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Adjusting Journal Entries

All companies must make adjusting entries at the end of a year, before preparing their annual financial statements. Some companies make adjusting entries monthly, to prepare monthly financial statements.

Adjusting entries fall outside the routine daily journal entries and activities of special departments, such as purchasing, sales and payroll. Accountants make adjusting and reversing journal entries in a way that does not interfere with the efficient daily operations of these essential departments.

Adjusting entries should not be confused with correcting entries, which are used to correct an error. That should be done separately from adjusting entries, so there is no confusion between the two, and a clear audit trail will be left behind in the books and records documenting the corrections.

In practice, accountants may find errors while preparing adjusting entries. To save time they will write the journal entries at the same time, but students should be clearly aware of the difference between the two, and the need to keep them separate in our minds.

Adjusting entries don't involve the Cash account. Any adjustments to Cash should be made in with the bank reconciliation, or as a correcting entry.

Adjusting entries involve a balance sheet account and an income statement account. Here are some common pairs of accounts and when you would use them.

Income Statement Account  Balance Sheet Account Adjustment to be made
Sales Revenue (cr) Accounts Receivable (dr) Accrue unrecorded sales
Earned Revenue (cr) Unearned Revenue (dr) Recognize earned revenue
Depreciation Expense (dr) Accumulated Depreciation (cr) Recognize depreciation expense
Insurance Expense (dr) Prepaid Insurance (cr) Apportion prepaid expense
Interest Expense (dr) Interest Payable (cr) Accrue interest expense
Supplies Expense (dr or cr) Supplies (dr to increase, or cr to decrease account) Recognize supplies used as an expense, and/or adjust Supplies account
Cost of Goods Sold (dr or (cr, as needed to offset Inventory adjustment) Inventory (dr to increase, cr to decrease balance) Adjust Inventory account to match year-end physical count

Legend: dr = debit; cr = credit; these are general rules of thumb. In all adjustments you should make the entry that is needed.

Notice most examples follow general rules: Revenues are credited, Expenses are debited, receivables are debited, payables are credited.

The Supplies or Inventory accounts need to be adjusted to reflect the physical amount of inventory or supplies at the end of the year. With Supplies we will count the physical items, for instance: 3 boxes of paper, 4 dozen pens, etc. and calculate a total value for supplies on hand, based on what we paid for the items originally. The Supplies account will be increased or decreased, as needed, to bring it to the correct balance.

Correcting Journal Entries

A correcting entry should be entered whenever an error is found. If errors are found at the end of the year, while preparing financial statements, accountants usually go ahead and correct the error at that time. There are various reasons a correction might be needed. A wrong account or dollar amount might have been entered. The entry could have used a debit, when a credit should have been entered.

Errors will carry through to the financial statements, so it is important to detect and correct them. The type of error should be noted, and brought to management's attention, if the accountant feels the error might be intentional. Intentional errors are called "falsifications" and are an indication there might be fraud.

Reclassifications

A reclassification is a correction entry used to correct a mis-classification or to change the classification of an entry. This might be necessary if an entry is made without complete information. For instance, the company might purchase a building and land for a single price. The two assets need to be entered separately. The company may have to wait for an appraisal, and will make a journal entry to record the purchase, then reclassify a portion of the purchase price to allocate the correct values to the land and building.

Reversing Journal Entries

A reversing entry is a very special type of adjusting entry. They can be extremely useful and should be used where necessary. A reversing entry comes in two parts: the original adjusting entry, and the reverse, or opposite entry. The second entry is written by simply reversing the position of all debits and credits. Ultimately, the end result on the books is zero, but the adjusting entry serves to correctly allocate an expense, so the financial statements are correct.

Let's look at an example. X Company has a payroll department, and cuts checks every two weeks after tabulating hours, and calculating net pay. A large number of allocations have to be made to various withholding accounts. The accountants don't want to interfere with the operations of the payroll department. And the employees also want the department to run efficiently so they can get their pay checks on time.

At the end of the year the accountants need to appropriately allocate payroll expenses, plus taxes due and payable. Rather than interfere with the payroll department the calculation is made on paper (or computer), and entered as an adjusting entry. It is marked to be reversed. After the closing entries are made, the first entries of the new year are the reversing entries. They undo the effects of the adjusting entry.

If the adjusting entry is not reversed, the books will not be correct. Both the accountants and payroll department will be making entries related to payroll. The reversing entry effectively allows the accountants to make adjusting entries without causing the books to be incorrect; the payroll department continues to make routine entries, and doesn't need to make any special entries or allocations.

Until you actually work with reversing entries they seem strange. Here's how the numbers play out. Let's look at a really simple example.

X Company's payroll expense is $1,500 per week; they pay salaries every two weeks. Assume that December 31 falls at the end of the week, and in the middle of the pay period. The payroll expense for the two week period needs to be split between two years, with $1,500 in year 1 and $1,500 in year 2.

Total for 2 week payroll = $3000

This is how the expense should be allocated:

Dec 31

Last week of year 1
First week of year 2
$1500
$1500

This is the journal entry the payroll department will make

Dec 31

Last week of year 1
First week of year 2
$0
$3000

At the end of the first week in January the payroll department will make its journal entry to record the two week payroll. But that journal entry will be for $3000, and not $1500 as it should be. Two things need to happen: 1) $1500 needs to be accrued in the year 1 financial statements; 2) the first week of year 2 needs to be adjusted, because it will record too much payroll expense.

If this adjusting entry is made, the year 1 payroll expense will be correct:

Adjusting Entry

Date
Account Debit
Credit
  Dec-31 Payroll Expense $1500
 
     Accrued Payroll Expense   $1500 
  To record payroll for last week of the year    

Reversing Entry

Date
Account Debit
Credit
  Jan-1 Accrued Payroll Expense $1500
 
     Payroll Expense   $1500 
  To reverse payroll accrual    

After the books are closed for the year the reversing entry is made, dated the first day of the new year. The Payroll Expense account carries a credit balance, which is not the normal balance for an expense account, and would normally indicate an error in posting or classifying the transaction. But for a reversing entry this is correct.

General Ledger

Payroll Expense

Date
 Description  Debit
 Credit
Balance
Jan-1
Reversing entry   $1500
($1500)
Jan-7
2-week payroll expense $3000 
  $1500 

After the payroll department post the 2-week payroll the Payroll Expense account will be correct. The balance is a debit of $1500, which is exactly what the Payroll Expense account should have for one week's payroll. If the reversing entry had not been made, the Payroll Expense account would need to be adjusted, because it would be overstated by $1500.