Definition and explanation:

Adjusting entries (also known as end of period adjustments) are journal entries that are made at the end of an
accounting period to adjust the accounts to accurately reflect the revenue and expenses of the current period. The
preparation of adjusting entries is the fourth step of accounting cycle and comes after the preparation of unadjusted trial
balance. Companies that prepare their financial statements in accordance with GAAP and PFRS usually prepare some
adjusting entries at the end of each accounting period. In this article, first we shall discuss the purpose of adjusting entries
and then explain the method of their preparation with the help of some examples.

The purpose of adjusting entries:

According to accrual concept of accounting, revenue is recognized in the period in which it is earned and
expenses are recognized in the period which they are incurred. Some business transactions affect the revenue and
expenses of more than one accounting period. For example, a service providing company may receive service fee from its
clients for more than one period or it may pay some of its expenses for many periods in advance. All revenue received or
all expenses paid in advance cannot be reported on the income statement of the current accounting period. They must be
assigned to the relevant accounting periods and must be reported on the relevant income statements.

The purpose of adjusting entries is to assign appropriate portion of revenue and expenses to the appropriate
accounting period. By making adjusting entries, a portion of revenue is assigned to the accounting period in which it is
earned and a portion of expenses is assigned to the accounting period in which it is incurred. It ensures that only the
relevant revenue and expenses are reported in the income statement of a particular accounting period and the financial
statements have been prepared correctly in accordance with accrual concept of accounting.

When adjusting entries are made?

Adjusting entries are usually made at the end of an accounting period. They can however be made at the end of a
quarter, a month or even at the end of a day depending on the accounting requirement and the nature of business carried
on by the company.

Types of adjusting entries:

Adjusting entries can be divided into the following four types.

(1). Adjusting entries that convert assets to expenses:

Some cash expenditures are made to obtain benefits for more than one accounting period. Examples of such
expenditures include advance payment of rent or insurance, purchase of office supplies, purchase of an office equipment
or any other fixed asset. These are recorded by debiting an appropriate asset (such as prepaid rent, prepaid insurance,
office supplies, office equipment etc.) and crediting cash account. This procedure is known as postponement or deferral of
expenses. An adjusting entry is made at the end of accounting period for converting an appropriate portion of the asset
into expense.

Example: On January 01, 2015, the Moon company paid $12,000 as advance rent of the head office building to Mr. X for
the first quarter of the of year. If the company makes adjusting entries on monthly basis, the relevant journal entries are
given below:

Entry on January 01 when the advance payment of rent is made:

Adjusting entry on January 31 to convert a portion of prepaid rent (an asset) to rent expense:
*12,000/4

As the advance rent is for a quarter (three months), the adjusting entry made on January 31 will also be made at the end
of the next two months.

(2). Adjusting entries that convert liabilities to revenue:

Sometime companies collect cash for which the goods or services are to be provided in some future period. Such receipt
of cash is recorded by debiting cash and crediting a liability account known as unearned revenue. This procedure is
known as postponement or deferral of revenue. At the end of accounting period the unearned revenue is converted into
earned revenue by making an adjusting entry for the value of goods or services provided during the period.

Example: The Moon company receives $180,000 cash from Mr. Y (a client of the company) on January 01, 2015. At the
end of January, the total value of the services provided to Mr. Y is $15,000. If accounts are adjusted at the end of each
month, the relevant journal entries are given below:

Entry on January 01 when advance payment is received:

Adjusting entry on January 31 to convert a portion of unearned revenue (a liability) to earned revenue:

(3). Adjusting entries for accruing unpaid expenses:

Unpaid expenses are expenses which are incurred but no cash payment is made during the period. Such expenses are
recorded by making an adjusting entry at the end of accounting period. It is known as accruing the unpaid expenses.

Example: The Moon company pays salary to its employees on fifth day of every month. The total salary payable for the
month of January is $8,500. If Moon company makes adjusting entries at the end of each month, it will record the
following adjusting entry on January 31:

Adjusting entry on January 31:

 (4). Adjusting entries for accruing uncollected revenue:

Uncollected revenue is the revenue that is earned but not collected during the period. Such revenue is recorded by
making an adjusting entry at the end of accounting period. It is known as accruing the uncollected revenue.

Example: The Moon company provides services valuing $34,000 to Mr. Z during the month of December. Mr. Z will be
billed next year. The company will record this accrued revenue by making the following adjusting entry:

Adjusting entry on January 31:

After preparing all necessary adjusting entries, they are either posted to the ledger accounts or directly added to the
unadjusted trial balance for the purpose of preparing adjusted trial balance of the company. Click on the next link below to
understand how an adjusted trial balance is prepared.

(5) Adjusting Entry for Depreciation Expense

When a fixed asset is acquired by a company, it is recorded at cost (generally, cost is equal to the purchase price of the
asset). This cost is recognized as an asset and not expense. The cost is to be allocated as expense to the periods in
which the asset is used. This is done by recording depreciation expense.

There are two types of depreciation – physical and functional depreciation.

Physical depreciation results from wear and tear due to frequent use and/or exposure to elements like rain, sun and wind.

