Why are adjusting entries necessary?
Adjusting entries are necessary to ensure that financial statements accurately reflect the financial position and performance of a business. These entries are made at the end of an accounting period (typically monthly, quarterly, or annually) to bring accounts up to date and record any necessary changes.
There are several reasons why adjusting entries are necessary:
1. Accrual accounting: Adjusting entries are required in accrual accounting, which is the generally accepted accounting principle (GAAP) used by most businesses. Accrual accounting records revenues and expenses when they are earned or incurred, rather than when money is received or paid. This means that adjusting entries are needed to recognize revenue or expenses that have been earned or incurred but have not yet been recorded.
2. Matching principle: The matching principle states that expenses should be recognized in the same period as the revenue they help generate. Adjusting entries ensure that expenses are properly matched with the related revenue. For example, if a business receives cash in advance for a service to be provided over multiple months, adjusting entries are needed to allocate the revenue and related expenses to the appropriate periods.
3. Time period assumption: Financial statements are prepared for specific time periods, such as a month or a year. Adjusting entries are necessary to properly allocate revenues and expenses to the correct time period. Without adjusting entries, financial statements would not accurately reflect the financial performance of a business for the given period.
4. Accurate financial statements: Adjusting entries help ensure that financial statements are accurate and reliable. By making adjustments for items such as prepaid expenses, accrued revenues or expenses, depreciation, and inventory, the financial statements provide a more realistic representation of the financial position and performance of the business.
To make adjusting entries, accountants typically review account balances, assess any necessary adjustments, and record them in the general ledger. These entries are made using adjusting journal entries, which update specific accounts and adjust the trial balance before preparing final financial statements. The specific types of adjusting entries required will depend on the nature of the business and its accounting practices.