Let's revisit the accounting cycle. Notice that step five relates to adjusting journal entries.
So question. Why adjust account balances? Why do they need adjustment?
Adjusting entries are necessary because the unadjusted trial balance may not contain up to date
and complete data as you've learned when you studied the unadjusted trial balance. Adjusting
entries updat asset and libiliity accounts as well as revenue and expense accounts.
Without this adjustment our financial statements could mislead investors and creditors.
Finally, adjusting entries help ensure that the revenue recognition and matching principle are followed.
So let's look at an example: A company buys $500 of supplies during the month.
At the end of the month the unadjusted trial balance shows $500 for supplies
Is $500 the correct amount?
Isn't likely that the company has uses some of the supplies?
Yet no one wants to make a journal entry each time someone takes a pen or staples some papers.
That would be a horribly inefficient use of time.
Yet pens were used and papers were stapled and those things need to be accounted for.
So this is why accountants record adjusting journal entries at the end of the period.
Failure to record the adjusting journal entry,
to adjust the supplies account, would result in an overstatement of assets, meaning too much
money in assets and an understatement of expense - too little supplies expense
at the end of the accounting period.
Overstatement and understatement are two concepts students struggle with.
They definity require critical thinking about the transactions to figure it out.
So when we make adjusting entries there are two main types of sub-categories. One is deferrals
and the other is accruals.
One type of deferral is prepaid expenses.
This means that cash is paid before expense is incurred.
Some common examples of adjusting entries for prepaid expenses are prepaid rent, supplies and depreciation.
Another type of deferral is unearned revenue. This means a cash is received
before revenue is earned.
Some common examples of adjusting entries for unearned revenues are
unearned rent revenue, season ticket revenue, airline ticket revenue, like that. An example of an accrual is accrued revenues.
This means that cash is received after revenue is earned.
Some common examples of adjusting entries for accrued revenues are service revenue and interest revenue.
Another type of accrual is accrued expenses.
This means it cash is paid after the expense is incurred.
Companies tend to have a lot of accrued expenses as this is the most common type of adjusting entry.
Some common examples of adjusting entries for accrued expenses or salary expense and interest expense.
Finally, let's look at some characteristics of an adjusting entry and how they differ from a regular
journal entry made in the ordinary course of business.
The first is that there is no underlying business event that causes an adjusting entry to happen.
They happen most often because of the passage of time or that information isn't available in the period we need it.
They are recorded at the end of the accounting period.
So adjusting journal entries will be dated at the end of the month.
They will always include one income statement account and one balance sheet account.
Again this requires some critical thinking but you can usually figure out the accounts affected by an adjusting entry by remembering this.
And finally they will never ever, never ever, ever, ever include the cash account.
At some point you are going to be really tempted to use the cash account when doing an adjusting entry. Please don't, it is certainly wrong.
Now I will say that there is an exception to this and that is when we're doing adjusting entries from the bank reconciliation,
but that's not what happening in this context so don't use cash.
They are required every time a company prepares financial statements.
Look at the steps here. You can't do step seven, prepare financial statements, without first doing step five, journalize and post adjusting entries.