Recording transactions in your accounting software isn’t always enough to keep your records accurate. If you use accrual accounting, your accountant must also enter adjusting journal entries to keep your books in compliance. By recording these entries before you generate financial reports, you’ll get a better understanding of your actual revenue, expenses, and financial position.
Accrual Accounting and Adjusting Journal Entries
Under the cash method of accounting, a business records an expense when it pays a bill and revenue when it receives cash. The problem is, the inflow and outflow of cash doesn’t always line up with the actual revenue and expense. Say, for example, a client prepays you for six months’ worth of work. Under cash accounting, revenue will appear artificially high in the first month, then drop to zero for the next five months.
Under accrual accounting, revenues and expenses are booked when the revenues and expenses actually occur instead of when the cash transaction happens. To put these revenues and expenses in the right period, an accountant will book adjusting journal entries. For this example, the accountant would record an equal amount of revenue for each of the six months to reflect that the revenue is earned over the whole period. The actual cash transaction would still be tracked in the statement of cash flows.
Types of Adjusting Entries
Most adjusting entries fall into one of five categories:
- Accrued expenses are those you’ve accrued but haven’t paid yet. A common accrued expense is a loan interest payment that’s due once a year. Accrued expenses usually appear as accounts payable liabilities.
- Deferred expenses are expenses you’ve paid but not yet realized the benefit of. If you prepay your insurance a year in advance, for example, that’s a deferred expense. Deferred expenses appear on the balance sheet as assets.
- Accrued revenues are those on which you’ve earned the revenue but are waiting for the cash payment. These appear as accounts receivable, an asset account.
- Deferred revenues occur when you’ve been prepaid by a client but you haven’t finished the work yet. This appears on the balance sheet as a liability.
- Noncash transactions represent expenses and reserves that don’t have a cash effect on your business. Depreciation and allowance for doubtful accounts are two examples of common noncash transactions.
Why and When to Book Adjusting Entries
How often your company books adjusting journal entries depends on your business needs. Once a month, quarterly, twice a year, or once a year may be appropriate intervals. If you intend to use accrual accounting, you absolutely must book these entries before you generate financial statements or lenders or investors.
Ideally, you should book these journal entries before you make any big financial decisions or evaluate your finances. If the entries aren’t booked, it’s easy to forget about obligations and get a skewed picture of your financial position. For example, if you have an annual loan interest payment due in February and no liability is reflected on the books in January, you’re going to overestimate your available cash. Likewise, if you make an annual business insurance payment and it’s not adjusted, you may believe your overall cost of doing business has increased when it hasn’t.
Booking the Journal Entries
Booking adjusting journal entries requires a thorough understanding of financial accounting. If the person who maintains your finances only has a basic understanding of bookkeeping, it’s possible that this person isn’t recording adjusting entries. Full-charge bookkeepers and accountants should be able to record them, though, and a CPA can definitely take care of it.
Adjusting journal entries can get complicated, so you shouldn’t book them yourself unless you’re an accounting expert. Your accountant, however, can set these adjusting journal entries to automatically record on a periodic basis in your accounting software. That way you know that most, if not all, of the necessary adjusting entries are reflected when you run monthly financial reports.