Adjusting Entries for Accounting Purposes
Adjusting entries are made at the end of the accounting period to make your financial statements more accurately reflect your income and expenses, usually—but not always—on an accrual basis. This can be at the end of the month or the end of the year. Adjusting entries usually fall into one of four categories: accruals, deferrals, depreciation and amortizations, and estimates.
You know the importance of keeping your business accounting records current, and so you prioritize this in your operations. You pride yourself on having a bookkeeper who can produce financial statements within a few days of each month’s end that provide you with the information you need to run your business.
Then you discover you have some adjusting entries that need to be made to your financial statements before closing your books for the year. Does this mean your books aren’t as accurate as you thought?
In this article, we’ll take a close look at adjusting entries for accounting purposes, how they are made, what they impact, and how to minimize their impact on your financial statements.
Adjusting Entries Defined
Typically, you—or your bookkeeper—will enter income and expenses as they are recognized in your business. This can be done on either a cash basis or an accrual basis. Even if you are a cash basis taxpayer, keeping your books on an accrual basis is more accurate and will help you make better management decisions.
Regardless of how meticulous your bookkeeping is, though, there will be a need to make adjusting entries from time to time. An adjusting entry is simply an adjustment to your books to make your financial statements more accurately reflect your income and expenses, usually—but not always—on an accrual basis.
Adjusting entries are made at the end of the accounting period. This can be at the end of the month or the end of the year. Your accountant will likely give you adjusting entries to be made on an annual basis, but your bookkeeper might make adjustments monthly.
How Adjusting Entries Are Made
Adjusting entries are typically made using a journal entry. If you use form-based accounting software—like QuickBooks, Xero, or FreshBooks—you might not be familiar with journal entries. That’s because form-based accounting software posts the journal entries for you based on the information entered into the form.
Every transaction in your bookkeeping consists of a debit and a credit. Debits and credits must be kept in balance in order for your books to be accurate. Your form-based accounting software takes care of this for you. For example, when you enter a check in your accounting software, you likely complete a form on your computer screen that looks similar to a check. Behind the scenes, though, your software is debiting the expense account (or category) you use on the check and crediting your checking account.
When you make a journal entry, the form component is stripped away, and you are left with something that looks like this:
Types of Accounting Adjustments
Adjusting entries usually involve one or more balance sheet accounts and one or more accounts from your profit and loss statement. In other words, when you make an adjusting entry to your books, you are adjusting your income or expenses and either what your company owns (assets) or what it owes (liabilities).
Adjusting entries usually fall into one of four categories:
Most accruals will be posted automatically in the course of your accrual basis accounting. However, there are times—like when you have made a sale but haven’t billed for it yet at the end of the accounting period—when you would need to make an accrual entry.
Another common accrual happens at year-end. Let’s say you pay your employees on the 1st and 15th of each month. At year-end, half of December’s wages have not yet paid; they will be paid on the 1st of January. If you keep your books on a true accrual basis, you would need to make an adjusting entry for these wages dated December 31 and then reverse it on January 1.
Note: These types of adjustments are not typically made by many small business accountants and bookkeepers, but they are valuable if you are trying to get a true handle on your income and expenses for each accounting period.
Accrual Entry Example
Using the above payroll example, let’s say as of December 31 your employees had earned wages totaling $8,750 for the period from December 15 through December 31. They didn’t receive these wages until January 1, because you pay your employees on the 1st and 15th of each month.
Even though the money had not yet left your account at year-end, you still incurred that expense. In true accrual basis accounting, you would need to make an adjusting entry to your books to match that expense to the period in which it was incurred. And you would do so with the following entry:
This entry would increase your Wages and Salaries expense on your profit and loss statement by $8,750, which in turn would reduce your net income for the year by $8,750.
The Wages and Salaries Payable account is a liability account on your balance sheet. When you actually pay your employees, the checking account for the business—also on the balance sheet—is impacted. But when you record accrued expenses, a liability account is created and impacted with your adjusting entry.
