How To Properly Adjust Financial Journal Entries
The two methods of recording the financial picture of a business are cash accounting and accrual accounting. Businesses using the cash method record expenses and income when money is paid or received. The cash method is the simpler of the two; it works similarly to a personal checkbook. The accrual method matches income and expenses to the correct period by using journal entries to record certain activities.
This gives a more accurate picture of how the company is performing, but it is also more time-consuming. Preparing and posting journal entries is one of the activities that must be performed when using the accrual method. If journal entries are overlooked or prepared incorrectly, the accuracy of the financial statements can be severely impacted.
Types of Journal Entries
There are many different situations that might require an adjusting journal entry. However, most can be classified into one of six categories.
1. Accrued expenses record expenses you have incurred but for which you have not paid. Examples of accrued expenses include:
- Goods or services you have received but for which the vendor has not yet submitted an invoice
- Bills for utilities, such as electricity, telephone, Internet service or water
- Taxes or other annual payments
- Payroll, if employees have hours worked in one period that will not be paid until the following period
- Pending credits, such as a vendor credit for returned goods
2. Deferred or prepaid expenses reflect expenses that you have paid for which services have not yet been delivered. For example, a company might make the insurance payments on their vehicles for a year in advance, or it might remit quarterly lease payments on their building.
3. Inventory adjustments are a common type of journal entry. Typically, journal entries are prepared to align the cost-of-goods sold with the number of units sold during the period. Most companies record all purchases to an inventory account that appears on the balance sheet, and then they prepare a journal entry to transfer the cost of the units actually sold in the period to an account that appears on the income statement.
4. Noncash transactions reflect activities that have no impact on the company's cash. Examples of these types of journal entries include amortization and depreciation, reserves set up to record inventory damaged in the warehouse or to allocate costs between locations or departments.
5. Accrued revenue or income reflects transactions for which you have delivered the goods or services but have not received payment. In most companies, accounts receivable will reflect the bulk of this category. However, accrued revenue could also include other items, such as interest earned in one period that the bank will not post until the following period.
6. Deferred revenue reflects payments received for which the work or goods have not been delivered. For example, a customer might pay in advance for a custom order that will take two months to complete.
The Need for Adjusting Journal Entries
The primary purpose of adjusting journal entries is to match income and expenses in the period in which they occurred. The following examples may help demonstrate how this matching principle can deliver financial statements that are more accurate.
• Expenses are recognized in the proper period. Suppose a company purchases a five-year service contract to cover preventive maintenance on its heating system. The contract costs $5,000, which the vendor requires the company to pay in advance. Under the cash method, the company would record the entire $5,000 in one period, expenses would be overstated and profits would be understated. Under the accrual method, only $1,000 is recorded as an expense each year.
• Income is recognized in the proper period. The labor, materials and overhead costs to provide a product or service to the customer is matched to the revenue.
To illustrate, suppose a customer pays $500,000 in advance for a company to manufacture a product according to his specifications. It will take two years to complete the order. The company buys the materials needed, pays its employees and covers the utilities, computer support, and other costs. Under the cash method, the company seemingly received a windfall when it received the $500,000, but for two years, it will be overstating its expenses, making it appear that the company is not earning as much as it is or possibly showing that the company is losing money.
How to Make an Adjusting Journal Entry
Journal entries require an understanding of how accounting systems work. They will always impact at least two accounts, and the debits and credits will net to zero. The following sample journal entries may be helpful.
1. A company receives a shipment of office supplies on the last day of the accounting period, but the vendor's invoice has not arrived. According to the purchase order, the invoice should be for $200. The journal entry would debit the account for office supplies in the amount of $200 and credit accrued expenses for $200.
2. A customer makes a purchase of $500 and charges it to her account. She has 30 days to remit payment. The journal entry would show a debit to accounts receivable of $500 and a credit to income of $500.
3. After receiving a shipment of 10,000 items and posting the cost of $100,000 to the inventory account, a company sells 1,000 of the items during the period. The journal entry would be to debit the cost-of-goods sold account for the value of 1,000 items, which is $10,000, and credit the inventory account for $10,000.
One area that often causes confusion when preparing journal entries is that some accounts normally have a credit balance and others normally have a debit balance. The type of account determines its normal balance.
• Assets typically have debit balances. Assets include cash, accounts receivable and inventory.
• Contra-assets are credit-balance accounts. Examples of contra-assets are reserves for inventory write-offs and allowances for questionable accounts receivables.
• Liabilities normally have credit balances. Liabilities include accrued expenses and unpaid taxes.
• Income accounts typically show credit balances. Income accounts include sales, interest earned and other revenue.
• Expenses normally have debit balances. Expenses may include cost-of-goods sold, wages, operating expenses and overhead.
To create a journal entry, follow these steps.
1. Consider which accounts are to be affected. There will be a minimum of two accounts, but the journal entry could involve much more.
2. Consider the purpose of the journal entry to help determine which accounts should be credited and which should be debited. For example, when accruing a liability, the liability account must be a credit, so the offsetting account or accounts must be debited.
3. Prepare a written or typed entry to document the journal entry. Make sure that the total of all debits equals the total of all credits.
4. Post journal entries as required. Journal entries should be posted before closing the books for the period or presenting financial statements to investors or lenders, but it can also be beneficial to post them prior to making major financial decisions or commitments.
Adjusting journal entries can be quite complex. Initially, they can appear daunting to those not in the accounting profession. With practice, however, they become much easier to prepare and require less time to complete.