Sowhat exactly does the term adjusting entry mean? Why is this stepimportant in the accounting cycle? Adjusting journal entries areentries recorded on the last day of an accounting period to alter thebook balances in the income and expense accounts so that they reportaccurate results and financial position of a company withinconventional frameworks of accounting. Generally, this processinvolves matching expenses and incomes during an appropriateaccounting period. The usage of adjusting journal entries is vital inany accounting cycle that involves period closing processing becauseit enables accountants to convert a preliminary trial balance into afinal trial balance that reflects the true financial position of afirm. Per se, it is unfeasible for a company to create compliant andstandardized financial statements without the service of adjustingentries. There are three types of adjusting journal entriesaccruals, non-cash, and prepayments. To illustrate how these journalentries are made, let’s look at hypothetical company ABC.
ABC’sfinancial cycle is four months. The company is about to start itssecond accounting cycle stretching from May to August 2016. FromJanuary to April 2016, the company accrues interest on a loan thatwas used to upgrade its facilities in September 2015. The interestexpense on this loan has accrued in this accounting period but hasnot been paid out by the 1stof May, 2016. Therefore, to close the Jan-Apr financial period, theaccountant of ABC will use adjusting journal entries to reflect thisundocumented and unsettled accrual expense once payments are madetypically on the 30thof April, 2016. This is an example of an accrual adjusting journalentry.
Assumecustomer X has paid ABC in advance for goods. Until ABC delivers thegoods, the monies received are recorded as a liability in thefinancial books of the company. After delivery, adjusting journalentries are made to report the confirmed revenue and reduce theliability. This is an example of a prepayment adjusting journalentry. Assuming ABC pays insurance for one year. Bearing in mind thatits accounting cycle lasts for four months, this implies that eightmonths of insurance expense is prepaid. Therefore, the accountant ofABC will use adjusting journal entries to make sure that this“future” expense is not recorded as an expense on the currentincome statement. This is an example of a non-cash adjusting journalentry. Hence, it becomes apparent that adjusting journal entries aresignificant in the accounting cycle.