The main goal of any entrepreneurial activity is to make a profit. At the same time, an important function of accounting department is to determine and reflect in the financial statements the success or failure of the company in achieving this goal. To reflect the success of a company, accountants use the term “net profit”, which is defined as the difference between income and expenses: If expenses exceed income, then they talk about a net loss.
When determining net profit, it must be remembered that, in accordance with the concept of IFRS, it is mandatory to do the accounting of income and expenses on an accrual basis. Adjusting entries are journal entries made at the end of an accounting period to allocate income and expenditure to the period on which they actually occurred.
Types and Explanation
Adjusting entries are bookkeeping records that are used to bring income and expenses in line at the reporting date. They reflect the economic activity already carried out, but not taken into account in a necessary way, due to the fact that it was necessary for the bookkeeper to record the business activity in some way even though no cash has come in or out of the business or services/goods provided. There are several types of adjustment entries:
- Deferred expenses are expenses that an organization already paid and which are recorded as assets until the related economic benefits are used up. Deferred expenses decrease either over time or as they are used. Before the adjustment, assets are overvalued and costs are understated.
- Deferred revenue is income received for future periods, so it is reflected in liabilities until the money is earned. Deferred revenue is earned after the delivery of goods or services to customers. Before the adjustment, liabilities are overstated and revenues are understated.
- Accrued income is income earned but not received in monetary terms (or for which no invoices have been issued). Accrued income can arise either after a certain period of time or in connection with the provision of services for which no invoices have been issued or funds have been received. Before the adjustment, both assets and income are understated.
- Accrued expenses are expenses incurred but not paid (or not invoiced). In the case of accrued expenses, before the adjustment, both liabilities and expenses are understated.
- Depreciation expense represents how much of an asset’s value has been used up. Otherwise, the true value of the company’s assets is overstated.
- Doubtful accounts represents the estimates of uncollectible amount for credit sales or revenue. In the case of bad debts, the money a business expects to receive in the future is overstated.
After reflecting in the journal all adjusting postings and transferring data from the journal to the general ledger, an adjusted trial balance is compiled, which reflects the balances for all accounts at the end of the reporting period.
On August 1, 2020, Green Leaf Co. received advance payment from a client amounting to $6,600 for 6 months of consulting services. At the end of the calendar year, the Green Leaf Co. would need to make an adjusting entry to reflect the portion of the money received that it has already earned.
To calculate how much it has already earned you would need to do the following calculation: $6,600 x 5 months / 6 months. At the end of the calendar year, it has received $5,500 for the consulting services and has yet to perform one more month of services to earn the remaining prepaid revenue. Below, you can see how it would be recorded in the accounting books.
Unearned Consulting Revenue
Let’s look at another example. For the month of December 2020, Pearl Smile Company had used a total of $780 worth of electricity and water. The company received the bill on January 3rd, 2021.
As you can see, this adjusting journal entry reflects an expense that Pearl Smile has incurred for that month. However, instead of crediting a cash account like you would do when paying for something, we are crediting a liability account. This amount will stay on the books under liabilities until it actually pays for the utilities.