Adjusting entries are made at the end of the accounting period to make your financial statements more accurately reflect your income and expenses, usually — but not always — on an accrual basis. This can be at the end of the month or the end of the year.
If you have adjusting entries that need to be made to your financial statements before closing your books for the year, does that mean your books aren't as accurate as you thought? This article will take a close look at adjusting entries for accounting purposes, how they are made, what they affect and how to minimize their impact on your financial statements.
Adjusting entries defined
Typically, you — or your bookkeeper — will enter income and expenses as they are recognized in your business. This can be done on either a cash basis or an accrual basis. Even if you are a cash basis taxpayer, keeping your books on an accrual basis is more accurate and will help you make better management decisions.
Regardless of how meticulous your bookkeeping is, though, there will be a need to make adjusting entries from time to time. An adjusting entry is simply an adjustment to your books to make your financial statements more accurately reflect your income and expenses, usually — but not always — on an accrual basis.
Adjusting entries are made at the end of the accounting period. This can be at the end of the month or the end of the year. Your accountant will likely give you adjusting entries to be made on an annual basis, but your bookkeeper might make adjustments monthly.
How adjusting entries are made
Adjusting entries are typically made using a journal entry. If you use form-based accounting software — like QuickBooks, Xero or FreshBooks — you might not be familiar with journal entries. That’s because form-based accounting software posts the journal entries for you based on the information entered into the form.
Every transaction in your bookkeeping consists of a debit and a credit. Debits and credits must be kept in balance in order for your books to be accurate. Your form-based accounting software takes care of this for you. For example, when you enter a check in your accounting software, you likely complete a form on your computer screen that looks similar to a check. Behind the scenes, though, your software is debiting the expense account (or category) you use on the check and crediting your checking account.
When you make a journal entry, the form component is stripped away, and you are left with something that looks like this:
Types of accounting adjustments
Adjusting entries usually involve one or more balance sheet accounts and one or more accounts from your profit and loss statement. In other words, when you make an adjusting entry to your books, you are adjusting your income or expenses and either what your company owns (assets) or what it owes (liabilities).
Adjusting entries usually fall into one of four categories:
Most accruals will be posted automatically in the course of your accrual basis accounting. However, there are times — like when you have made a sale but haven’t billed for it yet at the end of the accounting period — when you would need to make an accrual entry.
Another common accrual happens at year-end. Let’s say you pay your employees on the 1st and 15th of each month. At year-end, half of December’s wages have not yet paid; they will be paid on the 1st of January. If you keep your books on a true accrual basis, you would need to make an adjusting entry for these wages dated Dec. 31 and then reverse it on Jan. 1.
Note: These types of adjustments are not typically made by many small-business accountants and bookkeepers, but they are valuable if you are trying to get a true handle on your income and expenses for each accounting period.
In practice, you are more likely to encounter deferrals than accruals in your small business. The most common deferrals are prepaid expenses and unearned revenues.
Let’s say you pay your business insurance for the next 12 months in December of each year. You have paid for this service, but you haven’t used the coverage yet. This would be recorded as a prepaid expense in your books.
Or perhaps a customer has made a deposit for services you have not yet rendered. You are holding their money, but you haven’t earned it yet. This would be posted as unearned revenue in your books.
Depreciation and amortization
For tax purposes, your tax preparer might fully expense the purchase of a fixed asset when you purchase it. However, for management purposes, you don’t fully use the asset at the time of purchase. Instead, it is used up over time, and this use is recorded as a depreciation or amortization expense.
Depreciation and amortization is the most common accounting adjustment for small businesses.
Some businesses set up reserve accounts for expenses they think their company might incur, but they don’t have an actual amount yet. Two common estimate entries are for bad debt allowance: the portion of accounts receivable that the business estimates might be uncollectible based on its A/R collection history; and inventory spoilage/loss, or the amount of inventory the business estimates it will lose due to spoilage, obsolescence, theft or some other non-revenue activity.
When to make adjustments in accounting
Adjusting entries are typically made after the trial balance has been prepared and reviewed by your accountant or bookkeeper. Sometimes, as in the examples above, your bookkeeper can enter a recurring transaction in your bookkeeping, and these entries will be posted automatically each month before the close of the period.
Other times, the adjustments might have to be calculated for each period, and then your accountant will give you adjusting entries to make after the end of the accounting period.
Having adjusting entries doesn’t necessarily mean there is something wrong with your bookkeeping practices. If you are concerned something might be amiss, speak with your accountant; he or she will be able to tell you if something needs to be changed in your bookkeeping processes to reduce the need for adjusting entries.
Keep in mind, though, for most small businesses your accountant is also the person who files your tax returns. This means your accountant will likely only be concerned with adjusting entries that impact your tax situation, like depreciation. If your bookkeeper keeps your books on a true accrual basis, and your accountant is looking at your books from a tax-only perspective, your accountant might have more adjusting entries at the end of the year. Make sure you are clear on the purpose of any adjusting entries your accountant or your bookkeeper recommends.
Preventing adjusting entries from skewing your numbers
Usually, your accountant will make adjusting entries on an annual basis, posting the adjustment in December of the year impacted. Although this is fine if you review your financials only on an annual basis, it will skew your numbers — and your understanding of your numbers — on a month-to-month basis.
In each example above, the adjusting entry was broken down to be posted on a monthly basis. This results in a bit more work, but it pays off in terms of clarity for you.
If each entry above had been posted as of Dec. 31, your December expenses would have been increased by $19,950. By breaking them down by month, your December expenses would only be increased by $9,583 (the full amount of the Wages and Salaries expense for December, plus the one-month amount for each of the other expenses). That $10,000 difference could be the difference between a profit and a loss for the month of December, which could, in turn, impact your decisions when you are planning for December of the following year.
The final word
Many small-business owners find the accounting adjustments outlined here to be cumbersome and unnecessary, preferring instead to make only the required adjustments to get their financials in order for tax preparation. But in most cases, the benefit of having accurate financial statements for managerial purposes is worth the added effort. Sometimes, though, the level of detail mentioned here does not bring any additional clarity. Worse, sometimes offsetting entries aren’t made as they should be, which can lead to more confusion.
Speak with your accountant or bookkeeper about what information you want from your financial statements. This conversation should include how you use your financial information, how you would like to use it and the gaps in understanding you currently have. Your accountant or bookkeeper can then guide you regarding the accounting adjustments you need to make to your books on a regular basis.
Bookkeeping and accounting software
GoDaddy Bookkeeping $4.99 per month and up.
Sage 50cloud $47.25 per month and up.
Wave Financial Free (add-ons available).
Xero $11 per month and up.
Zoho Books $0 per month and up.
A version of this article was first published on Fundera, a subsidiary of NerdWallet.