When you work under the accrual method of accounting, you have to do more than simply keep track of the money as it comes in and goes out. There are some situations where money has been earned but not received and vice versa. Under the accrual method, you must record these transactions during the accounting period in which they occur. It may seem like extra work, but the accrual method is preferable over the cash method because it provides you with a more long range understanding of the financial wellbeing of your business. There are multiple situations in which you will need to include adjusting entries, but the two you will encounter most often are accrued revenues and accrued expenses.
There are times when you do not immediately receive the money you earned for products or services rendered. For example, if you are a restaurant vendor, you may deliver products first and send invoices later for your regular clients. The revenues are earned during the accounting period in which you delivered the product. But, you may not receive the funds from your customer until the next accounting period. In this case, adjusting entries are needed to accurately keep track of what you earned during the accounting period.
It is necessary to record all expenses accrued during an accounting period. There will be times when an expense is accrued but has not been paid out. In that situation adjusting entries are needed. For example, if you own a restaurant you likely receive deliveries from vendors on a regular basis. As you build trusted relationships with your vendors, you may receive delivery of products and get billed for them at a later date. If you receive a delivery of fresh fish on March 19th and your accounting period ends March 31st then you need to record that as an expense for that accounting period-whether or not the vendor has been paid.
Adjusting entries for accrued expenses can help you in more than one way. First, it will prevent you from spending money that has already been allocated for something else. Continuing with the example from above, you allocated the money to pay the vendor in the month of March. If the money does not leave the account in March, and you fail to record the accrued expense, it will look like that money is available for something else when you start the next accounting period. Second, adjusting entries for accrued expenses can help you more accurately forecast for future needs. When next spring rolls around, you may want to look back a year and see how much you spent on fish in the month of March in order to allocate enough money for future purchases.
Adjusting entries are an essential part of accurate accounting under the accrual method. Once all the adjusting entries are added to a particular accounting period, you can complete the financial statements for that period and use them to plan for the financial future of your business.