Understanding Adjusting Entries in Accounting

Adjusting entries in accounting are important because they make sure your financial records show the right earnings and expenses for your business. They’re made at the end of each accounting period to make sure all the money you made and spent during that time is properly accounted for.

In this article, we’ll explore the various types of adjusting entries – accruals, deferrals, estimates, and corrections. Plus, you’ll learn how to record these entries, some common errors, and how to correct them.

Also, this guide is related to our articles on understanding journal entries in accounting, understanding retained earnings, and accrued expenses: practical examples.

This list includes:

• What are adjusting entries in accounting?
• Types of adjusting entries
• How to record adjusting entries
• Examples of adjusting entries
• Common errors in adjusting entries

Let’s get started!

Types of adjusting entries

An adjusting entry in accounting is a change made at the end of a time period to correct or update the amounts in the accounts. This makes sure that all income and expenses are recorded in the right time period, like adding interest earned or bills not yet paid.

The main categories you need to know in adjusting entries are accruals, deferrals, estimates, and corrections. Here are some basic definitions, and then we’ll get into them all in more detail below.

Accruals: Accruals are expenses or revenues that you’ve incurred or earned but haven’t recorded yet. This happens because the cash flow related to these items will occur after the accounting period.

Deferrals: Deferrals have the opposite effect to accruals. They represent cash flows that have been recorded, but haven’t been earned or used up yet. Deferrals ensure that your income and expenditure are only reflected in your accounts when you’ve actually earned that revenue or used the goods or service.

Estimates: Sometimes, as a small business owner, you might not know the exact expense amount for an item right away. In these cases, you use estimates. Estimates can include items like depreciation, bad debts, and warranties. These expenses might not involve an immediate cash outflow, but they still have a financial impact on your business.

Corrections: These are adjustments made to financial records to fix mistakes or errors in previous accounting entries, so the records accurately reflect the true financial position of the business.

Accruals

Getting to grips with the business basics can sometimes feel like learning a new language, and accruals is definitely one of those unfamiliar words. It sounds complicated, but it’s actually pretty simple once you know what it is.

Accruals are revenues earned or expenses incurred which impact a company’s net income, even though cash related to the transaction has not been received or paid out yet.

For example, say you hire a freelance designer to help make your storefront more appealing and they invoice you for their work on July 30. Even though you might not pay them until August, for the purpose of your July financial statements, that is an accrued expense.

Why use accruals?

The main reason to use accrual accounting is that it gives you a clearer picture of your business’s financial health.

It might seem more straightforward to just record everything when cash enters or leaves your bank account. But to really understand what’s driving profits and losses, it’s more helpful to record revenues and expenses when they’re earned or incurred, not when money changes hands.

Accruals can help you match your revenues (sales) with your expenses (costs) more accurately, so you get a better idea of how much profit you’re really making.

Recording accrued expenses and revenues

Okay, so how do you actually record these transactions?

The two big categories are accrued revenues and accrued expenses.

For accrued expenses, let’s go back to the freelance designer example. On July 30, you get their invoice, but you know you won’t pay it until August. In your books, though, you need to record it as an expense in July. So you would debit (increase) your Design Expense account, and credit (increase) your Accounts Payable account.

Deferrals

Deferrals are another part of your financial accounting system that you should stay on top of.

Deferral entries for prepaid expenses and unearned revenue

Let’s start with prepaid expenses. Have you ever paid for something upfront to use in the future? That’s a prepaid expense. It could be rent, insurance, or even office supplies. When you initially pay for these, they are recorded as assets on your balance sheet–they’re things you’ve paid for but haven’t used yet.

On the flip side, unearned revenue comes into play when you get paid upfront for a product or service you’ll deliver or perform in the future. This money is considered a liability because even though you’ve been paid, you still owe a product or service.

Step-by-step guide on shifting these entries from assets/liabilities to expenses/revenue

Now that we know what deferrals are, let’s talk about how to shift these entries from assets and liabilities to expenses and revenue. This shifting process is the ‘deferral’ part of deferral entries.