Whenever you make an entry like this, it’s important to record a reversing entry in the following accounting period. So, on January 1, you would make the following entry:
Now, when you record your payroll for January 1, your Wages and Salaries expense won’t be overstated.
Again, this type of adjustment is not common in small business accounting, but it can give you a lot of clarity about your true costs per accounting period.
In practice, you are more likely to encounter deferrals than accruals in your small business. The most common deferrals are prepaid expenses and unearned revenues.
Let’s say you pay your business insurance for the next 12 months in December of each year. You have paid for this service, but you haven’t used the coverage yet. This would be recorded as a prepaid expense in your books.
Or perhaps a customer has made a deposit for services you have not yet rendered. You are holding their money, but you haven’t earned it yet. This would be posted as unearned revenue in your books.
Deferral Entry Example
Using the business insurance example, you paid $1,200 for next year’s coverage on December 17 of the previous year. If you are a cash basis taxpayer, this payment would reduce your taxable income for the previous year by $1,200.
However, for management purposes, you haven’t actually used what you have paid for as of December 31. The adjusting entry dated December 31 would be:
Let’s pause here for a moment for an explanation of what happened “behind the scenes” when you made your insurance payment on December 17. When you entered the check into your accounting software, you debited Insurance Expense and credited your checking account. However, that debit—or increase to—your Insurance Expense account overstated the actual amount of your insurance premium on an accrual basis by $1,200. So, we make the adjusting entry to reduce your insurance expense by $1,200. And we offset that by creating an increase to an asset account—Prepaid Expenses—for the same amount.
Each month of the following year, you would make the following entry to your books:
This entry will recognize the insurance expense as you actually incur it, at the rate of $100 per month ($100 x 12 months = the $1,200 you paid for your insurance premiums for the year). At the same time, your Prepaid Expenses asset account will be reduced by $100 per month.
At the end of the following year, then, your Insurance Expense account on your profit and loss statement will show $1,200, and your Prepaid Expenses account on your balance sheet will be at $0.
This type of entry is more common in small business accounting than accruals. However, if you make this entry, you need to let your tax preparer know about it so they can include the $1,200 you paid in December on your tax return. Remember, we are making these adjustments for management purposes, not for taxes.
Depreciation and Amortization
For tax purposes, your tax preparer might fully expense the purchase of a fixed asset when you purchase it. However, for management purposes, you don’t fully use the asset at the time of purchase. Instead, it is used up over time, and this use is recorded as a depreciation or amortization expense.
Depreciation and amortization is the most common accounting adjustment for small businesses.
Depreciation and Amortization Entry Example
This is probably an entry you are familiar with, but chances are you are only familiar with it as it impacts your taxes.
Whenever you purchase a fixed asset—like a vehicle, building, or large equipment—for your business, you don’t post the purchase directly to an expense account. Instead, the purchase is recorded to an asset account. The “behind the scenes” entry for the purchase of a $35,000 truck, for example, would be:
(If you didn’t pay for the vehicle in full, the credit would be posted to a long-term liability account. For simplicity’s sake, we’ll assume you paid cash.)
The Vehicles account is a fixed asset account on your balance sheet. We post the purchase in this manner because you don’t fully deplete the usefulness of the truck when you purchase it. You’ll probably keep the truck for several years.
Let’s say you will keep the truck for five years, and then you will replace it. When you are done with the truck, you will sell it for $10,000—the salvage value of the truck. The straight-line depreciation rate for the truck will be calculated as follows:
(Acquisition Cost – Salvage Value) / Useful Life = Depreciation Rate
($35,000 – $10,000) / 5 = Depreciation Rate
$25,000 / 5 = $5,000
You will depreciate the truck at a rate of $5,000 per year, or approximately $416.67 per month.
The adjusting entry to your books each month, then, would be:
The depreciation expense shows up on your profit and loss statement each month, showing how much of the truck’s value has been used that month. Accumulated depreciation is a contra asset account. This means it shows up under your Vehicle asset account on your balance sheet as a negative number. This has the net effect of reducing the value of your assets on your balance sheet while still reflecting the purchase value of the vehicle.
Unlike accruals, there is no reversing entry for depreciation and amortization expense.