Functional or economic depreciation happens when an asset becomes inadequate for its purpose or becomes obsolete.
In this case, the asset decreases in value even without any physical deterioration.

Understanding the Concept of Depreciation

There are several methods in depreciating fixed assets. The most common and simplest is the straight-line depreciation
method.

Under the straight line method, the cost of the fixed asset is distributed evenly over the life of the asset.

For example, ABC Company acquired a delivery van for $40,000 at the beginning of 2012. Assume that the van can be
used for 5 years. The entire amount of $40,000 shall be distributed over five years, hence a depreciation expense of
$8,000 each year.
Straight-line depreciation expense is computed using this formula:

Depreciable Cost – Residual Value

Estimated Useful Life

Depreciable Cost: Historical or un-depreciated cost of the fixed asset

Residual Value or Scrap Value: Estimated value of the fixed asset at the end of its useful life
Useful Life: Amount of time the fixed asset can be used (in months or years)

In the above example, there is no residual value. Depreciation expense is computed as:

= ($40,000 – $0 )/ 5 years
= $8,000 / year

With Residual Value

What if the delivery van has an estimated residual value of $10,000? The depreciation expense then would be computed
as:

= ($40,000 – $10,000) / 5 years

= $6,000 / year

How to Record Depreciation Expense

Depreciation is recorded by debiting Depreciation Expense and crediting Accumulated Depreciation. This is recorded at
the end of the period (usually, at the end of every month, quarter, or year).

The entry to record the $6,000 depreciation every year would be:

3
Dec Depreciation Expense 6,000.00  
1
    Accumulated Depreciation   6,000.00

Depreciation Expense: An expense account; hence, it is presented in the income statement. It is measured from period to
period. In the illustration above, the depreciation expense is $6,000 for 2012, $6,000 for 2013, $6,000 for 2014, etc.

Accumulated Depreciation: A balance sheet account that represents the accumulated balance of depreciation. It is
continually measured; hence the accumulated depreciation balance is $6,000 at the end of 2012, $12,000 in 2013,
$18,000 in 2014, $24,000 in 2015, and $30,000 in 2016.

Accumulated depreciation is a contra-asset account. It is presented in the balance sheet as a deduction to the related
fixed asset. Here's a table illustrating the computation of the carrying value of the delivery van.
   2012 2013 2014 2015 2016
$40,00
Delivery Van - Historical Cost $40,000 $40,000 $40,000 $40,000
0
Less: Accumulated Depreciation 6,000 12,000 18,000 24,000 30,000
$28,00
Delivery Van - Carrying Value $34,000 $22,000 $16,000 $10,000
0

Notice that at the end of the useful life of the asset, the carrying value is equal to the residual value.

Depreciation for Acquisitions Made Within the Period

The delivery van in the example above has been acquired at the beginning of 2012, i.e. January. Therefore, it is easy to
calculate for the annual straight-line depreciation. But what if the delivery van was acquired on April 1, 2012?

In this case we cannot apply the entire annual depreciation in the year 2012 because the van has been used only for 9
months (April to December). We need to prorate.

For 2012, the depreciation expense would be: $6,000 x 9/12 = $4,500.

Years 2013 to 2016 will have $6,000 annual depreciation expense.

In 2017, the van will be used for 3 months only (January to March) since it has a useful life of 5 years (i.e. April 1, 2012 to
March 31, 2017).

The depreciation expense for 2017 would be: $6,000 x 3/12 = $1,500, and thus completing the accumulated depreciation
of $30,000.

2012 (April to December) $ 4,500

2013 (entire year) 6,000
2014 (entire year) 6,000
2015 (entire year) 6,000
2016 (entire year) 6,000
2017 (January to March) 1,500
Total for 5 years $ 30,000

(6) Adjusting Entry for Bad Debts Expense

Companies provide services or sell goods for cash or on credit. Allowing credit tends to encourage more sales. However,
businesses that allow credit are faced with the risk that their receivables may not be collected.

Accounts receivable should be presented in the balance sheet at net realizable value, i.e. the most probable amount that
the company will be able to collect.

Net realizable value for accounts receivable is computed like this:

Accounts Receivable (Gross Amount) $100,000

Less: Allowance for Bad Debts 3,000
Accounts Receivable (Net Realizable
$ 97,000
Value)

Allowance for Bad Debts (also often called Allowance for Doubtful Accounts) represents the estimated portion of the
Accounts Receivable that the company will not be able to collect.

Take note that this amount is an estimate. There are several methods in estimating doubtful accounts.The estimates are
often based on the company's past experiences.

To recognize doubtful accounts or bad debts, an adjusting entry must be made at the end of the period. The adjusting
entry for bad debts looks like this:
 3
Dec Bad Debts Expense xxx.xx  
1
    Allowance for Bad Debts   xxx.xx

Bad Debts Expense a.k.a. Doubtful Accounts Expense: An expense account; hence, it is presented in the income
statement. It represents the estimated uncollectible amount for credit sales/revenues made during the period.

