before preparing a trial balance^[1] and generating financial statements. This process helps business owners maintain accurate financial records, which are crucial for understanding business performance and making informed decisions.

As a small business owner, tracking how money moves through your business is essential. You need to know how it enters your business, leaves it, and moves between different accounts.

But sometimes, the timing of your transactions doesn’t perfectly match up with when you record them. That’s where adjusting entries come in to ensure your financial records reflect reality.

Let’s take the example of John, a busy retail store owner in Austin. In August, John bills a customer $5,000 for a large order of merchandise. The customer pays the invoice in September.

Here’s how John handles this with adjusting entries:

Initial entry:
In August, John records the $5,000 in accounts receivable. This entry acknowledges the income he expects to receive, even though the cash hasn’t hit his bank account yet.

Adjusting entry:
Come September, John receives the $5,000 payment. He records this as cash deposited in his bank account. But let’s say the customer calls John in September, requesting a 5% discount due to a minor issue with the order, and John agrees.

John now needs to adjust his accounts to reflect this discount. He makes an adjusting journal entry to reduce accounts receivable and revenue by $250 (5% of $5,000).

Why are adjusting entries important?

Adjusting entries ensure that your financial records are accurate and comply with the matching principle, a fundamental concept within Generally Accepted Accounting Principles (GAAP). This principle states that expenses should be recorded in the same accounting period as the revenues they help generate. 

Without them, your financial records might show expenses paid or revenue collected at the wrong time, leading to discrepancies. This can throw off your income and expense matching and make it difficult to track the actual revenue.

Additionally, adjusting entries are crucial for managing depreciation of assets, which is vital for claiming tax deductions and maintaining accurate financial balances.

Who needs to make adjusting entries?

If you handle your accounting using the accrual system, you’ll need to make these adjustments to ensure your financial records reflect the timing of transactions accurately.

Conversely, if you use the cash accounting method, you typically won’t need to make adjusting entries because transactions are recorded when cash is received or paid. However, take note that cash accounting isn’t in line with GAAP, and it might not be the best for your business in the long run—even if it is working for you right now—as it may not provide an accurate reflection of longer-term financial health and performance.

Regardless of your accounting method, if you have a bookkeeper, they’ll take care of all entries (including adjusting entries), ensuring your financial records are accurate and compliant without you needing to worry about the details.

Types of adjusting entries

If the idea of making adjusting entries seems daunting, there’s no need to worry—there are only four types of adjusting entries, and they are easily distinguishable. Below, you’ll find descriptions of each type, along with examples.

1. Accruals

Accruals are transactions that have taken place but haven’t been entered in your company’s general ledger because cash hasn’t been exchanged yet. Adjusting entries help correct this timing difference.

Accrual adjustments are of two types: accrued revenues and accrued expenses.

Typically, these adjustments are automatically reversed the following month when transactions are completed through regular processing channels, like customer invoicing and bill payments.

Accrued revenues: A revenue accrual occurs when a sale has been made, but the customer has not yet been invoiced. For instance, if John sells $5,000 worth of merchandise in August but doesn’t get paid until September. He records the anticipated income in August as an accrued revenue adjustment. The adjusting entry in August would debit accounts receivable and credit accrued revenue.

Accrued expenses: An expense accrual accounts for products delivered or services rendered for which the business has not yet received a bill. In John’s case, suppose he hires a contractor for $400 in February but receives the invoice in March. He records the expense in February to reflect when the work was done, making an accrued expense entry. The adjusting entry would debit labor expenses and credit accounts payable.

2. Deferrals

Deferrals postpone the recording of transactions from the current period to a future accounting period. When handling deferrals, you’ll make two journal entries: one to initially record the transaction and another as an adjusting entry at a later time.

Like accruals, deferrals are also of two types: revenue deferrals and expense deferrals.

Revenue deferrals: A revenue deferral is required when a company receives payment or sends an invoice before the goods or services are delivered. This often happens when invoicing precedes the completion of work, particularly in projects that span over time or involve retainers or deposits. The initial journal entry records the payment, and a future adjusting entry recognizes the revenue once it is actually earned.

Suppose John decides to offer a special order service for custom products. In December, a customer pays $3,000 upfront for a custom order that will be completed and delivered in February. John records the payment as deferred revenue in December and then adjusts it to revenue in February when the goods are delivered.

For instance, if John pre-pays the annual insurance premium for his store in December 2023 for coverage that begins in 2024, he records this payment as a prepaid expense. He then makes monthly adjustments to allocate the insurance cost to the appropriate period.

3. Depreciation and amortization

Depreciation involves spreading the cost of tangible assets like equipment, vehicles, or buildings over their useful life. Instead of expensing the entire cost at once, you allocate it over several accounting periods. Each period, the accumulated depreciation changes on your balance sheet, and the depreciation expense appears on your income statement. Read “Depreciation: Definition and types with examples” to learn more.

Suppose John invests in equipment for his store, and these assets depreciate over time. Depreciation expenses spread the cost of these assets over their useful life. This type of adjusting entry ensures that the expense appears gradually over multiple periods.

Amortization is similar to depreciation but applies to intangible assets like patents and trademarks. The cost of these assets is spread over their useful life, appearing as an expense on the income statement and reducing the asset’s value on the balance sheet.

