Adjusting entries are made in the journal accounts as part of the process of preparing the final accounts. They are required because, under the principle of prudence, expenses need to be recognised when they occur, whilst revenues should only be recognised once they are substantially likely to occur. This is the basis of the accruals and deferrals concept. As such, adjusting entries are required when expenses have been incurred but not yet paid for in an accounting transaction, or when revenue has been generated in an accounting transaction, but may yet not be realised due to customer returns or the work not yet being completed. As a result of this, the main types of adjusting entry are accruals, for revenues or expenses that occur before a transaction takes place, and deferrals, for revenues or expenses that occur after the transaction takes place.
Accruals tend to be the more common form of adjusting entry, due to the fact that many expenses such as electricity and salaries and paid in arrears. For example, many companies will pay their electricity bills in arrears. Consider the example of a company which pays electricity of £100 per month, and pays their annual bill in arrears on the 30th June; however their accounting year finished on the 31st December. As of December 31st, the company will have received and used half a year’s worth of energy: £600. However, as the bill has not yet been paid, this would not appear in the transactions in the journal. Therefore, an adjusting entry is needed to debit the accrued costs of this electricity to the rents and rates account, with a corresponding credit in the accrued expenses account, which would count as a liability.
It is important to note that, if the electricity provider had the same accounting period, then the provider would also accrue this transaction, however they would accrue the revenues as a credit, and the unbilled revenue as a debit. Other items which may also need adjusting entries to account for accruals are:
- Overdue expenses
- Income tax costs
- Unpaid interest on investments or loans
The opposite of an accrual is a deferral, which occurs when a transaction is recorded in the journal, but all or part of the expense or revenue of the transaction has not yet been realised. As a result, the inclusion of the income or expense in the accounts needs to be deferred until the accounting period to which it relates. This can be understood using the same example as for accruals, but this time the company pays their electricity bills in advance. As a result, on the 31st December they have paid for one year of electricity, but have only received £600. To account for this, the rent and rates expense will be credited by the difference: £600. As debits increase expenses, the credit will reduce them, hence effectively deferring the expense to the next accounting period. At the same time, the prepaid expenses account will be debited, creating an asset to go on the financial statements to reflect that some of the electricity for next year has been purchased in advance.
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Whilst this example is useful for understanding purposes, it is not necessarily realistic, as most energy bills are based on usage and hence are billed in arrears. More common transactions which require adjusting entries tend to include:
- Annual insurance premiums paid in advance
- Rent instalments
- Office supplies that have not yet been used, such as printer paper
- Revenue which has been collected but not yet earned
As with the accruals example, in the case of revenue which has been collected but not yet earned, the revenue for the year would be debited, reducing it, and a liability account for prepaid revenue would be credited. This can be seen in the example above, where the electricity provider would have to reduce its revenues by £600 through a debit, and credit prepaid revenue. This prepayment is a liability to the electricity provider, as it represents an economic consideration they have to provide, in this case the electricity.
Given the wide range of potential items requiring adjustment, it is clear that there could be a large number of adjusting entries to be made, particularly for large firms with lots of properties. In order to include them all, accountants will need to be methodical, reviewing the adjustments made in previous years, considering all the company’s activities and which might need adjustments, and talking to various managers and department heads to determine any sources of unbilled revenue or deferred expenses.