Allowance for Bad Debts a.k.a. Allowance for Doubtful Accounts: A balance sheet account that represents the total
estimated amount that the company will not be able to collect from its total Accounts Receivable.

What is the difference between Bad Debts Expense and Allowance for Bad Debts?

Bad Debts Expense is an income statement account while the latter is a balance sheet account. Bad Debts Expense
represents the uncollectible amount for credit sales made during the period. Allowance for Bad Debts, on the other hand,
is the uncollectible portion of the entire Accounts Receivable.

You can also use Doubtful Accounts Expense and Allowance for Doubtful Accounts in lieu of Bad Debts Expense and
Allowance for Bad Debts. However, it is a good practice to use a uniform pair. Some say that Bad Debts have a higher
degree of uncollectibility that Doubtful Accounts. In actual practice, however, the distinction is not really significant.

Here's an Example
Gray Electronic Repair Services estimates that $100.00 of its credit revenue for the period will not be collected. The entry
at the end of the period would be:

3
Dec Bad Debts Expense 100.00  
1
    Allowance for Bad Debts   100.00

Again, you may use Doubtful Accounts. Just be sure to use a logical (and uniform) pair every time. For example:

3
Dec Doubtful Accounts Expense 100.00  
1
Allowance for Doubtful
      100.00
Accounts

If the company's Accounts Receivable amounts to $3,400 and its Allowance for Bad Debts is $100, then the Accounts
Receivable shall be presented in the balance sheet at $3,300 – the net realizable value.

Accounts Receivable (Gross Amount) $ 3,400

Less: Allowance for Bad Debts 100
Accounts Receivable - Net Realizable Value $ 3,300

(7) Correcting Entries – For Errors Made in the Journal

When an error is discovered in the accounting records, it should be corrected immediately to prevent the processing of
wrong data which results to unreliable financial statements.

A correcting entry is a journal entry whose purpose is to rectify the effect of an incorrect entry previously made.

To illustrate how to prepare correcting entries, here are some examples.

On December 5, 2016, Gray Electronic Repair Services paid $370 registration and licensing fees for the business.

The correct entry is:

Dec 5 Taxes and Licenses 370.00  

    Cash   370.00
Suppose the bookkeeper, for whatever reason, debited Transportation Expense instead of Taxes and Licenses.

The entry made was:

Dec 5 Transportation Expense 370.00  

    Cash   370.00

Upon analysis, the Transportation Expense is overstated (higher than in should be) because the bookkeeper recorded
transportation expense but it was not really a transportation expense.

Also, Taxes and Licenses is understated (lower than it should be). The amount should have been recorded but was not
recorded under this account.

To correct these errors, we should make an entry to offset the effects. Transportation Expense is overstated therefore we
should decrease it; Taxes and Licenses is understated therefore we should increase it.

The Cash account was credited in the entry made. Was the entry made to Cash correct? Look at the correct entry. Is it
proper to have Cash credited? Yes. Therefore, we have no problem with the Cash account.

Now, to increase Taxes and Licenses, we debit it. To decrease Transportation Expense, we credit it. Remember that to
increase/record an expense, we debit it; to decrease an expense, we credit it. The correcting entry would then be:

3
Dec Taxes and Licenses 370.00  
1
    Transportation Expense   370.00

Note: The correcting entry is dated when the error is discovered. In this case, we assumed that it was discovered and
corrected on December 31.

If an explanation or annotation is required, it would be something like: "To correct error made on taxes and licenses" or
"To record correction of error on entry made for taxes and licenses."

After making this entry, Transportation Expense will zero-out ($370 debit and $370 credit) and Taxes and Licenses will
now have a balance of $370.00, thus making our records correct.

Another Example
Let us assume the bookkeeper made another error.

On December 17, the company collected a receivable from a customer, $1,650.00. Suppose the bookkeeper recorded it
at $1,560.00 instead of $1,650.00. This was the entry made:

1
Dec Cash 1,560.00  
7
    Accounts Receivable   1,560.00

What is the correct entry? The entry should have been:

1
Dec Cash 1,650.00  
7
    Accounts Receivable   1,650.00

How will we correct this? Cash is understated because the accountant recorded $1,560 instead of $1,650. Accounts
Receivable is also overstated because it was reduced by $1,560 only but should have been reduced by $1,650. We
should then increase Cash and reduce Accounts Receivable by $90.

The correcting entry would be:

3
Dec Cash 90.00  
1
    Accounts Receivable   90.00
Another way of doing it (and an easier one) is to look at the entry made and correct entry. Upon analysis, you will see that
the amount debited to Cash is less that what should have been debited. The same goes for the amount credited to
Accounts Receivable. Cash should then be debited by $90 more and Accounts Receivable should be credited by $90
more.

Recap: Steps in Making Correcting Entries

The steps in preparing correcting entries may be summed up as follows:

Determine the entry made. – What was the erroneous/wrong entry made?
Determine the correct entry. – What entry should have been made?
Analyze #1 and #2 to come up with the correcting entry.
Steps 1 and 2 may be interchanged. Nonetheless, you need to know the entry made and the correct entry (should-be
entry) before you can come up with the correcting entry.