In a perfect world, your accounting process would always be completely on point. Every detail would be correct and immutable. But that’s not how it works. Errors occur and solutions must be found. Business accounting requires a constant process of double-checking data and ensuring accuracy.
There are times when information is entered correctly, but later developments necessitate amendments. So what are adjusting entries? They’re the amendments that must be made in order to accurately reflect the changes that occurred.
Adjusting entries are often required in a variety of scenarios. It’s inevitable that as you track the money entering your business, moving back and forth to accounts, and ultimately leaving your business, there will be times that something you recorded in the past will need to be rectified according to the present reality.
Let’s look at an example of when an adjusting entry might come into play. Your small business sells bedsheets, and one of your top customers is a local hotel called the Sleep Right Inn. You sell 75 complete sets of bedding to the hotel in January, as they needed to replace a bunch of sheets that were destroyed during raucous New Year’s Eve celebrations held by guests. The total bill for the bedding comes to $2,500, which you dutifully record as accounts receivable.
The owner of the Sleep Right Inn is actually an old college friend of yours, so he calls you up in February with a request. The various hotel repairs required after all the wild New Year’s Eve parties have really stretched his budget. He asks if you, as a fellow Cornell alum, can offer a discount on the bedding. At first, you decline, saying that your business is also going through tough times and you won’t be able to provide him a discount. But your friend is tenacious, and he sings “Far Above Cayuga’s Waters” over the phone, which is your all-time favorite song from your Cornell days. Growing emotional as a flood of memories pour over you, you agree to drop the total cost to just $1,750.
On February 1, you receive the reduced payment of $1,750 from your old college buddy at the Sleep Right Inn. The only problem is that your accounts receivable records from January still reflect the $2,500 you originally billed the hotel. You’ll need to go back to your January ledger and add a new entry that makes it clear that you only received $1,750 for the hotel’s order.
Adjusting entries such as the one used in the example above ensures that your financial records will all align. And with your income and expenses accurately correlated, there won’t be inaccuracies that come back to haunt you.
While the example of the hotel bedding dealt with a price modification, there are other situations where an adjusting entry might come into play. These include accrued expenses, accrued revenues, prepaid expenses, and depreciation.