Adjusting journal entries are journal entries with a specific purpose, to adjust financial data to be as close to an accrual method as possible, as of a specific time, usually the end of the month or year. Because the adjusting entries are focused on making the financial statements correct as of a specific date, the end of the month or year, they will all have the same date, the date of the financial statements, the last date of the period, often called the cutoff date. For example, adjusting journal entries related to calendar year-end financial statements will all be dated, December 31.
Now that we have an understanding of the cash method and accrual method, we can assess why adjusting entries are needed. In other words, why can’t the accounting department just record all transactions on an accrual method, and if the differences between the cash method and accrual method are just timing differences, and not permanent differences, why does it matter in the long run? Won’t all timing problems work themselves out over time and therefore, not need any adjustments?
Although the difference between recording transactions under an accrual method and cash method are just timing differences, meaning they will reverse themselves over time, they are important. One of the goals of financial statements is comparability, users having the need to compare the financial statements from one period to the next. Timing helps with this comparison. For example, a company paying a year’s worth of rent for $100,000, would record the entire amount in the current month under a cash method, most likely resulting in the month showing a net loss. Although this net loss will even itself out over the next year, the following 11 months not showing any rent expense under a cash method, the timing difference distorts our ability to compare one month to the next. The timing difference may lead us to conclude that the first month was not good and the rest of the year was much better, but this conclusion would not necessarily be accurate because the rent expense paid in the first month was used, or consumed, for the entire year. When measuring performance, it makes more sense to expense rent expense as the expense is used, rather than when it is paid, each month consuming, and expensing, the same amount of rent.
It’s useful to think of situations where companies have an incentive to distort financial information when considering the reasons for reporting financial data using an accrual method. A cash method makes it much easier to shift revenue from one period to the next. For example, a company could increase revenue reported in a calendar year under a cash method, by asking clients to prepay for goods and services, in exchange for a discounted price, receiving payments for goods and services in December which will not be provided until January, for example. The result of clients prepaying in December for work that will be done in January under a cash method is an increase in revenue reported in December, even though that revenue had not been earned. A company could also ask for an extension on payment terms until January for expenses incurred in December. The result of making payments in January under a cash method would be a reduction in the expenses reported in December, even though the expenses had been consumed in December. Under an accrual method, financial data cannot be distorted so easily through changes in payment terms.
The name, adjusting journal entries, can imply that adjusting journal entries are needed due to errors performed by the accounting department, errors that need adjustment. It is not true that adjusting entries are needed as a result of errors being made by the accounting departments. The adjusting journal entries are part of the normal accounting process, part of the plan, and even a perfect performance by the accounting department would not eliminate the need for adjusting journal entries.
At this point you may be asking; if normal journal entries are recorded on an accrual basis by the accounting department, why do we need adjusting entries? It is true that most normal journal entries will be recorded on an accrual basis. For example, the accounting department will record revenue when the job is done, and the invoice created, rather than when cash is received. There are some transactions, however, that the accounting department will not record on an accrual basis, and which will need adjustment and some transactions which will not be recorded by the normal accounting process at all. The reason the accounting department does not journalize some transactions on an accrual basis, is that it would not be cost effective to record every transaction on a perfect accrual basis. There is a cost benefit analysis when putting together an accounting
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