What is an adjustment journal entry?
An adjustment journal entry is an entry in the general ledger of a business that occurs at the end of an accounting period to record any unrecognized revenue or expense for the period. When a transaction is started in an accounting period and completed in a later period, an adjustment journal entry is required to correctly post the transaction. The adjustment of journal entries can also refer to financial reports which correct an error made previously during the accounting period.
Key points to remember
- Adjustment journal entries are used to record transactions that have taken place but have not yet been properly recorded in accordance with the accrual basis of accounting.
- The adjustment journal entries are recorded in the general ledger of a company at the end of an accounting period in order to respect the principles of matching and recognition of products.
- The most common types of journal entry adjustments are accrued liabilities, deferrals and estimates.
Understanding the adjustment of journal entries
The purpose of adjusting the entries is to convert cash transactions to the accrual method. Accrual accounting is based on the principle of revenue recognition which aims to recognize revenue for the period in which it was earned, rather than the period in which cash is received. For example, suppose a construction company begins construction in one period but does not invoice the customer until the work is completed in six months. The construction company will have to write an accrual journal at the end of each month to recognize the income for 1/6 of the amount which will be invoiced at half-yearly point.
An adjustment journal entry involves an income statement (income or expense) with a balance sheet account (asset or liability). It generally relates to balance sheet accounts for accumulated amortization, allowance for doubtful accounts, accrued liabilities, receivables, prepaid expenses, deferred revenues and unearned revenues. Income statements which may need to be adjusted include interest expense, insurance costs, depreciation and income. The entries are made in accordance with the reconciliation principle to match the expenses to the corresponding income during the same accounting period. The adjustments made to the journal entries are carried over to the general ledger which affects the financial statements.
In summary, the adjustment to journal entries most often corresponds to accrued liabilities, deferrals and estimates. Accrued liabilities are revenues and expenses which have not been received or paid, respectively, and which have not yet been recorded through a standard accounting transaction. Deferrals refer to income and expenses which have been received or paid in advance, respectively, and which have been recorded, but which have not yet been earned or used. The estimates adjust the entries that record non-monetary items, such as depreciation, allowance for doubtful accounts, or the inventory obsolescence reserve.
Not all journal entries recorded at the end of an accounting period are accrual entries. For example, an entry to record an equipment purchase on the last day of an accounting period is not an adjustment entry.
Example of adjusting a log entry
For example, a business whose fiscal year ends on December 31 takes out a loan from the bank on December 1. The loan conditions state that interest payments must be made every three months. In this case, the company’s first interest payment must be made on March 1. However, the company still has to accumulate interest expense for the months of December, January and February.
Since the company is expected to release its year-end financial statements in January, an adjustment entry is necessary to reflect the interest expense accrued for December. To accurately account for the business and the profitability of the business, accrued interest expense must be recorded in the December income statement and the liability for interest payable must be reported in the December balance sheet. The adjustment entry will debit the interest expense and interest payable payable for the amount of interest from December 1 to 31.