For purposes of measuring income and preparing financial statements, the life of a business is divided into a series of accounting periods. This practice enables decision makers to compare the financial statements of successive periods and to identity significant trends.
But measuring net income for a relatively short accounting period—-such us a month or even a year—poses a problem because, as mentioned above, some business activities affect the revenue and expenses of multiple accounting periods. Therefore, adjusting entries are needed at the end of each accounting period to make certain that appropriate amounts of revenue and expense are reported in the company’s income statement.
For example, magazine publishers often sell two- or three-year subscriptions to their publications. At the end of each accounting period, these publishers make adjusting entries recognizing the portion of their advance receipts that have been earned during the current period. Most companies also purchase insurance policies that benefit more than one period. Therefore, an adjusting entry is needed to make certain that an appropriate portion of each policy’s total cost is reported in the income statement as insurance expense for the period. In short, adjusting entries are needed whenever transactions affect the revenue or expenses of more than one accounting period. These entries assign revenues to the period in which they are earned, and expenses to the periods in which related goods or services are used.
Adjusting entries are accounting journal entries that convert a company’s accounting records to the accrual basis of accounting. An adjusting journal entry is typically made just prior to issuing a company’s financial statements.
To demonstrate the need for an accounting adjusting entry let’s assume that a company borrowed money from its bank on December 1, 2005 and that the company’s accounting period ends on December 31. The bank loan specifies that the first interest payment on the loan will be due on March 1, 2006. This means that the company’s accounting records as of December 31 do not contain any payment to the bank for the interest the company incurred from December 1 through December 31. (Of course the loan is costing the company interest expense every day, but the actual payment for the interest will not occur until March 1.) For the company’s December income statement to accurately report the company’s profitability, it must include all of the company’s December expenses—not just the expenses that were paid. Similarly, for the company’s balance sheet on December 31 to be accurate, it must report a liability for the interest owed as of the balance sheet date. An adjusting entry is needed so that December’s interest expense is included on December’s income statement and the interest due as of December 31 is included on the December 31 balance sheet. The adjusting entry will debit Interest Expense and credit Interest Payable for the amount of interest from December 1 to December 31.
Another situation requiring an adjusting journal entry arises when an amount has already been recorded in the company’s accounting records, but the amount is for more than the current accounting period. To illustrate let’s assume that on December 1, 2005 the company paid its insurance agent $2,400 for insurance protection during the period of December 1, 2005 through May 31, 2006. The $2,400 transaction was recorded in the accounting records on December 1, but the amount represents six months of coverage and expense. By December 31, one month of the insurance coverage and cost have been used up or expired. Hence the income statement for December should report just one month of insurance cost of $400 ($2,400 divided by 6 months) in the account Insurance Expense. The balance sheet dated December 31 should report the cost of five months of the insurance coverage that has not yet been used up. (The cost not used up is referred to as the asset Prepaid Insurance. The cost that is used up is referred to as the expired cost Insurance Expense.) This means that the balance sheet dated December 31 should report five months of insurance cost or $2,000 ($400 per month times 5 months) in the asset account Prepaid Insurance. Since it is unlikely that the $2,400 transaction on December 1 was recorded this way, an adjusting entry will be needed at December 31, 2005 to get the income statement and balance sheet to report this accurately.
For now we want to highlight some important points. There are two scenarios where adjusting journal entries are needed before the financial statements are issued:
Nothing has been entered in the accounting records for certain expenses or revenues, but those expenses and/or revenues did occur and must be included in the current period’s income statement and balance sheet.
Something has already been entered in the accounting records, but the amount needs to be divided up between two or more accounting periods.
Adjusting entries almost always involve a
balance sheet account (Interest Payable, Prepaid Insurance, Accounts Receivable, etc.) and an
income statement account (Interest Expense, Insurance Expense, Service Revenues, etc.)