Adjusting entries are the journal entries that change the balance of the affected accounts at the end of the accounting period. The adjustments are made to align and give as true and fair reported results from a company’s operations and financial position following the accounting framework such as GAAP or IFRS (Hoyle, 2015). The main purpose of an accounting entry is to adjust revenues and expenses to the period of occurrence; this enables the financial statements to reflect the accrual accounting method and matching concept.
Purpose of adjusting entries
The purpose of adjusting entries is to determine when the money changed hands and convert the real-time entries to entries reflecting the accrual accounting method. The purpose for adjusting entries can be described in three situations: (1) Delay in processing the financial transactions about an accounting period at the end of the accounting period; for example, when an electricity bill for December is processed in early January. (2) Processing a bill that represents an expense for more than one accounting period. At the end of an accounting period, only the amount incurred will be recorded, while the remaining amount will be deferred to future accounting periods. (3) the case of depreciation and amortization expense. The net book value of an asset will be adjusted with depreciation expense each year over the useful life of the asset.
In the case of accrued revenue, adjusting entries will be made to cash and receivable accounts to record the collection on the account by debiting the cash account and crediting the receivable account (Kieso, 2019). Accrued expenses paid at the accounting year-end require an adjusting entry that debits the accrued expense account and credits cash. Similarly, an adjusting entry is also made to accrue interest expense at the end of an accounting period. Unearned revenue and prepaid expenses accounts attract adjustments if revenue is recognized and the expenses are incurred at the end of an accounting period.
Effects of the adjusting entries on the financial position and profitability
- This adjusting entry is necessary because the cost of supplies utilized during the period must be determined and charged to the income statement as an expense. The adjusting entry decreases net income, and so a decrease in profitability. The adjusting entry does not impact the firm’s financial position.
- This entry is necessary because expenses are recognized when incurred and not when cash exchanges hands. The entry reduces the prepaid expense account by the amount incurred at the end of the period(Edmonds, 2013). Also, the adjusting entry decreases both profitability and financial position. Insurance expense is charged to an income statement resulting in a decrease in net income. A reduction in net income reduces shareholders’ funds, while a reduction in prepaid insurance reduces the value of total assets.
- This adjusting entry is required to charge the depreciation expense to the income statement. The adjustment reduces the net book value of the building and equipment account. Adjustments for the depreciation expense decrease both profitability and financial position.
- This adjusting entry is necessary because the service revenue account must be adjusted by the amount earned from the unearned revenue; the entry increases service revenue. The unearned service revenue account is adjusted by decreasing the account with the amount earned. The entry does not affect the company’s financial position but increases its profitability due to an increase in service revenue.
- This adjusting entry is necessary because it increases both the accounts receivable and service revenue accounts. The entry increases the financial position since total assets and shareholders’ funds will increase, as well as increase profitability.
- This adjusting entry accrues interest expense incurred for the accounting period ending November 30. Interest expense is charged on the income statement, and the amount incurred is also recognized in the balance sheet as a current liability. The transaction decreases both the financial position and the profitability of the firm.
Edmonds, T. P. (2013). Fundamental Financial Accounting Concepts. New York, NY: Mcgraw-Hill Irwin.
Hoyle, J. B. (2015). Advanced Accounting. Mcgraw Hill.
Kieso, D. E. (2019). Intermediate Accounting. John Wiley & Sons.
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Session 2: Point Problem-Chapter 3
Exercise(s) and/or Problem(s):
- Retrieve the Posted Solution for Ch 3 P-2 at the following link: Ch 3 P-2 .
- Prepare a brief discussion of what adjusting entries are and why adjusting entries are necessary.
- For each of the adjusting entries listed in the Posted Solution, explain why it is necessary and whether it increases or decreases financial position and whether it increases or decreases profitability (also called performance).
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