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Adjusting entries are journal entries usually made at the end of an accounting period to allocate income and expenditure to the period in which they actually occurred. The revenue recognition principle is the basis of making adjusting entries that pertain to unearned and accrued revenues under accrual-basis accounting. They are sometimes called Balance Day adjustments because they are made on balance day.
Most adjusting entries could be classified this way:
|Entries||Prepayments ( Deferral - cash paid or received before consumption)||Accrual - cash paid or received after consumption|
|Expenses||Prepaid expenses: for expenses paid in cash and recorded as assets before they are used||Accrued expenses: for expenses incurred but not yet paid in cash or recorded|
|Revenues||Unearned revenue: for revenues received in cash and recorded as liabilities before they are earned||Accrued revenues: for revenues earned but not yet recorded or received in cash|
Adjusting entries for prepayments are necessary to account for cash that has been received prior to delivery of goods or completion of services. When this cash is paid, it is first recorded in a prepaid expense asset account; the account is to be expensed either with the passage of time (e.g. rent, insurance) or through use and consumption (e.g. supplies).
A company receiving the cash for benefits yet to be delivered will have to record the amount in an unearned revenue liability account. Then, an adjusting entry to recognize the revenue is used as necessary.
Accrued revenues are revenues that have been recognized (that is, services have been performed or goods have been delivered), but their cash payment have not yet been recorded or received. When the revenue is recognized, it is recorded as a receivable.
Accrued expenses have not yet been paid for, so they are recorded in a payable account. Expenses for interest, taxes, rent, and salaries are commonly accrued for reporting purposes.
A third classification of adjusting entry occurs where the exact amount of an expense cannot easily be determined. The depreciation of fixed assets, for example, is an expense which has to be estimated.
The entry for bad debt expense can also be classified as an estimate.