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Adjusting Journal Entry

1. 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 entrer 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 called as adjusting journal entries.
 
2. What is the purpose of adjusting journal entry?

 
   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.

 
3. 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.


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Adjusting Journal Entry 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

[Note] Recorded amount of cash = $100

   Step 2: Identify the correct account balances.

  Debit Credit
Cash 1,000  
   Sales   1,000

[Note] Correct amount of cash = $1,000 debit balance
Correct amount of sales = $1,000 credit balance

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

  Debit Credit
Cash 900  
   Sales   900

[Note] Additional amount to be adjusted = Correct amount - Recorded amount = $1,000 - $100 = $900






Adjusting Journal Entry Example 2

On December 1, 20x1, 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, 20x1. Prepare the adjusting journal entry at December 31, 20x1.

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

  Debit Credit
Prepaid insurance 3,000  
   Cash   3,000

[Note] Recorded amount of cash = $3,000

   Step 2: Identify the correct account balances.

On December 31, 20x1, $1,000 insurance premium should be recognized as an expense for December.
(1) Insurance expense: $1,000 debit balance
(2) Prepaid insurance: $2,000 debit balance

[Note] Insurance expense for 20x1 = $3,000 x 1/3  = $1,000

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

To adjust these differences, following adjusting journal entry is needed.
This journal entry transfers $1,000 from the "Prepaid insurance" to the "Insurance expense" account.

  Debit Credit
Insurance expense 1,000  
   Prepaid insurance   1,000

[Note] Increase in the "Insurance expense" account --> Debit
Decrease in the "Prepaid insurance" account --> Credit


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