Adjusting Journal Entries

Accounting Study Guide

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GAAP

Basics of Journal Entries

What is an adjusting journal entry?

   Adjusting journal entry is a journal entry prepared to adjust account balances.
   The only way of changing account balances is to make journal entries.
   Account balances cannot be changed without journal entries.
   If current account balances do not represent correct amounts, journal entries are needed to change current balances to the correct balances.
      --> Journal entries prepared with this purpose are adjusting journal entries.

Why do companies need adjusting journal entries?

   Current account balances may not represent correct balances due to following reasons:
      a. Company made mistakes in preparing journal entries in the past.
      b. Accounting records are not updated to reflect new transactions or amount changes in previous transactions.

   Adjusting journal entries are usually prepared at the end of an accounting period to update account balances to reflect correct balances as of the balance sheet date (the date at the end of an accounting period).

The timing differences in recognizing revenues and expenses between accrual basis and cash basis accounting are frequently corrected by adjusting journal entries.

Three steps of preparing adjusting journal entries

Step 1: Identify the original journal entries that have been made during the period.

Step 2: Identify the correct account balances.

Step 3: Analyze the differences between correct and current balances and prepare journal entries to adjust such differences.

Example 1

Company A sold its products at the price of $1,000 for cash. However, this transaction was recorded as $100 sales. What is the adjusting journal entry to correct this mistake?

Step 1

Identify the original journal entries that have been made during the period.

		Debit	Credit
Cash		100
	Sales		100

Step 2

Identify the correct account balances.

	Cash	1,000	(Debit Balance)
	Sales	1,000	(Credit Balance)

Step 3

Analyze the differences between correct and current balances and prepare journal entries to adjust such differences.

Accounts	Correct	Current	Correct - Current
Cash	1,000	100	900
Sales	1,000	100	900

To adjust these differences, following adjusting journal entry is needed.

		Debit	Credit
Cash		900
	Sales		900

Example 2

On December 1, 2006 Company A signed an insurance contract and paid $3,000 cash as insurance premium for three months. Company recorded $3,000 as prepaid insurance on December 1, 2006. Prepare adjusting journal entries at December 31, 2006.