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Adjusting entries are journal entries usually made at the end of an accounting period to allocate income and expenditure to the period in which they actually occurred. The revenue recognition principle is the basis of making adjusting entries that pertain to unearned and accrued revenues under accrual accounting system. They are sometimes called Balance Day adjustments because they are made on balance day.
Based on the matching principle of accrual accounting, revenues and associated costs are recognized in the same accounting period. However the actual cash may be received or paid at a different time.
Types of adjusting entries
Adjusting entries could be classified this way:
| Prepayments (Deferral - cash paid before consumption) | Accrual - cash paid after consumption | |
| Expenses | Prepaid expenses: for expenses paid in cash and recorded as assets before they are used | Accrued expenses: for expenses incurred but not yet paid in cash or recorded |
| Revenues | Unearned revenue: for revenues received in cash and recorded as liabilities before they are earned | Accrued revenues: for revenues earned but not yet recorded or received in cash |
Prepayments
Prepaid expenses expire either with the passage of time (e.g. rent, insurance) or through use and consumption (e.g. supplies). At first prepaid expenses are included in assets, but are gradually expensed. If no adjusting entry is made, assets are overstated and expenses are understated. Depreciation is an extremely long-term case of prepaid expenses.Unearned revenue is liability for the company to perform certain services or deliver goods. For example, airlines owe you a flight if you buy a ticket. After the flight liability is recorded as earned revenue
Accruals
Accrued revenues are earned (that is, service is performed or goods are delivered) but not yet recorded or received. For example, professional fee for consultation. When the revenue is recognized, it is recorded as Accounts Receivable.Accrued expenses could be interest, taxes, rent, and salaries. One company's accrued expenses are accrued revenues for another. Allowance for doubtful accounts is also accrued expenses.
Example
Assume a magazine publishing company Tellchix-Uread charges an annual subscription fee of $12. The cash is paid up-front at the beginning of the subscription. The revenue, based on sales basis method, is recognized upon delivery. Therefore the initial reporting of the receipt of annual subscription fee is indicated as:
Debit | Credit
Cash $12 | Unearned Revenue | $12 |
The adjusting entry reporting each month after the delivery is:
Debit | Credit
Unearned Revenue $1 | Revenue | $1 |
The unearned revenue after the first month is therefore $11 and revenue reported in the income statement is $1.
See also
External links
Further reading:
- Adjusting Entries Explanation with examples.
"Adjusting entries"