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Adjustments and Reclasses in Accounting: Understanding the Basics

by | Mar 24, 2024

Adjustments are made at the close of an accounting period to rectify errors, record unaccounted income or expenses, and maintain the integrity of financial records to prepare comprehensive financial statements. This ensures financial data accurately reflects the financial position and performance of a business.

What is an adjustment in accounting?

An adjustment in accounting is a journal entry that impacts the income statement. An adjusting entry can also specifically mean an entry made at the end of the period to correct a previous error or to record unrecognized income or expenses.

Why make an accounting adjustment?

There are various reasons why adjusting entries may need to be made in accounting. One common reason is the accrual basis of accounting, which requires companies to record revenues and expenses when they are earned or incurred, rather than when cash is received or paid. This means some transactions may not have been recorded during the accounting period and adjustments need to be made to accurately present an organization’s financial position.

Adjustments can also arise due to errors, such as mathematical mistakes or incorrect classification of items in the financial statements. Errors, from forgotten entries to resource misallocations, require accounting adjustments to maintain the income statement’s accuracy. For example, if a purchase were mistakenly classified as an expense instead of an asset, an adjusting entry would need to be made to correct this error.

Another reason for adjustments is changes in estimates. Some items on a company’s balance sheet, such as accounts receivable and inventory, require estimates for their fair value. If these estimates change over time, adjustments must be made to accurately reflect the fair value of these line items on the financial statements.

What is a reclass in accounting?

A reclass is a journal entry that moves an amount from one account to another, typically with no income statement impact. Reclasses are necessary when invoices are miscoded or other errors are made and need to be corrected.

What is a reclass vs. an adjustment in accounting?

Typically accountants think of reclasses as journal entries that move an amount from one account to another with no income statement impact while an adjustment is a journal entry with an income statement impact.

Types of accounting adjustments

Types of adjustments in accounting include accruals, deferrals, estimates, and depreciation/amortization. Two of the most commonly made adjustments in accounting are accruals and deferrals, employed to maintain accrual basis financial statements.

Accruals

Accruals occur when revenues or expenses have been earned or incurred but not recorded in the books. One common example of an accrual adjustment is accrued expenses, such as accrued rent. With accrued expenses, costs have been incurred but the invoice has not been received, or it’s been received by not recorded. If a company has work performed during the period, but an invoice has not been received by the end of the period, the company would accrue the expense to record the amount owed. These adjustments help ensure all expenses are properly matched with their corresponding period.

Deferrals

On the other hand, deferrals are recorded items that need to be adjusted because they do not represent actual revenues or expenses for the period. Deferral adjustments often involve prepaid expenses and unearned revenues.

Prepaid expenses are payments made in advance for goods or services that will be used up over time, such as insurance premiums or rent payments. Adjustments for prepaid expenses recognize the used portion of the good or service as an expense in the current period, while the portion of the payment representing the unused goods or services can remain on the balance sheet as an asset until it is used.

Unearned revenue occurs when a company receives payment from customers for goods or services it has not yet provided, or earned. This is commonly seen for software licenses or subscriptions where customers pay upfront for the use of the product over a period of time. The unearned revenue must be adjusted over time as revenue is recognized based on how much of the product or service has been delivered. For example, a company may require full payment at the beginning of a three-year software subscription. The company would record the receipt of the cash payment but the revenue would be deferred and adjusting entries would be made to recognize the revenue evenly over the term of the contract.

Estimates

Assets such as accounts receivable and inventory frequently use estimates to accurately reflect their value. As actual transactions occur or additional information is known, a company will adjust its financial position. For example, a company may record a bad debt provision for accounts or invoices they deem to be uncollectible. If they learn of a customer filing bankruptcy or receive payment for an invoice they previously determined to be uncollectible, they would need to adjust their estimate.

Depreciation and amortization

Depreciation is a process by which organizations account for the deterioration of a fixed asset’s value over time. Amortization refers to the spreading of the costs of long-term intangible assets over their useful lives. Both of these methods are used to match the expense with the revenue generated from using the asset. For example, a company that purchases a delivery truck with a useful life of five years for $50,000 would make an annual depreciation adjustment of $10,000 to evenly spread the cost of the truck over the period it will be contributing to the operations of the company.

Summary

Adjustments in accounting are necessary to ensure that a company’s financial statements accurately reflect a company’s financial performance and position. These adjustments may seem complex, but they are essential for providing stakeholders with reliable and transparent financial information. As such, organizations need to have an understanding of the various types of accounting adjustments and their impact on the overall financial statements.

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