Accounting systematically divides arbitrary points in time into artificial time periods in order to assess the financial and economic conditions of an entity (Time Period Assumption). It is this division that allows a company to create periodic and annual financial statements and derive conclusions from them. As a result of this, certain transactions undertaken by a company must relate to the time period to which they correspond. In accounting this is referred to as the accrual basis of accounting. Accrual accounting mandates that companies record transactions that change a company's financial statements in the period in which the events or transactions undertaken occur.
In order to conform to accrual accounting, companies must make adjusting entries every time financial statements are prepared. These adjusting entries, done at the end of every period, ensure that the revenue recognition principle and expense recognition principle are followed. Furthermore, without these entries, the trail balance would not contain all of a company's current data. Since a company's financial statements are partially prepared from the trial balance, all relevant events must be taken into account.
Types of Adjusting Entries
Deferrals postpone the recognition of expenses and revenues. This occurs because companies may pay for goods or services ahead of time or may have been paid in advanced to provide goods or services. In the case of expenses, companies first record a prepaid asset instead of expensing the cost of the good or service purchased because it has not yet contributed to revenue. As the prepaid asset is consumed, an adjusting entry is made in the corresponding period to account for the portion that has been incurred as an expense. In the case of revenues, a liability is first recorded because no revenue has yet been earned and obligation to perform is owed. When the goods or services are actually rendered, revenue is consider earned, and an adjusting entry is recorded in the relevant period.
Accruals accumulate revenues that have been earned and expenses that have been incurred. Accruals usually occur because companies provide or consume goods or services during a period; but don't initially record them because they are billed or paid at a later date or at the completion of the service. As a result, adjusting entries must be made at the end of the accounting period. In the case of accrued revenues, both assets (Receivables) and revenues increase. In the case of accrued expenses, both liabilities (Payables) and expenses increase.
The purpose of adjusted entries is to update the accounts and make sure that all relevant data is taken into account at the statement date. After this entries have been made the adjusted trial balance can be prepared. The adjusted trial balance will prove the equality of total debit balances to total credit balances. Once this equality is ensured, the adjusted trail balance can be used to prepare the periodic or annual financial statements.