Adjusting Entries and Closing Entries: How to Ensure Accuracy in Financial Reporting?

Adjusting Entries and closing entries represent a set of important accounting procedures that are performed at the end of the financial period to ensure the accuracy and completeness of the financial data recorded in the books. These adjustments are necessary to apply the accrual basis and the matching principle, which are two of the most important principles of financial accounting. In this article, we will explain Adjusting Entries and closing entries, discuss their types and how they are performed, focusing on their role in preparing the final financial statements, as well as highlighting their importance in improving the quality and reliability of financial reports.

What are Adjusting Entries?

Adjusting Entries are accounting entries made at the end of the financial period to adjust the balances of certain accounts, to ensure that the financial statements accurately reflect the entity’s financial position in accordance with generally accepted accounting principles (GAAP), particularly the accrual and matching principles.

• Accrual Basis: Stipulates that revenues are recognized when earned and expenses are recognized when incurred, regardless of the timing of cash receipts or payments.
• Matching Principle: Stipulates that the revenues of the financial period must be matched with the expenses that contributed to generating those revenues, in order to determine net profit or loss correctly.

Importance of Adjusting Entries:

• Ensuring the Accuracy of Financial Data: Adjusting Entries help ensure that the financial statements accurately reflect the entity’s financial position by adjusting the balances of accounts that do not show the correct value at the end of the financial period.
• Applying the Accrual Basis: Adjusting Entries help in applying the accrual basis by recognizing revenues and expenses in the financial period to which they relate, regardless of the timing of cash flows.
• Achieving the Matching Principle: Adjusting Entries contribute to achieving the matching principle by linking the revenues of the financial period with the expenses that contributed to their generation.
• Improving the Quality of Financial Reports: Adjusting Entries improve the quality, relevance, and reliability of the financial information provided to users of the financial statements.
• Making Better Decisions: Adjusting Entries provide more accurate financial information that helps management, investors, and creditors make informed economic decisions.

Types of Adjusting Entries:

Adjusting Entries are classified into four main types:

1. Accrued Expenses:
   • Definition: Expenses that relate to the current financial period but have not been paid or recorded in the books by the end of the period.
   • Example: Employees’ salaries accrued for December but will be paid in January of the following year.
   • Treatment: The expense is recognized in the financial period to which it relates, and the liability is recognized in the Statement of Financial Position.
   • Journal Entry:
     • Debit: Expense (Expense Name)
     • Credit: Accrued Expense (Expense Name)
2. Accrued Revenues:
   • Definition: Revenues that relate to the current financial period but have not been collected or recorded in the books by the end of the period.
   • Example: Revenue from services provided to customers in December but not collected by the end of the year.
   • Treatment: The revenue is recognized in the financial period to which it relates, and the asset (right to collect) is recognized in the Statement of Financial Position.
   • Journal Entry:
     • Debit: Accounts Receivable (or other asset depending on the nature of the revenue)
     • Credit: Revenue (Revenue Name)
3. Prepaid Expenses:
   • Definition: Expenses that have been paid in advance and relate to more than one financial period.
   • Example: Paying an annual insurance premium at the beginning of the year.
   • Treatment: The portion that relates to the current period is recognized as an expense, and the remaining portion is recognized as an asset in the Statement of Financial Position under the heading “Prepaid Expenses.”
   • Initial Entry (upon payment):
     • Debit: Prepaid Expenses
     • Credit: Cash
   • Adjusting Entry: *Debit: Expenses *Credit: Prepaid Expenses.
4. Unearned Revenues (Deferred Revenues):
   • Definition: Revenues that have been collected in advance for services or goods that have not yet been provided.
   • Example: Collecting rent for a full year in advance.
   • Treatment: The portion that relates to the current period is recognized as revenue, and the remaining portion is recognized as a liability in the Statement of Financial Position under the heading “Unearned Revenues.”
   • Initial Entry (upon recieving payment):
     • Debit: Cash
     • Credit: Unearned Revenue
   • Adjusting Entry:
     • Debit: Unearned Revenue (Revenue Name)
     • Credit: Revenue (Revenue Name)

Examples of Adjusting Entries:

