Adjusted entries

What Is Adjusted entries?

Adjusted entries are journal entries recorded at the end of an accounting period to ensure that a company's financial statements accurately reflect its financial performance and position under the accrual accounting method. They are a critical component of financial accounting, specifically designed to adhere to the matching principle and revenue recognition and expense recognition principles. These entries adjust amounts that have been earned or incurred but not yet recorded, or that have been recorded but not yet fully consumed or realized, such as payments made in advance or services rendered but not yet billed. Without adjusted entries, financial statements might misrepresent a company's true profitability and financial standing.

History and Origin

The need for adjusted entries arose directly from the evolution of accrual accounting. Early accounting practices, predominantly cash-based, simply recorded transactions when cash exchanged hands. However, as business transactions grew more complex, involving credit sales, long-term contracts, and multi-period expenses, a cash-only view failed to provide a complete picture of a company's financial health. The concept of accrual accounting, which recognizes revenues when earned and expenses when incurred regardless of cash movement, became increasingly necessary to provide more accurate and timely financial information. The Oxford English Dictionary cites the earliest known use of "accrual accounting" in the 1910s.¹⁹

The formalization of such accounting principles, including the regular application of adjusted entries, gained significant momentum in the United States following the Stock Market Crash of 1929 and the subsequent Great Depression. These events highlighted the need for standardized and transparent financial reporting to protect investors. In response, legislative actions like the Securities Act of 1933 and the Securities Exchange Act of 1934 paved the way for the establishment of Generally Accepted Accounting Principles (GAAP).¹⁶, ¹⁷, ¹⁸ The Securities and Exchange Commission (SEC) was established to regulate securities markets and mandate financial reporting, often delegating standard-setting to the private sector.¹⁴, ¹⁵ This regulatory environment, guided by bodies like the Financial Accounting Standards Board (FASB), solidified the requirement for companies to employ accrual accounting, making adjusted entries an indispensable part of the accounting cycle. The FASB's Statement of Financial Accounting Concepts No. 6, "Elements of Financial Statements," further elaborates on the conceptual framework that underpins the recognition of assets, liabilities, revenues, and expenses, which directly necessitates adjusting entries to ensure proper reporting.¹³

Key Takeaways

• Adjusted entries are made at the end of an accounting period to update accounts before preparing financial statements.
• Their primary purpose is to ensure compliance with the accrual accounting principles, particularly the matching principle, which dictates that expenses be matched with the revenues they helped generate.
• Every adjusted entry affects at least one income statement account (revenue or expense) and one balance sheet account (asset or liability).
• Adjusted entries generally do not involve cash accounts, as they relate to non-cash accruals and deferrals.
• Common types include adjustments for prepaid expenses, unearned revenue, accrued expenses, and accrued revenue.

Interpreting the Adjusted entries

Adjusted entries are crucial for accurate financial reporting. They bridge the gap between cash transactions and the economic reality of a business by ensuring that revenues and expenses are recognized in the period to which they truly belong, rather than when cash changes hands. For investors and creditors, properly prepared adjusted entries mean that the reported net income on the income statement and the values of assets and liabilities on the balance sheet are more reliable indicators of a company's performance and financial health.

For instance, if a company has significant prepaid expenses, not adjusting for the portion consumed during the period would overstate assets and understate expenses, leading to an inflated profit figure. Conversely, failing to record accrued expenses would understate liabilities and overstate profits. Analysts interpreting a company's performance rely on these adjustments to gain a true understanding of profitability, liquidity, and solvency. The presence of well-documented and consistently applied adjusted entries indicates a robust accounting system that adheres to established accounting standards.

Hypothetical Example

Consider "Tech Solutions Inc.," a company that pays its employees every two weeks. The last payday was December 22nd. The accounting period ends on December 31st. By December 31st, employees have worked 7 days (December 23rd through December 31st) for which they have earned wages but have not yet been paid. Total wages earned during these 7 days amount to $15,000.

Without an adjusted entry, the income statement for December would understate wage expense, and the balance sheet would understate liabilities. To correct this, Tech Solutions Inc. would make the following adjusting entry on December 31st:

This adjusting entry increases the Wage Expense on the income statement for December, accurately reflecting the cost incurred during the period. It also creates a liability called Wages Payable on the balance sheet, recognizing the company's obligation to pay these wages in the next period. This ensures that the financial statements provide a precise picture of Tech Solutions Inc.'s financial obligations and performance for the year.

Practical Applications

Adjusted entries are fundamental to the preparation of accurate financial statements for virtually all businesses that use accrual accounting, from small enterprises to multinational corporations.

