What are Adjustment Entries?
Adjusting entries are the entries that are made on the last day of an accounting period. This is done so that a company's financial statements go in accordance with the accrual method of accounting. In simple words, the adjusting entries are needed in a company for the following reasons:
Income statement records the revenues which were earned during the accounting period.
Balance sheet reports the receivables who has a right to receive at the end of the accounting period.
Income statement reports the expenses and losses to incur during the accounting period.
Balance sheet records the liabilities which has incurred as of a particular accounting period.
Types of Adjustment Entries
Primarily the types of the adjusting entries are discussed in the given sections:
These entries help a business in reporting all the revenues, which it had earned during the accounting period. There might arise a case when a company has already provided a service, but did not receive the payment yet. So, the accrual type of adjusting entries are shown in the financial statements to account for such as these revenues.
Like the accrued income or the revenue, a company only should record the expenses which it incurs. A business should also report an expense even if it does not incur its expenses. For example, a company assigns a worker on a contract basis. The company is expecting to get an invoice on January 3rd and remit the payment on January 8th. However, the services of the worker were availed in the month of December itself. Therefore, the company needs to account the expenses and liability as of December 31st.
Deferred expenses are the payment paid in the present for the future expenses. One must also refer these payments as the deferred expense until the expenses expire or the company avails the service. Like, a company pays Rs.10000 on December 25 towards a machine insurance for the six-month period starting January 1. This means the insurance is actually prepaid for a period between the December 25th and December 31.
It is in relation to the use of the fixed asset in the business, a company depreciates an asset at a certain rate which has a useful life for more than a year. Through the depreciation period, the company allocates this cost of the asset as an expense in the accounting periods where the company uses the asset. Example, a machine costing Rs.50000 with no salvage value and useful life of 20 years will result in a monthly depreciation expense of Rs.50000/240 (20*12).
If the company receives any amount in advance before earning, the company should mention the same as a liability in the current accounting period. Like, a company gets an advance of Rs.5000 for offering a service which will offer at a later date. As on December 31st, the company should analyse the portion of the service which it has already delivered. The portion will come as income, and the balance will be the deferred revenue.
Importance of Adjustment Entries
Adjusting Entries helps in the following cases:
The income statement of the company only records the revenues which the company earns during the accounting period.
Receivables in the balance sheet reflects the accurate amount which the company has the right to receive at the end of an accounting period.
Income statement encompasses the expenses and losses which a company incurs during the accounting period.
Balance sheet also consists of the liabilities which the company incurs as of the end of the accounting period.
This also helps in calculating the exact revenues and expenses.
Updating the financial statements can be done through these entries.
To fix an error, adjustment entries are passed easily.