The purpose of accounting in any business entity is to properly record the financial transactions, classify them, and present them as useful information in financial statements and analysis.
However, the financial statements and analysis can only be useful and fair if the recording and classification process of economic events and transactions has been done accurately.
Besides, the recording of accounting events is governed by different accounting principles. Therefore, a lot of entries other than the normal journal entries are passed in the accounting books. Adjusting entries and correcting entries represent such entries that are passed beside the normal economic events.
Adjusting entries are made at the end of the accounting period to close different accounts before moving into the next financial period. Correcting entries are made to fix any errors and omissions made by the accounting and bookkeeping staff during a financial period.
In this article, we will differentiate between adjusting entries and correcting entries. Besides, we will also discuss different types of adjusting and correcting entries with examples. So, let’s get into it.
What Are Adjusting Entries?
The accounting professionals of any business entity pass some entries at the end of a financial period to transfer the closing balances in different general ledger accounts.
These entries are also passed on, recording any unrecognized income or expense for the given accounting period. We can also define the adjusting entries as the changes to already-recorded journal entries to match revenues of a certain period with the corresponding expenses.
Adjusting entries are a significant part of the accounting process as it’s the essence of the accrual method of accounting. However, there is no need to adjust entries if a business follows the cash basis of accounting.
Types Of Adjusting Entries
We mentioned earlier that the adjusting entries are made under different ledgers. Therefore, we can categorize the adjusting entries into five types: deferred revenues, prepaid expenses, accrued revenues, accrued expenses, and non-cash items.
Deferrals represent the deferred revenues of an entity that have not been earned yet. It implies that the customer/client has paid the business in advance, and the revenues have yet to be realized. A common example of deferrals is the subscription services where clients pay annual or monthly subscriptions in advance.
Unearned Revenue When Cash Received
|Cash Account/ Bank Account||xxx|
|Service Revenue Earned||xxx|
|(Cash received against the services provided)|
Revenue Realized After Services Have Been Delivered
|(Revenues Recognized )|
On the other hand, Prepaid expenses represent the amount of money that an entity has paid in advance. The services against the prepaid expenses are yet to be received. The prepaid rent, insurance premium, etc., are common examples of prepaid expenses
Accruals(Revenues & Expenses)
Accruals can be accrued revenues or accrued expenses of an entity. The accrued revenues represent the part of earned revenues that the entity has yet to receive from the client.
The entity has provided the services but has not received the cash. Therefore, revenues are credited against the account receivables.
Similarly, accrued expenses represent the portion of incurred expenses by the entity. However, these expenses have not been cleared yet. It implies that the entity has taken services from a supplier/service provider but not paid for the services. Therefore, the accrued expenses are debited against the account payables.
Non-cash items or estimates are also recorded by adjusting entries. The most common adjusting entries among all the non-cash items are depreciation expense and doubtful debt. The provision for doubtful debts, depreciation expenses, inventory obsolescence, etc., are treated as non-cash items.
Depreciation is defined as the periodic allocation of the cost of an asset in different accounting periods throughout the asset’s useful life.
The adjusting entry for the depreciation expense will be as follows:
|(depreciation expense realized)|
Why Adjusting Entries Are Passed?
The matching principle of accounting implies that the revenues and expenses should be recognized when they’re earned or incurred.
It implies that the revenues and expenses must be recorded in the corresponding financial period irrespective of the cash received. Therefore, the adjusting entries are passed, and balances are transferred to general ledger accounts.
If the adjusting entries are not passed, the expenses that have actually been incurred in the financial periods won’t be recorded accurately.
Similarly, if the client has paid money in advance, but services have not been provided yet, the income will be overstated if adjusting entries are not passed.
Besides, the importance of adjusting entries can’t be undermined from the perspective of the non-cash items in the financial statements for balancing the books of accounts.
What Are Correcting Entries?
The correcting entries are passed to rectify and correct the erroneous entries that had been passed in ledger accounts during the last financial period. A depreciation expense might be recorded as amortization when posted in the ledger.
Why Are Correcting Entries Passed?
The accounting staff often make many mistakes and errors during a financial period while recording the economic transactions and events.
Therefore, it’s important to fix the errors before concluding the financial statements. The journal entries are passed to rectify the errors and mistakes made during recording financial transactions.
The correcting entries are most commonly identified during the preparation of trial balance. Trial balance is the conclusion of general ledger accounts. The difference between the debit and credit balances of the trial balances is indicative of mistakes.
How To Pass Correcting Entries?
Once the difference in balances of the debit and credit sides in the trial balance has been identified, the next step is fixing it. There are two ways to pass correcting entries: reversal entry or single journal entry.
The reversal entry is passed by making another journal entry for rectification of the previous entry that was erroneously passed. The next step is passing a new correct entry.
In the case of a single journal entry, the wrong aspect of the erroneous entry is corrected by passing a new entry.
In essence, the first way implies passing two journal entries, one to cancel the effect of a wrong entry and then passing a new one. On the other hand, a single entry is passed when you use the single journal entry method.
Let’s understand the examples with the reversal and single entry methods.
A trading company has purchased the inventory worth $25,000 from supplier X. The entry passed in the books of the trading company was as follows:
|Supplier X a/c||25,000|
|(Entry to record credit purchases amount $25,000)|
After a month, it was found that the amount payable in the Supplier Y account was not correct. After locating the error, it was found that the accountant had wrongly credited the amount of Mr. X to Supplier Y’s account.
The following entries will be passed to rectify the error:
|Supplier Y a/c||25,000|
|To Purchases a/c||25,000|
|(Reversal entry to rectify the wrong credit)|
|Supplier X a/c||25,000|
|(Entry to rectify the credit purchases to the right account )|
|Adjusting Entries||Correcting Entries|
|Adjusting entries are passed to conclude the ledger balances by posting any unrecognized revenues or expenses||The entries passed to rectify the mistakes made in the accounting records|
|Following are the types of adjusting entries: accruals, deferrals, non-cash items||The correcting entries can be passed in two ways: reversal entries and single journal entry|
|Recording any unrecognized income or expense for the given accounting period||Correction and rectification of the errors in posting entries in ledgers|
|Recognition of the expenses and revenues under the accrual method of accounting||True and fair view of the financial statements|
|Depreciation expense, prepaid expenses, unearned revenue, etc.||Wrong account debited, the wrong amount posted, etc.|
|The matching principle of accounting||True and Fair View of Financial Health|
We have discussed everything about the adjusting entries and the correcting entries. Besides, you can easily differentiate between the two based on the entries’ types, benefits, and purpose.
However, one thing is common about both types of entries: both adjusting and correcting entries are passed at the end of a financial period.