• Financial Reporting and Compliance: Publicly traded companies in the U.S. are mandated by the SEC to file GAAP-compliant financial statements regularly. This compliance necessitates the consistent application of adjusted entries to ensure that financial reports adhere to principles like revenue recognition, expense recognition, and the matching principle. The SEC’s Financial Reporting Manual outlines various reporting requirements that implicitly rely on proper accrual accounting adjustments.
  *¹² Performance Measurement: Accurate adjusted entries allow management, investors, and analysts to correctly assess a company's profitability. For example, if a company earns revenue over several months for a service provided (e.g., a subscription), accrued revenue entries ensure that only the portion earned in a given accounting period is reported, providing a realistic measure of performance.
• Valuation and Investment Decisions: Investors rely on adjusted financial statements to value companies and make informed investment decisions. Accurately stated assets, liabilities, and earnings (after all necessary adjusted entries) help in assessing a company's intrinsic value and risk profile.
• Loan Covenants and Creditworthiness: Lenders often include financial ratios and targets in loan agreements (covenants) that are based on GAAP financial statements. Companies must ensure their adjusted entries accurately reflect their financial position to remain compliant with these covenants and demonstrate creditworthiness.

Limitations and Criticisms

While essential for accurate accrual accounting, adjusted entries are not without limitations and potential criticisms.

One primary concern relates to the inherent subjectivity involved in certain adjustments. Many adjusted entries, such as those for depreciation (an accrued expense that allocates the cost of an asset over its useful life) or the allowance for doubtful accounts, rely on estimates and management judgment. While accounting standards provide guidelines, there can be a range of acceptable estimates, creating a degree of discretion. This discretion, if misused, can lead to "earnings management," where companies manipulate financial reports within accounting standards to achieve specific targets or present a desired financial image. S¹¹uch practices, even if technically legal, can obscure the true underlying economic performance of a company.

⁹, ¹⁰Furthermore, the complexity introduced by adjusted entries can make financial statements more challenging for non-experts to understand. While they provide a more comprehensive picture than cash-based accounting, the numerous accruals and deferrals require a deeper understanding of accounting principles. This complexity has drawn criticism, particularly in the public sector, where some argue that the adoption of accrual accounting (and thus its associated adjusted entries) makes financial information less transparent and more arbitrary for citizens and politicians. C⁶, ⁷, ⁸ritics suggest that the benefits of accrual accounting, including its reliance on adjusted entries, may not always outweigh the increased costs and complexities, particularly for organizations where cash flow remains the most critical measure of solvency.

⁵## Adjusted entries vs. Cash basis accounting

The fundamental distinction between adjusted entries and cash basis accounting lies in their timing of revenue and expense recognition. Adjusted entries are a core component of accrual accounting, a method that recognizes revenues when earned and expenses when incurred, regardless of when cash is received or paid. This approach aims to provide a more accurate depiction of a company's economic activities over a specific accounting period.

In contrast, cash basis accounting records revenues only when cash is received and expenses only when cash is paid out. It does not utilize adjusted entries because there is no need to account for uncollected revenues or unpaid expenses. While simpler to implement, cash basis accounting can misrepresent a company's financial performance by not aligning revenues with the efforts to generate them, or expenses with the benefits received. For instance, under cash basis, a large sale made on credit at the end of a year would not be recorded until payment is received in the next year, distorting the current year's revenue. Adjusted entries correct such distortions under the accrual method, ensuring that the income statement and balance sheet reflect the economic substance of transactions, not just cash movements. Most large businesses and public companies are required to use accrual accounting and thus regularly employ adjusted entries.

FAQs

What are the four main types of adjusted entries?

The four main types of adjusted entries correspond to accruals and deferrals: prepaid expenses (deferred expenses), unearned revenue (deferred revenue), accrued expenses, and accrued revenue.

³, ⁴### Why are adjusted entries necessary?
Adjusted entries are necessary to ensure that a company's financial statements adhere to the accrual accounting principles, specifically the matching principle. They ensure that revenues are recognized when earned and expenses when incurred, providing a more accurate picture of financial performance and position.

Do adjusted entries involve cash?

Generally, adjusted entries do not involve cash. They are typically made to update non-cash accounts like assets, liabilities, revenues, and expenses that have accrued or been deferred over an accounting period but for which no cash has yet changed hands or changed hands in a prior period.

²### When are adjusted entries made?
Adjusted entries are typically made at the very end of an accounting period, after all regular transactions have been recorded in the general ledger and an unadjusted trial balance has been prepared, but before the final financial statements are issued.¹