What Are Accounting Adjustments?

Using the above payroll example, let’s say as of Dec. 31 your employees had earned wages totaling $8,750 for the period from Dec. 15 through Dec. 31. They didn’t receive these wages until Jan. 1, because you pay your employees on the 1st and 15th of each month.

Even though the money had not yet left your account at year-end, you still incurred that expense. In true accrual basis accounting, you would need to make an adjusting entry to your books to match that expense to the period in which it was incurred. And you would do so with the following entry:

This entry would increase your Wages and Salaries expense on your profit and loss statement by $8,750, which in turn would reduce your net income for the year by $8,750.

The Wages and Salaries Payable account is a liability account on your balance sheet. When you actually pay your employees, the checking account for the business — also on the balance sheet — is impacted. But when you record accrued expenses, a liability account is created and impacted with your adjusting entry.

Whenever you make an entry like this, it’s important to record a reversing entry in the following accounting period. So, on Jan. 1, you would make the following entry:

Now, when you record your payroll for Jan. 1, your Wages and Salaries expense won’t be overstated.

Using the business insurance example, you paid $1,200 for next year’s coverage on Dec. 17 of the previous year. If you are a cash basis taxpayer, this payment would reduce your taxable income for the previous year by $1,200.

However, for management purposes, you haven’t actually used what you have paid for as of Dec. 31. The adjusting entry dated Dec. 31 would be:

Let’s pause here for a moment for an explanation of what happened “behind the scenes” when you made your insurance payment on Dec. 17. When you entered the check into your accounting software, you debited Insurance Expense and credited your checking account. However, that debit — or increase to — your Insurance Expense account overstated the actual amount of your insurance premium on an accrual basis by $1,200. So, we make the adjusting entry to reduce your insurance expense by $1,200. And we offset that by creating an increase to an asset account — Prepaid Expenses — for the same amount.

Each month of the following year, you would make the following entry to your books:

This entry will recognize the insurance expense as you actually incur it, at the rate of $100 per month ($100 x 12 months = the $1,200 you paid for your insurance premiums for the year). At the same time, your Prepaid Expenses asset account will be reduced by $100 per month.

At the end of the following year, then, your Insurance Expense account on your profit and loss statement will show $1,200, and your Prepaid Expenses account on your balance sheet will be at $0.

This is probably an entry you are familiar with, but chances are you are only familiar with it as it impacts your taxes.

Whenever you purchase a fixed asset — like a vehicle, building or large equipment — for your business, you don’t post the purchase directly to an expense account. Instead, the purchase is recorded to an asset account. The “behind-the-scenes” entry for the purchase of a $35,000 truck, for example, would be:

(If you didn’t pay for the vehicle in full, the credit would be posted to a long-term liability account. For simplicity’s sake, we’ll assume you paid cash.)

The Vehicles account is a fixed asset account on your balance sheet. We post the purchase in this manner because you don’t fully deplete the usefulness of the truck when you purchase it. You’ll probably keep the truck for several years.

Let’s say you will keep the truck for five years, and then you will replace it. When you are done with the truck, you will sell it for $10,000 — the salvage value of the truck. The straight-line depreciation rate for the truck will be calculated as follows:

(Acquisition Cost – Salvage Value) / Useful Life = Depreciation Rate

($35,000 – $10,000) / 5 = Depreciation Rate

$25,000 / 5 = $5,000

You will depreciate the truck at a rate of $5,000 per year, or approximately $416.67 per month.

The adjusting entry to your books each month, then, would be:

The depreciation expense shows up on your profit and loss statement each month, showing how much of the truck’s value has been used that month. Accumulated depreciation is a contra asset account. This means it shows up under your Vehicle asset account on your balance sheet as a negative number. This has the net effect of reducing the value of your assets on your balance sheet while still reflecting the purchase value of the vehicle.

Unlike accruals, there is no reversing entry for depreciation and amortization expense.

Let’s assume you have $250,000 in inventory and you know you typically lose 2% of your inventory to theft or spoilage each year.

First, let’s calculate the dollar amount of the inventory loss:

$250,000 x 0.02 = $5,000

You lose, on average, $5,000 of your inventory each year. On a monthly basis, that’s $416.67. So, each month, you would make the following entry to your books:

The Inventory Loss account could either be a sub-account of cost of goods sold, or you could list it as an operating expense. We prefer to see it as an operating expense so it doesn’t skew your gross profit margin. The Reserve for Inventory Loss account is a contra asset account, and it shows up under your Inventory asset account on your balance sheet as a negative number.

When you do your physical inventory each year, you will reverse the entry for the year:

And then you will record the actual inventory loss. Let’s say it winds up being $3,750.

Because you know your inventory amount has decreased by $3,750, you will adjust your actual inventory number instead of posting to the reserve account.