Adjusting entries are made to record the accruals for the period. By passing the adjustment entries, the expenses/revenue which relate to the period but are not paid are recorded. This is done while preparing the Financial Statements. Both USGAAP and IFRS require certain adjusting entries while making the financial statements.
As per the Accrual concept of accounting, revenue/expense need to be recognised in the year when it is earned/incurred. The flow of money does not necessarily reflect income/expense for the period. For example, if there are annual fees paid for usage of a particular asset, the expense should be recognised during the 12 months, and it would not be correct to record it entirely in the month when payment was made. This is done so that companies do not use cash flows to overstate or understate their profits for the period.
For example, if an organisation wants a loan, it would like to overstate its profit as then the financial institution would be happy to lend. In order to overstate their profits, they could collect certain receivables in advance and could defer the payment of expenses.
To avoid such malpractices, the accrual system of accounting is widely used. Under this method, the expense and revenue do not depend on the cash flow but on the period for which they were earned/incurred. If we go with the earlier example itself, the advance payment received by the company would not be considered as current period income as it is not related to goods sold during the period and therefore these payments would be capitalised. Similarly, the expenses though were not paid during the period, since they relate to the period, they would be expensed out, and liability would be created. This will help to reflect the correct profit for the period and the outside parties using this data can rely on it and take decisions accordingly. These entries could be recorded in the books through Ledger entries, or they could be directly adjusted in the Trial Balance.
There are different types of adjusting entries made:
- Capitalising expenses - The expenses which are incurred for more than the period for which accounts are prepared needs to be reduced from the expense and added to the Balance sheet in the form of prepaid assets. It also includes any expenses the benefit of which can be reaped for the coming periods. For example, Fixed Assets have a long life and can be used for many years. It would not be correct accounting to expense out the payments made towards these fixed assets in the year of payment. These expenses are therefore capitalised and expense out throughout the life of the asset in the form of depreciation.
- Deferral of Revenue - Sometimes organisations collect cash in advance for sales to be made in future. This cash received is not part of the revenue for the current period as the services would only be provided on a future date. Therefore, such money collected is credited to a liability account called the Unearned Revenue account. Once the services are provided with the liability account is reversed and charged to revenue.
- Accrual of Unpaid expenses - There are various expenses which are paid on an accrual basis, i.e. these are paid after the services/goods are provided. Therefore, though the expense forms a part of the period since those are not paid it will not appear as part of the accounts unless an accounting entry is passed for the same. For example, Purchase of goods made the payment of which would be done in the future. That amount would debit this type of entry with creating a liability(Payable account) and the expenses
- Accrual of uncollected revenue - Similar to the accrual of expenses, it is also necessary to record all the revenue that forms part of the period even if the amount for the same is not yet collected. The examples of such entries are interest accruals. Also though the interest would be paid say for example annually, while closing the monthly books it is essential to accrue the interest for the month.
There are a lot of entities/parties that use the financial statements of companies. It is necessary to ensure that the beneficiaries of such statements are getting correct and accurate data so that they can take informed decisions. For example, an investor would depend on the Financial Statements to make an investing decision. If the profits are overstated, the investor may inappropriately invest more into the company which could probably lead to his or her loss of money. Similarly, the creditors to the organisation may provide them credit based on their profitability which may lead to bad debts and loss to them if the statements are not correctly presented. Adjusting entries, therefore, form an integral part of accounting.
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When we talk about adjusting entries in accountancy, it is an essential part as it determines the total income and expenditure of an organisation in the particular accounting period. Companies and business firms usually perform such kind of work at the end of the very last day of the financial year in which they record all the smallest of the entries that have not been documented or left in between.
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