If John acquires a patent for a unique product design for his store, amortization spreads the cost of this intangible asset over its useful life. Each period, John records a portion of the patent cost as an amortization expense. This helps match the expense with the revenue generated by the patent over time, ensuring accurate financial records.

4. Estimates

Estimates are a type of adjusting entry that don’t involve cash but are crucial for keeping your accounts accurate. They help adjust the values of assets and liabilities on your balance sheet and make sure that your income statement reflects potential expenses. This aligns with accounting principles that emphasize matching expenses with revenues and maintaining verified records.

Suppose John notices that some inventory routinely becomes unsellable due to damage or becoming outdated. By making an adjusting entry to account for this unsellable inventory, he ensures the balance sheet shows a more accurate inventory value and the income statement properly accounts for this loss. This results in a decrease in inventory value and an increase in the cost of goods sold, keeping your financial reports accurate and up-to-date.

What are the steps for making adjusting journal entries?

Adjusting journal entries are essential for ensuring your financial records are accurate and up-to-date at the end of an accounting period.

Here’s a guide to the steps involved in making these adjustments:

1. Identify which original journal entries need to be adjusted

The first step is to review your original journal entries and identify any errors or omissions that need correction. Look for transactions that have not been recorded properly, such as accrued revenues or expenses, deferred revenues, prepaid expenses, and depreciation.

2. Determine what type of adjustment is needed

Once you’ve identified the entries that need adjustment, determine the type of adjustment required. This could involve recognizing revenue that has been earned but not yet recorded, accounting for expenses incurred but not yet paid, or adjusting for depreciation and amortization of assets.

3. Calculate the amount of the adjustment

Next, calculate the precise amount that needs to be adjusted. This involves determining the correct amount of revenue or expense that should be recorded for the period. For example, if you’re adjusting for accrued expenses, calculate how much has been incurred but not yet recorded.

4. Make the adjusting journal entry

Finally, make the adjusting journal entry in your accounting records. Recording the adjustment in your general ledger and ensure that your financial statements reflect the correct amounts. For instance, if you’re adjusting for accrued revenue, you would debit accounts receivable and credit the revenue account.

Why are adjusting entries important for small business accounting?

Adjusting entries are key to accurately understanding your small business’s financial position. Here’s why:

1. Ensuring revenue accuracy

If revenue earned in a given month isn’t accounted for in that same month, your financial statements might show lower revenue than actually earned. For instance, suppose John sold some products to a customer on January 31. If these revenues aren’t accrued because the customer is billed in February, the revenue for January would appear lower than it should. This violates the revenue recognition principle^[2], which mandates that revenue should be recognized when it is earned.

2. Proper expense recording

It’s just as important to record expenses accurately as it is revenue. This includes not just the obvious outlays, but also accrued expenses such as payroll and services received but not yet billed. For example, if a computer repair needed at the end of February is not invoiced until March, the expense should still be recorded in February to reflect the true costs incurred during that month.

3. Accuracy of financial statements

Financial statements, such as balance sheets and income statements, are foundational for making informed business decisions. Adjusting entries ensure these documents accurately reflect the company’s financial status at the end of each accounting period, allowing for precise assessment and strategic planning. Without these adjustments, financial statements may not present an accurate picture of the company’s financial health.

Different bookkeeping methods and adjusting entries

Manual bookkeeping:

If you manage your own bookkeeping manually using spreadsheets, you’re responsible for handling all the adjusting entries. This means you must make these entries yourself to ensure your books are accurate.

When it’s time to generate financial statements, you’ll need to refer to these adjusting entries. Alternatively, you can keep detailed notes so your accountant can understand the adjustments when they prepare the statements for you. While this method offers control and flexibility, it requires diligence and attention to detail.

Automated bookkeeping:

For those who use accounting software, the process of making adjusting entries is somewhat streamlined compared to using spreadsheets. The software can automate parts of the process and generate financial statements for you. However, you’re still responsible for ensuring that adjusting entries are accurate and completed on time. The software simplifies the task but doesn’t eliminate the need for careful oversight and accuracy.

If you have a bookkeeper, you don’t need to worry about making adjusting entries yourself. Your bookkeeper will handle all the necessary adjustments and ensure they are correctly recorded in your financial records.

The bottom line

While cash accounting might seem like the simpler option when managing the books yourself, it can introduce errors that accrual accounting helps to prevent. This makes understanding adjusting entries crucial, as they help maintain accurate financial records while ensuring your accounting practices align with GAAP.

However, managing complex accounting tasks like adjusting entries can stretch your capacity, often requiring more time and focus than you might realistically have available.

This is where CoCountant steps in. We provide comprehensive bookkeeping and accounting services tailored to the needs of small business owners like you. Our services include daily bookkeeping where every transaction, every day, is diligently recorded. You work with an assigned dedicated professional familiar with your business who can engage with you as often as needed.

Moreover, CoCountant practices GAAP accounting, ensuring trustworthy and standardized accounting practices for clarity and compliance. With our support in managing deferred revenue and accruals, you can accurately track income and expenses, even if cash hasn’t changed hands, ensuring your financials are always accurate and ready for any regulatory scrutiny.

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