• Example (1): Accrued Expenses:
  • Situation: Company “A” did not pay its employees’ salaries for December by the end of the fiscal year. The accrued salaries amount to 50,000 Riyals.
  • Adjusting Entry:
    • 50,000 Riyals Debit: Salary Expense
    • 50,000 Riyals Credit: Salaries Payable
• Example (2): Accrued Revenues:
  • Situation: Company “B” provided services to a client in December and did not collect the value of the services by the end of the fiscal year. The value of the services is 20,000 Riyals.
  • Adjusting Entry:
    • 20,000 Riyals Debit: Accounts Receivable
    • 20,000 Riyals Credit: Service Revenue
• Example (3): Prepaid Expenses:
  • Situation: Company “C” paid an annual insurance premium of 12,000 Riyals on October 1st.
  • Original Entry (upon payment):
    • 12,000 Riyals Debit: Prepaid Insurance Expense
    • 12,000 Riyals Credit: Cash
  • Adjusting Entry on December 31st:
    • 3,000 Riyals Debit: Insurance Expense (12,000 × 3/12)
    • 3,000 Riyals Credit: Prepaid Insurance Expense
• Example (4): Unearned Revenues:
  • Situation: Company “D” received advance quarterly rent of 6,000 Riyals on December 1st.
  • Original Entry (upon collection):
    • 6,000 Riyals Debit: Cash
    • 6,000 Riyals Credit: Unearned Rent Revenue
  • Adjusting Entry on December 31st:
    • 2,000 Riyals Debit: Unearned Rent Revenue (6,000 × 1/3)
    • 2,000 Riyals Credit: Rent Revenue

What are Closing Entries?

Closing entries are a set of accounts that are prepared at the end of the financial period to summarize the entity’s results of operations and determine its financial position. Closing entries include Income Statement accounts and Statement of Financial Position accounts.

Income Statement accounts include:

• Trading Account: Used in trading entities to determine gross profit or loss.
• Profit and Loss Account: Used to determine net profit or loss after deducting all expenses from all revenues.

Statement of Financial Position accounts include:

• Capital account.
• Retained earnings account.

Steps for Preparing Adjusting Entries and Closing Entries:

1. Perform a Physical Count: Some assets, such as inventory and cash, are physically counted to ensure the accuracy of the balances recorded in the books.
2. Identify Necessary Adjusting Entries: The necessary Adjusting Entries are identified to apply the accrual basis and the matching principle.
3. Record Adjusting Entries: Adjusting Entries are recorded in the general journal and posted to the general ledger.
4. Prepare an Adjusted Trial Balance: A new trial balance is prepared after recording the Adjusting Entries to ensure the equality of debits and credits and the accuracy of the balances.
5. Prepare Closing Entries: The trading account and the profit and loss account (or Statement of Comprehensive Income) are prepared to determine the entity’s result of operations (profit or loss).
6. Close Temporary Accounts: All revenue and expense accounts are closed to the profit and loss account, and then the balance of the profit and loss account is closed to the capital account or retained earnings.
7. Prepare the Statement of Financial Position: The Statement of Financial Position is prepared after closing the temporary accounts, and it reflects the entity’s financial position at the end of the financial period.
8. Prepare the Statement of Changes in Equity: It shows the changes in equity during the period, including the effect of Adjusting Entries and the result of operations.

Importance of Adjusting Entries and Closing Entries:

Adjusting Entries and closing entries are among the most important accounting procedures that ensure the accurate and fair preparation of financial statements. These procedures provide the information needed to:

• Determine the Entity’s Results of Operations Correctly: Adjusting Entries help determine net profit or loss accurately by applying the accrual basis and the matching principle.
• Present the Entity’s Financial Position Fairly: Adjusting Entries ensure that the Statement of Financial Position reflects the true value of the entity’s assets, liabilities, and equity at the end of the financial period.
• Improve the Quality of Financial Reports: Adjusting Entries and closing entries improve the quality, relevance, and reliability of the financial information provided to users of the financial statements.
• Make Informed Economic Decisions: Adjusting Entries and closing entries provide more accurate financial information that helps management, investors, and creditors make informed economic decisions.
• Comply with Accounting Standards: Adjusting Entries and closing entries help ensure the entity’s compliance with International Financial Reporting Standards (IFRS) and generally accepted accounting principles (GAAP).

Role of Technology in Performing Adjusting Entries and Preparing Closing Entries:

Accounting Software and Enterprise Resource Planning (ERP) systems help facilitate the process of making Adjusting Entries and preparing closing entries through:

• Automating the process of recording adjusting entries.
• Performing calculations related to adjustments automatically.
• Generating the necessary reports to prepare closing entries.
• Improving the accuracy and efficiency of the process of preparing financial statements.

Conclusion:

Adjusting Entries and closing entries represent essential procedures in Financial Accounting aimed at ensuring the accuracy and completeness of the financial data recorded in the books. Companies must adhere to applying these procedures correctly to ensure that financial statements are prepared in accordance with IFRS and to provide reliable and transparent financial information that meets the needs of users of these statements.

Understanding Adjusting Entries and closing entries and how they are performed is essential for accountants, auditors, and anyone seeking to understand how financial statements are prepared and analyzed. Mastering these skills enhances your proficiency in Financial Accounting and helps you succeed in the world of business and investment. Finally, technological developments facilitate the process of making Adjusting Entries and preparing closing entries and improve the quality and accuracy of the financial information provided, enhancing the effectiveness of these procedures in achieving their objectives.