Question

You have been hired as the Controller at Coastline, Inc. to prepare the monthly adjusting journal entries, if necessary, as part of the accounting cycle. Your junior accountant asks you to explain: Why adjusting journal entries are important / necessary in the accounting cycle process? What are the four categories of adjusting journal entries per U.S. GAAP?

Answer 1

Answer]

Importance of adjusting journal entries in the accounting cycle process

Adjusting entries are usually made on the last day of an accounting period (year, quarter, month) so that the financial statements reflect the revenues that have been earned and the expenses that were incurred during the accounting period. Creating adjusting entries is one of the steps in the accounting cycle. It occurs after you prepare a trial balance, which is an accounting report to determine whether your debits and credits are equal. If the debits and credits in your trial balance are unequal, you must create accounting adjustments to fix the discrepancy.

In accrual basis accounting, adjusting journal entries are necessary because the exchange of cash does not always occur at the moment you purchase an item, provide services or incur an expense. Adjusting journal entries are completed at the end of an accounting period, and help to give a more accurate picture of a company’s financial status. These entries include accrued liabilities and assets, and deferred expenses and revenues.

Companies that prepare their financial statements in accordance with US GAAP and IFRS usually prepare some adjusting entries at the end of each accounting period.

Four categories of adjusting journal entries as per U.S.GAAP

Accrued Expenses

Accrued expenses or accrued liabilities are expenses that you incur but for which you have not issued payment. Accrued expenses include rent you owe for your office, interest on your business loans and your employees’ earnings that you have not yet paid. To recognize an accrued expense, prepare an adjusting journal entry by debiting the applicable expense account and crediting the matching payable account. When you issue payments, reverse the entry by debiting cash and crediting the expense payable account.

Unearned 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.

Prepaid 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.

Accrued Revenues

Accrued revenues include items or services that you have delivered or performed but for which you have not yet received payment. When you bill your customer for the work you have completed, you start the process to recognize revenues that you have earned. You will recognize this revenue by recording the adjusting entry for accrued revenues, debiting the receivable account and crediting the revenue account. When you do receive a payment, you would then adjust your journal by debiting cash and crediting the applicable receivable account.