What are Adjustment Entries?

At the end of every accounting period Adjustment Entries are made in order to adjust the accounts precisely replicate the expenses and revenue of the current period. It is also known as end of period adjustment. It can also be referred as financial reporting that corrects the errors made previously in the accounting period. The basic characteristics of every adjustment entry is that it affects at least one real account and one nominal account.     

Need for Adjustments

The resolution of Adjustment Entries is to change cash transaction into Accrual Accounting. Accrual accounting is one of the two accounting method where the other is cash accounting. The accounting method where revenue or expenses are logged when a transaction occurs rather than when payment is made or received is known as Accrual Accounting. It follows the matching principle, which defines those expenses and revenue should be documented in the same period. For example, assume a building company begins building at one period but does not invoice the customer until the work is completed in six months. Now the building company needs to do an adjustment entry at end of every month to recognize revenue for 1/6 of the amount that will be invoiced at six-month point. Adjustment entries includes both balance sheet accounts and income statement accounts. Due to this reason, adjusting entries are necessary.      

Important Rules for Adjusting Entries 

There are three rules for Adjustment entries,

• It never contains cash. It is done to make the accounting records accurately imitate the matching principle
• There will only be one debit and one credit in the adjustment entry.
• It always has one income statement account (expense or revenue) and one balance sheet account (liability or asset or equity).

Composition of Adjusting Entries   

Adjustment entry always affects at least one real account and one nominal account.        

Nominal Account

It is an account used to record income, gains, expenditure, and losses in a particular accounting period of time. It includes all accounts in the income statement, including owner’s withdrawal. Nominal account is also known as income statement accounts or temporary accounts. Examples are salaries expense, drawings, rent expense, printing expense.   

Real Accounts

It has a balance which is measured cumulatively, rather than period to period. It includes all accounts relating to assets and liabilities. It does not close at year end and are carried forward. It includes all accounts in the balance sheet. They are also known as balance sheet accounts or permanent accounts. Examples are bank account, cash account, rent receivable, MR. X capital.   

How Accounting Adjustments Link to Financial Statements?   

 Accounting adjustments bring an assets and liabilities account balance to its correct amount. They also update related expense or revenue account. Every adjusting entry affects one or more nominal account or real accounts. An adjusting entry never affects cash.     

Categories of adjusting entries and their journal entries        

1. Accrued expenses    

It is quite common that every business enterprise has their unpaid expenses during their day-to-day business operations at the end of an accounting period.  

Accrued expense is an expense which occurs when the business has taken the benefit, but no cash payment is paid for that benefit. In the others word, we can say that an expense which is due but has not been paid. The entry to bring such expenses into account is:     

So, when this above adjustment entry is made a new account called accrued expense account is open, which will appear in the liabilities side of the balance sheet. In income statement the treatment of accrued expense is -The amount of accrued expenses is added to the total expense under a particular heading. 

2. Deferred expense or prepaid expenses   

Usually in every business, company pays several expenses of various items in advance in the day-to day business operations activities. It is done because the company will be benefitted not only in current accounting period but in the next accounting year also. This portion of expense is carried forward to the next year and is termed as deferred expense. The adjustments related to deferred expenses are made by passing the following entry:     

So, when the above adjustment entry is passed a new account called prepaid expense is open which is shown on the liabilities side of the balance sheet and in income statement the amount of prepaid expenses is deducted from the total of the particular expense. 

3. Accrued income   

When the company earned revenues from certain items of income such as interest on loan, rent etc. during the current accounting year but has not been actually received at the end of the same accounting year. Such incomes are called as accrued income. The adjusting entry for accrued income is:   

When the above entry is passed, the new account of accrued income is open which is shown on the asset side of the balance sheet and in income statement amount of accrued income will be added to the related income.

4. Unearned revenues or income received in advance   

When the company received income in advance in the current accounting period but the whole amount of it does not belong to the current period and certain portion of that income belongs to the next accounting period is known as unearned revenues. The adjustment entry for unearned revenues is   

When the above adjustment entry is passed a new account will be open which is shown as a liability side in the balance sheet. The effect of this entry is that the balance in the income account will be equal to the amount of income earned for the current accounting period.   

5. Depreciation 

 In simple words, Depreciation means decline in monetary value of an asset over time due to wear and tear and passage of time. Depreciation is a business expense that’s why it is shown in the debit side of the profit and loss account. The entry relating to this is:   

The effect of above entry is that the amount of depreciation is deducted from the concerned fixed asset (like machinery, plants, furniture) in the asset side of the balance sheet.    

Context and Applications

This topic is significant in the professional exams for both undergraduate and graduate courses, especially for 

• B.B.A 
• M.B.A