Firstly, start with prepaid expenses. The goal is to move them to an ‘expenses’ category over time as you utilize what you’ve paid for. For instance, if you pay for a year’s worth of insurance upfront, every month you should move one-twelfth of the cost from Prepaid Expenses (an asset) to Insurance Expense (an expense). This way, your financial statements accurately represent that you’re slowly using up the prepaid item.

Here’s how to do it:

1. Identify the prepaid item and the period it covers.
2. Divide the total prepayment by the number of periods it covers to get a per-period cost.
3. Enter the prepayment as an asset in your accounting system.

Each period, move the calculated per-period cost from the asset account to the expense account until the total prepayment is fully expensed.

Estimates

When you’re running a small business, your accounting records often include estimates. These figures, such as depreciation and bad debts, might not be actual dollars out of your pocket today, but they reflect future expenditure or potential losses which need to be accounted for.

In this section, you’ll learn how to understand, calculate and record these estimates in your books.

Understanding estimates

Depreciation and bad debts are two common examples of estimates in business accounting. If you own an asset–say a delivery van for your business–that asset loses value over time, which is something you need to factor into your numbers. That loss in value is called depreciation.

Similarly, if you’ve made sales on credit, there’s always a risk that some of those debts will not be paid by your customers. That’s what we call bad debts.

These are estimates because you’re predicting future outcomes based on past and present data.

Calculating depreciation

To work out depreciation, you’ll need to understand the expected lifespan of your assets, how much they cost you, and their potential value at the end of that lifespan. This value, often called scrap or salvage value, is what you could sell the asset for after it’s done its duty for your business.

Many small business owners use the straight-line method for simplicity. Divide the cost of the asset, minus its salvage value, by the number of years you expect to use it. That’s your depreciation expense which you should record each year.

Calculating bad debts

For bad debts, things can get a little trickier, because you’re trying to predict human behavior–will your customers pay their bills or not? Some businesses choose an easy route by setting aside a fixed percentage of sales as a bad debt provision. Others prefer overlooking their history of uncollected debts and use that percentage. Whichever method you go for, make sure you track and adjust for it.

Corrections

Anyone can make a mistake or two while making initial accounting entries. These errors can throw off your books and create discrepancies in your financial reports, though, so you’ll need to learn how to identify and correct them. Let’s break it down.

First, you have to keep your finger on the pulse with regular checks on your accounting entries. There are several ways you might spot an error. You might see inconsistencies between your bank statements and your records, an imbalance in your trial balance, or odd-looking figures in your financial reports.

Here are some common mistakes you might come across that require correction entries:

1. Duplicate entries: One of the most common mistakes in accounting is making duplicate entries. Check to make sure you haven’t entered the same transaction twice.
2. Data entry errors: These mistakes can range from entering the wrong amounts and dates to misclassifying entries.
3. Omitting entries: This happens when you forget to record a transaction. It’s important to record all the ins and outs consistently to keep your books balanced.

Once you notice a discrepancy, do something about it right away. Here’s how:

1. Reverse entries: For entries posted in the wrong account, first remove from the incorrect account and then post to the right one.
2. Adjusting entries: To correct errors like duplicate entries or omitted entries, make an adjusting entry. If it’s a duplicated entry, remove it. If it’s an omitted entry, add it.
3. Re-calculation: If you made a math error or typo, recalculate and double check until it comes right.

Conclusion

We’ve learned about the importance of adjusting entries in keeping your financial records accurate in keeping your small business running smoothly. These entries help align your balance sheet and income statements and keep everything in check, and now that you know exactly what they are, you can use them effectively in your business.

Next, check out our articles on understanding prepaid expenses, understanding owner’s equity and modified cash basis accounting.

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Author: Julia Kelly

Co-founder at Rigits

I write about how small business owners can better understand and utilize their financials for growth.

Julia Kelly