Step 5 of the accounting process involves the preparation of adjusting entries. Adjusting entries are made to update the accounts and bring them to their correct balances.
The preparation of adjusting entries is an application of the accrual concept of accounting and the matching principle.
The accrual concept states that income is recognized when earned regardless of when collected and expenses are recognized when incurred regardless of when paid.
Also, the matching principle aims to align expenses with revenues. Expenses should be recognized in the period when the revenues earned with them are recognized.
Why Are Adjusting Entries Necessary
The purpose of adjusting entries is to update the accounts to conform with the accrual concept. At the end of the accounting period, some income and expenses may have not been recorded, taken up or updated; hence, there is a need to update the accounts.
If adjusting entries are not prepared, some income, expense, asset, and liability accounts may not reflect their true values when reported in the financial statements. For this reason, adjusting entries are necessary.
Types of Adjusting Entries
Generally, there are 4 types of adjusting entries. Adjusting entries are prepared for the following:
- Accrued Income – income earned but not yet received
- Accrued Expense – expenses incurred but not yet paid
- Deferred Income – income received but not yet earned
- Prepaid Expense – expenses paid but not yet paid
Also, adjusting entries are made for:
- Doubtful Accounts or Bad Debts, and other allowances
Composition of an Adjusting Entry
Adjusting entries affect at least one nominal account and one real account.
A nominal account is an account whose balance is measured from period to period. Nominal accounts include all accounts in the Income Statement, plus owner's withdrawal. They are also called temporary accounts and income statement accounts.
Examples of nominal accounts are: Service Revenue, Salaries Expense, Rent Expense, Utilities Expense, Mr. Gray Drawing, etc.
A real account has a balance that is measured cumulatively, rather than from period to period. Real accounts include all accounts in the balance sheet. They are also called permanent accounts and balance sheet accounts.
Real accounts include: Cash, Accounts Receivable, Rent Receivable, Accounts Payable, Mr. Gray Capital, and others.
All adjusting entries include at least a nominal account and a real account.
Note: "Adjusting entries" refer to the 6 entries mentioned above. However, in some branches of accounting (especially auditing), the term adjusting entries could refer to any entry that aims to adjust incorrect account balances.
As a result, there is little distinction between "adjusting entries" and "correcting entries" today. In the traditional sense, however, adjusting entries are those made at the end of the period to take up accruals, deferrals, prepayments, depreciation and allowances.
In the next lessons, we will illustrate how to prepare adjusting entries for each type and provide examples as we go.