Adjusting Journal Entries in Accrual Accounting

The preceding discussion of adjustments has been presented in great detail because it is imperative to grasp the underlying income measurement principles. Perhaps the single most important element law firm bookkeeping of accounting judgment is to develop an appreciation for the correct measurement of revenues and expenses. These processes can be fairly straightforward, as in the preceding illustrations.

• Prepaid expenses include goods or services that a company has paid for but not utilized yet.
• Accruals are expenses and revenues that gradually accumulate throughout an accounting period.
• At the end of the accounting period, only expenses that are incurred in the current period are booked while the remaining is recorded under prepaid expenses.
• In essence, the intent is to use adjusting entries to produce more accurate financial statements.
• An adjusting entry for depreciation expense is a journal entry made at the end of a period to reflect the expense in the income statement and the decrease in value of the fixed asset on the balance sheet.

However, it is also reduced each year by the ever-growing accumulated depreciation. The asset cost minus accumulated depreciation is known as the book value (or “net book value”) of the asset. For example, at December 31, 20X2, the net book value of the truck is $50,000, consisting of $150,000 cost less $100,000 of accumulated depreciation. By the end of the asset’s life, its cost has been fully depreciated and its net book value has been reduced to zero. Customarily the asset could then be removed from the accounts, presuming it is then fully used up and retired.

Prepaid Expenses

The methodology states that the expenses are matched with the revenues in the period in which they are incurred and not when the cash exchanges hands. Adjusting journal entries can also refer to financial reporting that corrects a mistake made previously in the accounting period. This is posted to the Interest Receivable T-account on the debit side (left side).

If the reversing entry had not been made, the Payroll Expense account would need to be adjusted, because it would be overstated by $1500. A reclassification is a correction entry used to correct a mis-classification or to change the classification of an entry. This might be necessary if an entry is made without complete information. For instance, the company might purchase a building and land for a single price.

Why Are Adjusting Journal Entries Important?

Also, the income statement accounts that may require an adjusting entry include depreciation expense, interest expense, insurance expense, and revenue. To begin the process, an unadjusted trial balance must be prepared. This unadjusted trial balance will give you all of the debit and credit balances in the revenue, expense, asset, liability, and equity accounts.

This is posted to the Service Revenue T-account on the credit side (right side). You will notice there is already a credit balance in this account from other revenue transactions in January. The $600 is added to the previous $9,500 balance in the account to get a new final credit balance of $10,100. Depreciation expense has two main effects on an organization’s financial statements. First, it is treated as an expense in the income statement, which reduces taxable income.

What are adjusting entries?

After the books are closed for the year the reversing entry is made, dated the first day of the new year. The Payroll Expense account carries a credit balance, which is not the normal balance for an expense account, and would normally indicate an error in posting or classifying the transaction. In practice, accountants may find errors while preparing adjusting entries. To save time they will write the journal entries at the same time, but students should be clearly aware of the difference between the two, and the need to keep them separate in our minds. All companies must make adjusting entries at the end of a year, before preparing their annual financial statements.

Suppose in February you hire a contract worker to help you out with your tote bags. In February, you make $1,200 worth for a client, then invoice them. Adjusting entries will play different roles in your life depending on which type of bookkeeping system you have in place.

The first is the accrual entry, which is used to record a revenue or expense that has not yet been recorded through a standard accounting transaction. The second is the deferral entry, which is used to defer a revenue or expense that has been recorded, but which has not yet been earned or used. The final type is the estimate, which is used to estimate the amount of a reserve, such as the allowance for doubtful accounts or the inventory obsolescence reserve. If you receive payment in advance for services that have not yet been performed, the payment must be posted as deferred revenue, with a monthly journal entry necessary until the prepaid revenue has been earned. When expenses are prepaid, a debit asset account is created together with the cash payment.