Adjusting Journal Entry

Definition

An Adjusting Journal Entry is a financial transaction record and a type of accounting adjustment in a company’s general ledger, made at the end of an accounting period. Its purpose is to bring the company’s financial statements into compliance with the accrual accounting method. This entry can include adjustments to business expenses, revenues, assets or liabilities and is often used to record depreciation, allowances for doubtful accounts, or adjustments related to prepaid expenses and accrued income.

Phonetic

The phonetic transcription of “Adjusting Journal Entry” is: /əˈdʒʌstɪŋ ˈdʒɝːnəl ˈɛntri/

Key Takeaways

1. Accuracy in Financial Statements: Adjusting Journal Entries (AJEs) are essential for maintaining the accuracy of a company’s financial statements. They ensure that the revenue recognition and expense recognition principles are adhered to, providing a true representation of a company’s financial condition.
2. Periodical Adjustments: These entries are typically made at the end of an accounting period (monthly, quarterly, or yearly) to match revenues and expenses to the period in which they actually occurred. It includes accrued, deferred, and estimated amounts.
3. Essential to Account Reconciliation: AJEs are critical in reconciling account differences found during the financial audit. They can help in resolving discrepancies, preventing financial errors, and guaranteeing compliance with the relevant accounting standards.

Importance

Adjusting Journal Entry is a critical concept in business and finance as it enables the correct reflection of financial transactions for a specific accounting period. These entries, typically made at the end of an accounting period, aid in achieving matching accuracy between revenues and expenses and ensure that the financial statements (Income Statement, Balance Sheet, and Cash Flow Statement) provide an accurate and fair view of the company’s financial performance and position. Without these adjustments, the financial reports might be misleading, with inconsistencies in income recognition and asset and liability valuation. Thus, Adjusting Journal Entries play an essential role in maintaining compliance, facilitating financial analysis, decision making, and maintaining transparency with stakeholders.

Explanation

The primary purpose of an Adjusting Journal Entry (AJE) in finance and business is to ensure that the financial statements reflect an accurate and updated view of a company’s financial situation. These adjustments are typically made at the end of an accounting period, like monthly, quarterly, or yearly, to align the company’s financials with the accrual accounting method. This allows a company to accurately gauge its financial position by matching its income and expenses in the correct period. For instance, if a company recognizes revenue in a future period or incurs an expense that hasn’t been recorded, AJEs provide a mechanism to account for such transactions in the correct periods.Moreover, an Adjusting Journal Entry can be utilized to rectify any anomalies in the accounting books resulting from flawed entries or to account for prepayments and accruals. For instance, if business expenses have been prepaid for future accounting periods, an AJE can be used to allocate such expenses to the right periods, leading to an appropriate illustration of the company’s expenses for each period. Similarly, if revenues or expenses accrue over time and haven’t been recorded, AJEs comprehensively ensure their reflection in the financial statements. By aligning income and expenses with the right periods, AJEs play an instrumental role in providing a true picture of a company’s financial state, aiding strategic and operational decision-making.

Examples

1. Depreciation Expense: Let’s say a business purchased an expensive piece of machinery that’s expected to last and be used for 5 years. Rather than expensing the entire cost up front, the cost is spread out over the equipment’s lifespan. An adjusting journal entry is made at the end of each accounting period to account for the depreciation. Assume a company purchased a machine for $50,000 and it has a 5-year life. The depreciation expense will be $10,000 per year. At year’s end, the adjusting entry would be to debit (increase) the depreciation expense account by $10,000 and credit (increase) the accumulated depreciation account by $10,000.2. Accrued Wages: Assume a company has employees that get paid every two weeks, but the pay date falls after the closing of a monthly accounting period. The company still owes these employees for the week of work before the closing. To accurately report labor expense, the company would make an adjusting journal entry debiting the wage expense account and crediting the accrued wages payable account.3. Prepaid Rent: Let’s assume a company prepays its rent for the year at a cost of $120,000. That prepaid rent is initially recorded as an asset. But as each month passes an adjusting entry needs to be made to move the cost from an asset to an expense. Here, an adjusting journal entry would be made at the end of each month debiting (increasing) rent expense $10,000 (120,000/12) and crediting (decreasing) prepaid rent $10,000. This would reflect the amount of prepayment that has been used up or ‘expired’ for the month.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Accruals: These are revenues earned or expenses incurred which are not yet recorded.
• Deferrals: These are payments of cash which are to be listed on a later date.
• Depreciation: This accounts for the wear and tear on fixed assets such as equipment or buildings.
• Prepaid Expenses: These are expenses paid in advance and its value is consumed over time.
• Accrued Revenues: These are revenues that have been earned but have not yet been received in cash or recorded.

Sources for More Information

• Investopedia
• Accounting Coach
• Corporate Finance Institute
• The Balance Small Business