Keep in mind, this calculation and entry will not match what your accountant calculates for depreciation for tax purposes. But this entry will let you see your true expenses for management purposes.
Some businesses set up reserve accounts for expenses they think their company might incur, but they don’t have an actual amount yet. Two common estimate entries are for bad debt allowance: the portion of accounts receivable which the business estimates might be uncollectible based on their A/R collection history; and inventory spoilage/loss: the amount of inventory the business estimates it will lose due to spoilage, obsolescence, theft, or some other non-revenue activity.
Estimate Entry Example
Let’s assume you have $250,000 in inventory and you know you typically lose 2% of your inventory to theft or spoilage each year.
First, let’s calculate the dollar amount of the inventory loss:
$250,000 x 0.02 = $5,000
You lose, on average $5,000 of your inventory each year. On a monthly basis, that’s $416.67. So, each month, you would make the following entry to your books:
The Inventory Loss account could either be a sub-account of cost of goods sold, or you could list it as an operating expense. We prefer to see it as an operating expense so it doesn’t skew your gross profit margin. The Reserve for Inventory Loss account is a contra asset account, and it shows up under your Inventory asset account on your balance sheet as a negative number.
When you do your physical inventory each year, you will reverse the entry for the year:
And then you will record the actual inventory loss. Let’s say it winds up being $3,750.
Because you know your inventory amount has decreased by $3,750, you will adjust your actual inventory number instead of posting to the reserve account.
Like accruals, estimates aren’t common in small business accounting.
When to Make Adjustments in Accounting
Adjusting entries are typically made after the trial balance has been prepared and reviewed by your accountant or bookkeeper. Sometimes, as in the examples above, your bookkeeper can enter a recurring transaction in your bookkeeping, and these entries will be posted automatically each month before the close of the period.
Other times, though, the adjustments might have to be calculated for each period, and then your accountant will give you adjusting entries to make after the end of the accounting period.
Having adjusting entries doesn’t necessarily mean there is something wrong with your bookkeeping practices. If you are concerned something might be amiss, speak with your accountant; he or she will be able to tell you if something needs to be changed in your bookkeeping processes to reduce the need for adjusting entries.
Keep in mind, though, for most small businesses your accountant is also the person who files your tax returns. This means your accountant will likely only be concerned with adjusting entries that impact your tax situation, like depreciation. If your bookkeeper keeps your books on a true accrual basis, and your accountant is looking at your books from a tax-only perspective, your accountant might have more adjusting entries at the end of the year. Make sure you are clear on the purpose of any adjusting entries your accountant or your bookkeeper recommends.
Preventing Adjusting Entries From Skewing Your Numbers
Usually, your accountant will make adjusting entries on an annual basis, posting the adjustment in December of the year impacted. Although this is fine if you only review your financials on an annual basis, it will skew your numbers—and your understanding of your numbers—on a month-to-month basis.
In each example above, we broke down the adjusting entry so it is posted on a monthly basis. This results in a bit more work, but it pays off in terms of clarity for you.
If we had posted each entry above as of December 31, your December expenses would have been increased by $19,950. By breaking them down by month, though, your December expenses would only be increased by $9,583 (the full amount of the Wages and Salaries expense for December, plus the one-month amount for each of the other expenses). That $10,000 difference could be the difference between a profit and a loss for the month of December, which could, in turn, impact your decisions when you are planning for December of the following year.
The Final Word
Many small business owners find the accounting adjustments outlined here to be cumbersome and unnecessary, preferring instead to only make the required adjustments to get their financials in order for tax preparation. We think the benefit of having accurate financial statements for managerial purposes is worth the added effort—in most cases. Sometimes, though, the level of detail mentioned here does not bring any additional clarity. Worse, sometimes offsetting entries aren’t made as they should be, which can lead to more confusion.
Speak with your accountant or bookkeeper about what information you want from your financial statements. This conversation should include how you use your financial information, how you would like to use it, and the gaps in understanding you currently have. Your accountant or bookkeeper can then guide you regarding the accounting adjustments you need to make to your books on a regular basis.