Mary Girsch-Bock studied accounting and business at UIC. After working as an accountant for many years in various industries, including healthcare and property management, she returned to her first love, writing. She specialized in accounting and business articles, with an emphasis on software reviews, which she wrote for more than 20 years. She continues to write for the first publication she ever wrote for, CPA Practice Advisor, while blogging for several software companies.
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In order for your financial statements to be accurate, you must prepare and post adjusting entries. We’ll explain what they are and why they’re so important.
In order to create accurate financial statements, you must create adjusting entries for your expense, revenue, and depreciation accounts.
Adjusting entries are made at the end of an accounting period to properly account for income and expenses not yet recorded in your general ledger, and should be completed prior to closing the accounting period.
Adjusting entries are Step 5 in the accounting cycle and an important part of accrual accounting. Adjusting entries allow you to adjust income and expense totals to more accurately reflect your financial position.
After you prepare your initial trial balance, you can prepare and post your adjusting entries, later running an adjusted trial balance after the journal entries have been posted to your general ledger. The purpose of adjusting entries is to ensure that your financial statements will reflect accurate data.
If adjusting entries are not made, those statements, such as your balance sheet, profit and loss statement, (income statement) and cash flow statement will not be accurate.
If you earned revenue in the month that has not been accounted for yet, your financial statement revenue totals will be artificially low. For instance, if Laura provided services on January 31 to three clients, it’s likely that those clients will not be billed for those services until February.
If Laura does not accrue the revenues earned on January 31, she will not be abiding by the revenue recognition principle, which states that revenue must be recognized when it is earned.
As important as it is to recognize revenue properly, it’s equally important to account for all of the expenses that you have incurred during the month. This is particularly important when accruing payroll expenses as well as any expenses you have incurred during the month that you have not yet been invoiced for.
For example, your computer crashes in late February. A computer repair technician is able to save your data, but as of February 29 you have not yet received an invoice for his services.
In order to account for that expense in the month in which it was incurred, you will need to accrue it, and later reverse the journal entry when you receive the invoice from the technician.
At the end of each month, you should run financial statements: a balance sheet, profit and loss or income statement, and a cash flow statement. Used to make any closing entries, it’s important that these statements reflect the true financial position of your company.
There are five main types of adjusting entries that you or your bookkeeper will need to make monthly. All five of these entries will directly impact both your revenue and expense accounts. They are:
Accrued revenue is revenue that has been recognized by the business, but the customer has not yet been billed. Accrued revenue is particularly common in service related businesses, since services can be performed up to several months prior to a customer being invoiced.
Revenue must be accrued, otherwise revenue totals would be significantly understated, particularly in comparison to expenses for the period. For example, Justin owns a CPA firm. His firm does a great deal of business consulting, with some consulting jobs taking months.
Justin will want to accrue the revenue earned in those months before he is able to bill his clients, otherwise his expenses will appear quite high on his income statement, while his revenue will be artificially low.
An accrued expense is an expense that has been incurred before it has been paid. For example, Tim owns a small supermarket, and pays his employers bi-weekly. In March, Tim’s pay dates for his employees were March 13 and March 27.
However, his employees will work two additional days in March that were not included in the March 27 payroll. Tim will have to accrue that expense, since his employees will not be paid for those two days until April. Payroll expenses are usually entered as a reversing entry, so that the accrual can be reversed when the actual expenses are paid.
Deferred revenue is used when your company receives a payment in advance of work that has not been completed. This can often be the case for professional firms that work on a retainer, such as a law firm or CPA firm.
In many cases, a client may pay in advance for work that is to be done over a specific period of time. When the revenue is later earned, the journal entry is reversed.
Prepaid expenses also need to be recorded as an adjusting entry. For instance, if you decide to prepay your rent in January for the entire year, you will need to record the expense each month for the next 12 months in order to account for the rental payment properly.
If you don’t, your financial statements will reflect an abnormally high rental expense in January, followed by no rental expenses at all for the following months.
Depreciation expense and accumulated depreciation will need to be posted in order to properly expense the useful life of any fixed asset.
Depreciation is always a fixed cost, and does not negatively affect your cash flow statement, but your balance sheet would show accumulated depreciation as a contra account under fixed assets.
Each adjusting entry will be prepared slightly differently. Here are examples on how to record each type of adjusting entry.
Any time that you perform a service and have not been able to invoice your customer, you will need to record the amount of the revenue earned as accrued revenue. For example, John owns a cleaning service. He bills his clients for a month of services at the beginning of the following month.
His bill for January is $2,000, but since he won’t be billing until February 1, he will have to make an adjusting entry to accrue the $2,000 in revenue he earned for the month of January.
| Date | Account | Debit | Credit |
|---|---|---|---|
| 1-31-2020 | Accrued Revenue | $2,000 | |
| Revenue | $2,000 |