If you’re running a business, I’m sure you know by now just how crucial it is to keep accurate bookkeeping records, and that you need to record every transaction in your accounting software. But if you’re using the accrual basis of accounting, you’ll also need to take another step to get your books in compliance - you’ll also need to make adjusting entries. This is typically done just before generating financial reports, and ensures that you get a more accurate picture of your revenue and expenses, and consequently, of your overall financial health.
Why Make Adjusting Entries?
To understand why it’s necessary to make adjusting entries to your journals, let’s quickly review the difference between the two approaches to accounting: the cash basis and the accrual basis. In the cash method, transactions are recorded as they occur. In other words, expenses are booked when you pay a bill, and revenue is booked when you receive the payment. That’s great for keeping track of your bank account, but it leaves a gap in your financial picture. For example, if you’re a service provider, and your client prepays you for a one-year contract, your income will appear high for the first month of the contract, and then drop to zero for the next eleven months.
In contrast, with accrual accounting, expense and revenue is realized at the time when the expenses occur, or the revenue is earned, regardless of when the cash changes hands. So in the above example, the revenue for would be spread out evenly over the twelve months of the annual contract. Adjusting entries are basically what convert your cash flow records to fit the accrual method.
Types of Adjusting Entries
There are five broad categories under which most adjusting entries fall:
Accrued expenses - These are expenses that are accrued, although they haven’t been paid out yet. An example might be certain types of loans on which interest payments are made annually (but the interest is accruing all year). These generally appear as accounts payable liabilities.
Deferred expenses - These have been paid out, though you haven’t yet realized the income, for example, a service contract for which you pay a year in advance. These adjusting entries will appear as assets on your balance sheet.
Accrued revenues - When you’ve earned the revenue, but haven’t received it yet, these will appear as accounts receivable (which are assets).
Deferred revenues - In my example above (the contract you’ve been prepaid for), you’ll have to make an adjusting entry as a liability.
Non-cash transactions - These are essentially just accounting entries, in which no cash actually changes hands, like depreciation or amortization.
When are adjusting entries made?
This will vary somewhat according to the needs of your business. Generally speaking, it’s part of the process of closing out a period of bookkeeping, which could be monthly, quarterly, or annually. For the most part, you’ll want to make adjusting entries before you run financial statements, so that you get a more complete and realistic view of your company’s financial profile.