What is the purpose of adjusting entries?

Adjusting entries are made at the end of an accounting period to ensure that revenues and expenses are recognized in the period they occur, in accordance with the accrual basis of accounting. The purpose of adjusting entries includes:

Accurate Financial Reporting:

To provide a more accurate picture of a company's financial position and performance by ensuring that all revenues and expenses are recorded in the correct accounting period.

Compliance with Accounting Principles:

To adhere to the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), which require the matching of revenues and expenses to the period in which they are earned and incurred.

Reflecting Actual Financial Activity:

To account for transactions that have occurred but have not yet been recorded, such as accrued expenses or revenues, prepaid expenses, and depreciation.

Updating Account Balances:

Adjust the balances of asset, liability, revenue, and expense accounts to reflect the correct amounts at the end of the period.

Types of Adjusting Entries

Accrued Revenues:

Revenues that have been earned but not yet received in cash or recorded.

Example: A company performed a service in December but will not bill the client until January.

Journal Entry:

Debit: Accounts Receivable

Credit: Revenue

Accrued Expenses:

Expenses that have been incurred but not yet paid in cash or recorded.

Example: Salaries earned by employees in December but paid in January.

Journal Entry:

Debit: Expense

Credit: Accounts Payable

Prepaid Expenses:

Expenses are paid in cash and recorded as assets before they are used or consumed.

Example: Insurance paid in advance for the next six months.

Journal Entry:

Debit: Expense

Credit: Prepaid Expense (Asset)

Unearned Revenues:

Cash is received and recorded as liabilities before the revenue is earned.

Example: A company received payment for services to be performed in the future.

Journal Entry:

Debit: Unearned Revenue (Liability)

Credit: Revenue

Depreciation:

Allocation of the cost of a tangible asset over its useful life.

Example: Depreciation of equipment.

Journal Entry:

Debit: Depreciation Expense

Credit: Accumulated Depreciation (Contra Asset)

Amortization:

Allocation of the cost of an intangible asset over its useful life.

Example: Amortization of a patent.

Journal Entry:

Debit: Amortization Expense

Credit: Accumulated Amortization

Example Adjusting Entries

Accrued Salaries:

Journal Entry:

Debit: Salaries Expense $5,000

Credit: Salaries Payable $5,000

Prepaid Insurance:

Assume $1,200 prepaid insurance covers a year, with $100 used each month.

Journal Entry:

Debit: Insurance Expense $100

Credit: Prepaid Insurance $100

Adjusting entries ensures that the financial statements reflect the true financial condition of the business and provide a basis for making informed business decisions.

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