How to make adjusting entries in financial accounting

Adjusting entries are part of accrual concept of accounting. In general, accounting transactions are recorded by following accrual basis of accounting except in few schools, government departments and non profit organisations. In accrual accounting, following rules are followed;

  • Revenue is recognised when earned, regardless of when cash is actually collected, and
  • Expenses are matched to revenues, regardless of when cash is paid out.

Based on this principle, revenue is recognized as earned when goods and services are delivered and a legal obligation to pay for such goods and services is created. Similarly in other cases, revenue is recognized as earned when different set of conditions are satisfied and legal obligation arises. For instance, based on the rental agreement, rent is recognized when time for payment is passed.

Expenses are recognized to match these accrued revenues. For instance, if you have not paid rent for your office building for the month of march but already used it for official purpose during the year then irrespective of date of payment, you have to recognize it for the year in the month of March as rent incurred.

These set of transactions are passed as adjusting entries in accounting system at the end of the accounting period after preparing trial balance.

Here are different type of adjusting entries passed in accounting system. Please note, in an organisation, you will be seeing these type of many adjusting entries, these are just examples to understand the concept. The main purpose of passing these adjusting entries is to adjust revenues and expenses for the reported accounting period in which they are incurred.

Prepaid insurance

Prepaid insurance means, you have paid insurance premium in advance for a period.

For example, suppose you have paid Rs 12,00,000 as insurance premium on 1st April 2018 towards factory insurance for a year, then every month to recognize insurance as a expense, you have to pass adjusting entries.  

At the time of payment towards insurance premium you need to pass following accounting entry;

Prepaid insurance account  Dr. Rs. 12,00,000

To Cash Account Rs 12,00,000

Prepaid insurance and Cash account are balance sheet items. Therefore, both will be shown in the balance sheet.

At the end of 1st month, insurance for a month has expired. Therefore, following adjustment entry for a month has to be passed;

Insurance expenses Account Dr. Rs 1,00,000

To Prepaid Insurance Account Rs 1,00,000

With this adjustment entry, your insurance expense account will be taken to income statement and prepaid insurance account will be reduced by Rs 1,00,000. Balance in prepaid insurance account at the end of 1st month will be Rs 11,00,000.

For the whole year, you need to post similar adjusting entries so that at the year end, amount in prepaid insurance account will be zero in balance sheet.

Similarly you can pass adjusting entries for prepaid rent.

Adjusting entries for accumulated depreciation

In an organisation, assets are used to produce goods or to render services. Over the useful life, these assets lose their value. Accountants pass adjusting entries to account the value for wear and tear of the assets by charging the amount to income statement under the head depreciation and taking out the same amount from the original cost of the asset. Here is the adjustment entry for depreciation;

Depreciation Account Dr.

To Accumulated Depreciation

Depreciation for the period is taken to the income statement and accumulated depreciation is shown in the balance sheet by subtracting it from the historical cost of the asset.

Suppose, the company has purchased a machinery costing Rs 12,00,000 on 1st April 2018 with a useful life of 10 years. If the rate of depreciation is 10%  (assumed), then depreciation for a month would be Rs 10,000 {(1200000*10%)/12}.

The adjustment entry for the 1st month of using machinery would be as follows;

Depreciation Account Dr. Rs. 10,000

To Accumulated Depreciation Rs 10,000

At the end of April, accumulated depreciation account will show balance of Rs 10,000. This amount will be shown in balance sheet by subtracting from the historical cost of the asset.

Now we have discussed prepaid insurance, prepaid rent and accumulated depreciation. In all these type of adjusting entries, you are recognizing expenses after making payments for it.

There will be cases where company has already incurred expenses for business revenue but not recognized as the amount has not paid. You also have to record income which has been earned but not received through adjusting entries.

Let us understand how adjusting entries are passed in these type of cases with the help of expenses incurred for salary.

Adjusting entries for Salary

Adjusting entry for payroll is done for the amount that has been incurred but has not been paid prior to the end of accounting period. Assume that Rs 1,00,000 incurred as salary for the month of December 2018 which has not been paid till the last month of December.

In this case, you have incurred salary expenses as your employees have done their work for the month. To recognize salary for the month of December in October-December quarter, you need to post following adjustment entry;

Salary / Payroll Expenses  Dr. Rs 1,00,000

To Salary Payable Rs 1,00,000

On the 1st of January, following reversing entry has to be passed to nullify the adjusting entry:

Salaries Payable Rs 1,00,000

      Salary expenses Rs 1,00,000

When you pay salary in the month of January, you need to pass following entry;

Salary Expenses Dr. Rs 1,00,000

To Cash/Bank Rs 1,00,000

These type of adjusting entries for salary are to be passed for all the 12 months if not paid on or before the end of the month.

Accrued revenue

If you perform a service or sold a product to a customer but did not bill in the same month in which services are rendered or product is sold, then you need to pass adjusting entries by taking revenue in the month in which its incurred. For this you have to pass following adjustment entry;

Accounts Receivable Account Dr.

To Revenue Account

Similarly adjusting entries are to be passed for unearned revenues. For instance, in case of e-commerce companies, if customer has placed a order of an item on the internet and its not reached him till the end of march, then the company has to record it as unearned revenue in the month in which its incurred with following adjustment entry.

Unearned revenue Account Dr.

To Revenue Account

Based on all these adjusting entries, passed to the accounting system, you need to prepare adjusted trial balance. In ERP or accounting software, it will automatically gets prepared. You are required to check it before finalizing income statement and balance sheet of the company.