Under GAAP, or the generally accepted accounting principles, financial statements must be prepared on an accrual basis. This allows users of the financial reports to see a clear picture of a company’s resources, income, liabilities, and expenses that occurred in the time period that the statements are for. To meet the revenue recognition principle and the matching principle, a company needs to make adjusting entries to account for transactions that have not fully transpired. Two types of adjusting entries are made: prepayments and accruals.
*Adjusting entries for prepayments
Prepayments consist of items where cash has been disbursed or received before used, consumed, expired, or earned. It is often not cost effective to record these items on a daily basis, so adjusting entries are made at the end of the period recognize or expense the actual amount used within the period. Common prepayments include inventory, insurance, and rent. Other assets that require an adjusting entry under the prepayments are fixed assets that depreciate over time.
-When supplies are purchased, the transaction is recorded as asset, such as Office Supplies with a debit entry, and Cash is reduced with a credit entry. At the end of the period, the supplies remaining are counted and the actual expense is figured. Then, that expense is recorded at the end of the month as Office Supplies Expense, reducing the asset account Office Supplies with a credit entry, and increasing the expense account Office Supplies Expense with a debit entry.
-If a company purchases an insurance policy for the year and prepays the entire cost of the policy, it is recorded as an asset. The Prepaid Insurance account would record a debit entry, increasing the account, while Cash would be credited, decreasing the account. As costs expire, Insurance Expense would be debited, and Prepaid Insurance would be credited in the month the expense was for.
-Depreciation is used to assign the cost of plant, property or equipment that is recorded as an asset. For example, if a new computer system is purchased, the Office Computers account would be debited. Cash or liability accounts would be credited to record the purchase. Sine the computers are used to generate revenue in future periods, the expense of the computers over those time periods is spread over their useful lives. The depreciation amount is recorded as a credit in a contra-account to the asset account Accrued Depreciation-Office Computers, and a debit in an expense account, Depreciation Expense. This allows for several layers of transparency to be seen: the original cost of the computer equipment, the amount of depreciation that has expired, and the amount of depreciation expense recorded.
*Adjusting entries for accruals
When a company has revenues that are earned but no cash has been received yet, or expenses that have been incurred, but they haven’t paid, these are considered accruals. At the end of the accounting period and adjusting entry needs to be made to assign these items to the correct time period. .
-Accrued Revenues can include items such as unrecorded Interest Income, Commissions, Rent Revenues, and Fees. For instance, an adjusting entry for unbilled Rent Revenue for February is recorded as a debit to Accounts Receivable to show it is owed, and a credit to Rent Revenue because it was earned in that month.
-Accrued Expenses are expenses that have not been paid, and can represent items such as Interest Expense, Utilities Expense, and Taxes. In the case of Interest Expense, the interest owed accrues each month. However, the bill does not arrive until the tenth of the following month. An adjusting entry is made to record the item by debiting the Interest Expense account, and crediting the Interest Payable account.
-Accrued Salaries & Wages are a common item to need an adjusting entry. For instance, a company that pays their salary employees weekly will run into pay periods that cross over different accounting periods. The employees may have two work days in of March: the 29th and 30th, and three work days in April: the 1st, 2nd and 3rd. The work for the days in March is not paid until the 6th of April and represents accrued wages expense. If they are paid $100 per day, the accrued expense for March would be $200. The Salaries Expense account for March would be debited $200 and the Salaries Payable would be credited for $200. This allows the company to accurately reflect the salaries expenses for the prior month.
Adjusting entries are needed to present accurate financial data for prepayments and accruals to be in accordance with GAAP. Adjusting entries have an effect on both the Balance Sheet and the Income Statements and keep in line with the revenue recognition principle and the matching principle.