adjusting entries are required

3 min read 01-10-2024

Adjusting entries are a crucial component of the accounting cycle, ensuring that financial statements reflect the true economic condition of a business. In this article, we'll explore what adjusting entries are, why they are required, and how they impact the overall financial reporting process.

What Are Adjusting Entries?

Adjusting entries are journal entries made at the end of an accounting period to allocate income and expenses to the correct period. These entries are necessary to comply with the accrual basis of accounting, which states that income and expenses should be recorded when they are earned or incurred, regardless of when cash is received or paid.

Why Are Adjusting Entries Required?

Adjusting entries serve multiple purposes in accounting:

Accurate Financial Reporting: They ensure that the financial statements accurately reflect the company's financial position. Without these adjustments, assets, liabilities, revenues, and expenses may be misrepresented.
Compliance with Accounting Principles: Adjusting entries are necessary to adhere to Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). These principles require that financial information is complete and reflects the company's activities for the reporting period.
Matching Principle: Adjusting entries help align revenues with the expenses incurred to generate them, providing a clearer picture of profitability for the period.

Types of Adjusting Entries

There are four main types of adjusting entries:

Accrued Revenues: Revenues that have been earned but not yet recorded. For example, a service provided in December that won’t be billed until January requires an adjusting entry to record the revenue in December.
Accrued Expenses: Expenses that have been incurred but not yet recorded. For instance, salaries earned by employees in December but paid in January need to be recognized in December’s records.
Deferred Revenues: Cash received before services are performed or goods are delivered. For example, if a company receives a payment in advance for a yearly subscription, it must adjust the revenue as the service is delivered over the year.
Deferred Expenses: Payments made in advance for future expenses, such as rent or insurance. These costs should be adjusted over time as the benefits of the expense are realized.

Example of an Adjusting Entry

Consider a scenario where a company pays $1,200 for a one-year insurance policy on June 1. At the end of December, an adjusting entry would be necessary to account for the insurance expense incurred for the seven months from June to December.

Original Entry:
- Debit Insurance Expense: $1,200
- Credit Cash: $1,200
Adjusting Entry (end of December):
- Debit Insurance Expense: $700 (for seven months)
- Credit Prepaid Insurance: $700

In this way, the financial records reflect that $700 of the insurance cost has been consumed, while $500 remains as a prepaid expense.

Practical Importance of Adjusting Entries

The significance of adjusting entries can be illustrated through the role they play in financial analysis. Investors and stakeholders often rely on accurate financial statements for decision-making. Adjusting entries help ensure that reported income and expenses genuinely reflect the company’s operational performance, leading to more informed investment decisions.

Conclusion

Adjusting entries are essential for accurate financial reporting and compliance with accounting standards. They uphold the integrity of the financial statements by ensuring that all revenues and expenses are properly matched and reported in the correct period. Understanding the necessity and mechanics of these entries can greatly enhance financial literacy among business owners, accountants, and investors alike.

By maintaining accurate records through adjusting entries, companies not only ensure regulatory compliance but also gain insights into their financial health, ultimately aiding in better strategic planning and decision-making.

References

This article draws on insights gained from various academic sources, notably those found on Academia.edu. For more in-depth studies on adjusting entries and their applications, you can explore relevant articles contributed by professionals in the accounting field.

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