What are adjusting journal entries?
Adjusting journal entries are important to understand for college accounting courses, the FAR section of the CPA exam, the AUD section of the CPA exam, and just corporate accounting in general!
Overview of Adjusting Journal Entries:
When preparing financial statements in accordance with United States Generally Accepted Accounting Principles (GAAP), adjusting journal entries (“AJE’s”) may need to be recorded at the end of period to properly state a company’s financial statements. Adjusting entries are used to “adjust” the company’s trial balance so that the trial balance accounts are accurate and can be used to prepare the financial statements.
The visual below is our “mental map” for determining how we should go about determining what adjusting journal entries a company should record.
The main reason an adjusting journal entry would be required is to properly match revenues with expenses under the matching principle. However, there could be other reasons like adjusting the general ledger to reconcile with the subledger.
Timing and procedures:
As part of the monthly or annual close process for a company, the accounting team would go through all types of accounts (accruals, deferrals, estimates, etc.) and determine if the balance needs to be adjusted. Every single trial balance account should be checked to determine if the balance is properly stated in the general ledger. It is important that the general ledger balances are accurate, as the general ledger is utilized to create the trial balance and eventual financial statements. These adjusting entries that are recorded at the end of a period may reverse in subsequent periods when the cash inflow/outflow occurs.
Preparing the Adjusted Trial Balance:
We learned what an adjusting journal entry (“AJE”) is, but how does it fit into the preparing the final adjusted trial balance that will be utilized to create the company’s financial statements. We will always start with the unadjusted trial balance, record any adjusting journal entries, and that will give us our adjusted trial balance. The process is the same as taking a broken car, adjusting it, and getting to a final working car!
How to prepare adjusting journal entries?
The list goes on for the types of adjusting entries that companies would record, or you could see on the CPA exam or would need to record for a real company. It is extremely important to focus on the big picture and not try and memorize the examples below. You will need to use your own intuition to evaluate a business event and determine what the proper adjusting journal entry would be.
Accounts receivable (gross):
A company often must adjust their gross accounts receivable balance at period-end to record revenue and the associated receivable for goods that were shipped to a customer on the last day of the year. Then, when the customer remits payment in the subsequent year, the receivable is removed as cash has been collected from the customer.
Allowance for bad debt:
A company maintains an allowance for bad debt reserve for any gross accounts receivable amounts that the company will not collect. A company will often calculate the required allowance for bad debt reserve at the of the period and an adjustment will be made to the current balance.
A company will often need to adjust their inventory balance at period-end due to the physical inventory count, in-transit inventory, reserve balances, etc.
In the example below, a company would perform a physical inventory count on the last day of the year to know the actual inventory in the warehouse. The inventory balance on the balance sheet would be adjusted to reflect the amount of inventory that was counted in the company’s warehouse. Since inventory increased, we would debit inventory and credit cost of goods sold (reduces the expense for the period).
If a company makes prepayments throughout the year, they may need to record an adjusting entry to defer a portion of the expense that relates to future periods for when the expense should be recognized.
A company will often need to record adjusting entries to record invoices that were received after period-end for services that relates to the current year financial statements. As we know, the expense should be recorded in the same period that services by the vendor or supplier were performed.
Unless a company pays its employees on the last day of the year, the company will typically need to record an adjusting entry for accrued payroll. The adjusting entry would capture payroll expense incurred for any employees who worked but have not yet received their paycheck. This often occurs when the period-end date falls on a weekend and employees do not receive their paychecks.
A company will record an income tax provision throughout the year, but at the end of the year, the company will typically hire a CPA or Tax firm to calculate the annual income tax provision. Depending on the final income tax provision, the company may need to record an adjustment to “true-up” the income tax provision in their financial records.
Record AJE’s to Adjusted Trial Balance:
Now that you have any understanding of the different types of adjusting journal entries, you need to understand how to record the adjusting entries into the final trial balance. As you can see below, we would have started with the unadjusted trial balance. We would then record the adjusting entries into the general ledger, and that would give us our adjusting or adjusted trial balance. The final adjusted trial balance is then used to create the financial statements.
If you would like to use the Excel workbook that was used to create the adjusted trial balance in this lecture, please navigate to the link below and you will be able to download the Excel file:
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