You may think you know all about adjusting journal entries—even when to make them. What are some of the misconceptions about adjusting entries, and how do they affect both the balance sheet and the income statement? Jean Scheid offers some insight to AJEs.
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What Is an Adjusting Journal Entry?
There are basically two types of adjusting journal entries (AJEs): Those that correct postings to the wrong accounts or the wrong amount (these are easily corrected), and those that are needed for an accounting period that is not normally utilized in daily journal entries. These AJEs can include items such as depreciation or prepaid expenses, expected income in some circumstances, and deferred expenses.
One misconception about adjusting entries is that they do indeed, once posted, affect financial statements.
If you take a look at your balance sheet and you have $50,000 in equipment and tools (fixed assets), that $50,000 doesn’t remain the same each month. For example, you need to find out how to depreciate those fixed assets periodically and include the depreciation amount. By making depreciation AJEs to fixed assets, the value of those assets goes down—or in other words, the value of your total assets goes down. Failure to make depreciation adjustments to fixed assets can result in a misconception of the value of your assets—something you never want to do. If you don’t adjust for depreciation, your balance sheet is inaccurate.
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Prepaid Expense AJEs
The world of prepaid expenses! These can include payments made for utility hookups, prepaid rent or mortgage payments, and prepaid franchise fees. Because these are normally a one-time expense, they aren’t usually posted in your everyday bookkeeping tasks—but that doesn’t mean they are expenses you should ignore. In the case of money paid to hookup your utilities or telephone, most expect to obtain these dollars back. On simple balance sheets, there is usually a line item for prepaid expenses and this would be such an area where you should enter (post) the amount you prepaid. This, in the long run, will show an accurate accounting of what you expect to receive once you gain these hookup dollars back, reflecting in your liability expense accounts.
Not every business utilizes expected income when considering misconceptions about adjusting entries, but some do. A franchise business may have dollars coming from the franchisor (most likely received in a monthly statement) that should be recorded via an adjusting journal entry. Because the dollars have not yet been received, but will indeed come, by including this expected income your assets will increase. For example, as a franchised auto dealer, I know each month I will receive factory dollars but don’t know the exact amount until the factory (franchisor) sends me a monthly statement—usually at the end of the month. Therefore, I must take that amount and adjust anticipated income to increase my asset base.
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Deferred Expense AJEs
Along with depreciation, deferred expenses are probably one of the largest misconceptions about adjusting journal entries that bookkeepers can make. After all, if you haven’t “spent" any money on an “expense" it’s not usually posted in the normal accounting lifecycle. There are many areas where businesses do need to account for deferred expenses. A few examples include inventory or equipment purchases where some of the expense is deferred for a certain period of time or rent, mortgages, and fees that are deferred for a future set period. Making an adjusting journal entry to reflect these expenses will affect your income statement as well as your balance sheet. Failure to do so will lead to balance sheet limitations and, consequently, to explanations about the deferred expense.
Adjusting journal entries are not usually made during your monthly account posting or the typical journal entries you make. They are, however, just as important. Failure to include them at month or accounting period end will offer up incorrect financial statements, and that means explaining your financial books later—something most of us don’t want to do.
Stay on top of your adjusting journal entries and make sure to check your trial balance once they’ve been made. If needed, re-adjust so that your trial balance—the most important part of your accounting documents—does indeed balance.
There are many misconceptions about adjusting entries, but making timely entries ensures accurate accounting.