How to Make Adjusting Entries
If you own a small business, you know the value of having accurate accounting information. It helps you keep track of things like sales, expenses, and taxes. Good bookkeeping can also demonstrate the profitability of your business to investors.
There are two types of accounting methods. The cash-basis accounting system is better for very small businesses. It records cash as it comes in, regardless of when it's earned. If you're paid for an item on Jan. 3, for example, the money goes on your income statement account on that date.
The second form, accrual accounting, records income when it's earned. If your company makes a sale on Feb. 10 but the customer doesn't pay for it until March 1, for instance, it would still appear on your income statement on Feb. 10. Accrual accounting gives business owners and investors a better picture of a company's profitability. It's also considered to be one of the Generally Accepted Accounting Principles (GAAP) accepted by the Financial Accounting Standards Board (FASB).
Because you're recording income at a different time than when you receive it, accrual accounting requires you to make journal entries adjusting money from various accounts as it comes in. In this guide, we'll take a look at what adjusting entries you'll need to make for accrual accounting.
What Are Adjusting Entries?
Journal entries are records in your general ledger that track your company's income. Adjusting entries are just as they sound: journal entries that alter existing journal entries. These are typically made at the end of an accounting period, like the end of the month or year. They can affect how transactions show up on your income statement and balance sheet account.
For example, unearned revenue (the money you've received for tasks you haven't completed yet), is a liability on a balance sheet and doesn't show up on an income statement. An adjusting entry is made when the work is completed, changing that unearned revenue to earned income. Then, it becomes an asset on a balance sheet and shows up on an income statement as revenue.
Example of an Adjusting Entry
Let's say you're a construction contractor. Your team is about to build a $200,000 home in January. You require a deposit of $50,000 from the family before you start. Because you haven't earned the $50,000 yet, you record it as unearned revenue.
You make an adjusting entry after the completion of the project in July, changing that $50,000 from unearned revenue into revenue for July.
Why Are Adjusting Entries Needed?
You'll need to make an adjusting entry every time you want to change which account that income or an expense is recorded under in your general ledger.
You can also make adjusting entries to correct errors like switching revenue between debits and credits, but we'll only focus on the ones necessary for accrual accounting.
What Are the 5 Types of Adjusting Entries?
In the next few sections, we'll go over the five types of adjusting entries you'll need to make. These may seem straightforward but can be pretty complicated when you apply them to your entire business. If you're not an accountant by trade, it might be wise to get the help of a certified public accountant (CPA). Skynova also has accounting software that can help you handle your business's bookkeeping.
Sometimes, you'll perform services or deliver products one month and bill for them in another month. Accrued revenue is money you've done the work for (earned) but haven't received yet.
For example, let's say you're a freelance journalist. You finish and deliver an article for a magazine on April 15. You charge $500 for the article, but you won't invoice the magazine until May 1.
When you deliver the article, you'll make a journal entry debiting accrued revenue and crediting revenue.
When you bill for your service in May, you'll make an adjusting entry accruing the revenue to April and identifying it as money owed to your business (accounts receivable).
It's important to note that the revenue remains the same. All you're doing is accruing the revenue so it appears in April instead of May. When you receive the payment, you'll make one final entry crediting accounts receivable and debiting cash.
Accrued expenses are services or goods your company has received but has yet to pay for. The most common accrued expenses are workers' wages. If an employee works one month but won't be compensated until the next month, their pay must be accrued as a business expense.
Let's say you're a lawyer and pay a paralegal $1,500 biweekly. The paralegal will be paid on the first of March for work performed in February. You would debit wage expenses and credit wages payable.
When you actually pay your paralegal, you'll make an adjusting entry to show that you no longer owe the wages. In this entry, you'll debit wages payable and credit cash.
While payroll is the most common example of an accrued expense, there are a few other examples, such as:
- Utilities that won't be paid until the next month
- Worker bonuses
- Reimbursements for things like travel
When customers pay you for services or goods that you'll deliver in the future, you have deferred revenue. Deferrals (also known as unearned revenue) are common with many subscription services.
Let's say your company sells editing software on a subscription basis for a fee of $10 a month, and a client chooses to pay upfront for the entire year. When the $120 payment comes in on Jan. 1, you'll debit cash and credit deferred revenue.
At the end of each month (when you've earned that month's revenue), you'll make an adjusting entry debiting your deferred revenue by the monthly expense and crediting a revenue account.
You'll make these adjusting entries over the next 12 months until all your deferred revenue has become earned revenue.
Prepaid expenses are assets your business pays for first and then uses over the course of an accounting period. But how can an expense be an asset? Prepaid costs only go into an expense account when they're used up.
Let's say you teach martial arts and rent a space to hold classes. The rent expense is $2,000 a month, but you decide to pay $24,000 for the full year upfront. When you first make the payment, you'll debit prepaid expenses and credit cash.
At the end of every month, you'll make an adjusting entry debiting expenses and crediting prepaid expenses by the monthly cost of the gym ($2,000).
You'll make these entries for the next year until your prepaid expenses (assets) have been transferred to expenses (liabilities). You can also make prepayments for things like insurance expenses and office supplies. Having prepaid insurance and other prepaid expenses means there's less for you to remember every month.
When your business purchases an expensive piece of equipment, you'll want to depreciate it over the amount of time it will be of use. Accumulated depreciation means recording the expense of the item over time. The reason you record depreciation is so the expenses for your piece of equipment are recorded in the current period along with the revenue earned from it.
Let's say you're a mechanic and purchase a toolset for $11,000. You estimate that you'll be able to use the tools for 10 years (the useful life) and then sell them for $1,000 (the salvage value). The process for calculating the items' monthly depreciation expense is as follows:
- Subtract the salvage value from the asset's initial cost (to find the amount you can depreciate)
- Divide the depreciable amount by the asset's useful life (number of years)
- Divide the remaining amount by 12
|Accumulated Monthly Depreciation|
|=||[($11,000 - $1,000) / 10] / 12|
To record this, you'll make an adjusting journal entry every month debiting depreciation expenses and crediting accumulated depreciation.
In this example, you'll make these adjusting entries for 120 months until the full $11,000 has been accounted for.
Maintain Accurate Financial Statements Using Skynova
While cash-basis financial reporting records payments as they come in, accrual accounting records revenue as it's earned. Although accrual accounting is more complicated, it can tell a great deal about your company's month-to-month performance.
To keep accurate accounting records in accrual accounting, you'll have to make a series of adjusting journal entries to ensure revenue shows up in the same accounting cycle as its correlated expenses. By making precise adjusting journal entries, you can make sure that you have detailed accounting ledgers that will help you stay in compliance and evaluate your business's performance.
When you consider all your company's assets and liabilities, doing your own accrual accounting can get pretty convoluted. Skynova has the software products and business templates that can help you stay on top of money matters so you can focus on your business.
Notice to the Reader
This article is intended to be a guide for common adjusting journal entries. Your business's particular needs may differ. It's important for any business to seek the help of a professional accountant to verify the accuracy of its accounting records and ensure it stays in compliance with state and federal regulations.