Introduction of Adjusting Entries

Introduction:

In accounting adjusting entries are journal entries usually made at the finish of an accounting period to allocate income and expenditure to the period in which they actually occurred. The revenue recognition principle is the basis of making adjusting entries that pertain to unearned and accrued revenues under accrual-basis accounting. They are sometimes called Balance Day adjustments because they are made on balance day.

Based on the matching principle of accrual accounting, revenues and associated costs are recognized in the same accounting period. However the actual funds may be received or paid at a different time.

Types of adjusting entries

Most adjusting entries could be classified this way:

	Prepayments (Deferral - cash paid or received before consumption)	Accrual - cash paid or received after consumption
Expenses	Prepaid expenses: for expenses paid in cash and recorded as assets before they are used	Accrued expenses: for expenses incurred but not yet paid in cash or recorded
Revenues	Unearned revenue: for revenues received in cash and recorded as liabilities before they are earned	Accrued revenues: for revenues earned but not yet recorded or received in cash

Prepayments:

Adjusting entries for prepayments are necessary to account for funds that has been received prior to delivery of goods or completion of services. When this funds is paid, it is first recorded in a prepaid expense asset account; the account is to be expended either with the passage of time (e.g. rent, insurance) or through use and consumption (e.g. supplies).

A company receiving the funds for benefits yet to be delivered will must record the amount in an unearned revenue liability account. Then, an adjusting entry to recognize the revenue is used as necessary.

 Example

Assume a journal publishing company charges an annual subscription fee of £12. The funds is paid up-front at the beginning of the subscription. The income, based on sales basis technique, is recognized on delivery. Therefore the preliminary reporting of the receipt of annual subscription fee is indicated as:

                        Debit  |  Credit
                        ----------------
Cash                     £12   |         
  Unearned Revenue             |   £12
                               |         

The adjusting entry reporting each month after the delivery is:

                        Debit  |  Credit
                        ----------------
Unearned Revenue           £1  |   
  Revenue                      |    £1   
                               |

The unearned revenue after the first month is therefore £11 and revenue reported in the income statement is £1.

Accrued revenues are revenues that have been recognized (that is, services have been performed or goods have been delivered), but their money payment have not yet been recorded or received. When the revenue is recognized, it is recorded as a receivable.

Accruals

A third classification of adjusting entry occurs where the exact amount of an expense cannot basically be determined. The depreciation of fixed assets, for example, is an expense which has to be estimated.

Accrued expenses have not yet been paid for, so they are recorded in a payable account. Expenses for interest, taxes, rent, & salaries are often accrued for reporting purposes.
Estimates
The entry for bad debt expense may even be classified as an estimate.