Adjusting entries also known as adjusting journal entries are made at the end of each financial year before preparing financial statements. In the previous discussion, Mostly adjusting entries are based on matching principle where accountants match revenue and expense in their occurrence period. We have discussed accounting cycle steps and illustrated the accounting system from evaluation of accounting transactions through preparation of unadjusted Trial Balance. We have also learnt that financial statements prepared on the basis of Unadjusted Trial Balance. These are actually ‘Draft’ in nature which are to be influenced by recording of certain adjusting entries which are inserted in books of accounts after obtaining additional and final information.
When preparing financial statements with the help of Unadjusted Trial Balance the accurate results of business concerns cannot be ascertained due to the following reasons:
- Some expenses may still be payable at the end of accounting period and despite incurring the same no entry whatsoever may have been recorded. Examples include salaries for the last month which are required to be inserted in the books of accounts because the same in needed to be reflected in the Financial Statements;
- Some expenses paid during the accounting period may have not yet fully expired. For instance, insurance expenses are usually paid as lump sum for a certain period (say one year) without taking the accounting period into account. Such sort of payments are required to be meticulously evaluated and portion attributable to the current period should be charged against income for the period, while the remaining portion should be stated as ‘current assets’ in the balance sheet.
- In the same way as above in (2), some portion of income statement may relate to the next accounting period. Therefore, the portion related to the upcoming period should be shown as ‘unearned income’ instead disclosing the same as income in Profit and Loss account.
- Deprecation on fixed assets are usually charged at the end of the period
Therefore, in view of above discussino, it is necessary to bring these items of income and expenses accrued or unexpired into the books of accounts before preparing the Final Financial Statements.
The recording of adjusting entries is called ‘adjustments’ or adjustments in financial statements. These adjusting entries sometimes also called ‘end term adjustments’.
Following are the common and usual adjustments made at the end of accounting period are
- Outstanding expenses
- Prepared expenses
- Accrued income
- Unearned income
- Depreciation on fixed assets
- Interest on capital/drawings
Adjusting Entries Examples and Explanation
Let’s briefly discuss these adjusting entries for more understanding.
At the end of accounting period there may be some expenses which have been incurred and become due for payment, but still no payment and entry are made in the books of accounts. The examples of such expenses are salaries payable, wages payable, interest accrued on borrowings made etc. The following general entry is made for such expenses:
Prepaid expenses are those expenses which are paid but not yet expired. In more simple words we can say that prepaid expenses are those expenses which are paid in advance and the relevant period of such advance payments is not yet concluded or arrived. Examples include prepared insurance, prepaid advertising expenses, prepaid rent etc. when an expense or portion thereof is prepaid, the following journal entry is recoded.
At the end of accounting period, there may some sort of income or portion thereof is still receivable which means the business has earned that income but not yet received and recorded. Following entry is made:
It may also happen that income received during the year may still be un-earned at the end of current accounting period. This means that the purpose for which this amount has been received has not yet been fully completed. When an income or portion thereof is unearned, the following adjusting entry is recorded.
Depreciation on Fixed Assets
Any fixed asset which procured and used, its value decreases with the passage of time due to the usage and market trends as well. This gradual decrease in the value of fixed assets is called depreciation. To the record the deprecation at the end of the accounting period, the following adjustment is made:
Interest on Capital and Drawings
In some enterprises, interest on capital invested by the owner or partners is calculated and charged as expense against the income for the period. This adjusting entry is usually made at the end of the period when all business expenses are accounted for and charged against the income. Adjusting entry is:
Similarly, interest on drawings can also be charged against owner partner’s capital. When interest on drawings is calculated, the following adjusting entry is recorded: