Step 3 - 5: Prepare unadjusted balance, adjustments, and adjusted balance

Creating the unadjusted balance, making necessary adjustments, and preparing the adjusted balance are crucial stages in the accounting cycle. These actions help ensure compliance with accounting principles, the precise matching of revenues and expenses, and overall financial accuracy.

ADJUSTING FOR BALANCE

Creating the unadjusted balance, making necessary adjustments, and preparing the adjusted balance are crucial phases in the accounting cycle. These actions ensure compliance with accounting principles, precise alignment of revenues and expenses, and overall financial accuracy.

STEP 3: PREPARE UNADJUSTED TRIAL BALANCE

The unadjusted trial balance lists account balances from the general ledger at a specific date, prior to any adjustments. It highlights total debits and credits, offering a snapshot of account balances at that time. The term "unadjusted" indicates it is prepared before end-of-period adjustments.

As shown in the following example, the unadjusted trial balance includes the account name (and often the account number) and the account's natural balance, whether it appears on the left (debit) or right (credit) side of the accounting equation. The totals of the debit and credit columns should be equal. If not, there may be errors in recording or posting transactions.

Before providing financial information, it's important to complete the accounting cycle as there may be important adjustments needed. By skipping the crucial steps of preparing the unadjusted trial balance, making adjusting entries, and preparing the adjusted trial balance before running the financial statements, you risk providing incomplete or inaccurate financial information.  

At the end of each accounting period, you will prepare adjusting entries (step 4) to ensure the financial statements reflect the business's activities accurately. 

Once you've recorded the adjusting entries, you'll prepare the adjusted trial balance (step 5), which shows the updated and final balances of all accounts. This trial balance provides a clear and accurate picture of the business's financial position at the end of the accounting period.

STEP 4: PREPARE ADJUSTING ENTRIES

At the close of the accounting period, bookkeepers undertake the task of making adjusting entries. This requires reviewing the unadjusted trial balance and updating it by recording necessary adjustments. These adjustments, which encompass deferrals, accruals, and tax adjustments, can affect net income, the balance sheet, and owner's equity.

To ensure financial statements accurately reflect all revenues earned and expenses incurred during the accounting period, adjusting entries are made on the last day of the period. These entries are essential to account for business transactions not yet recorded in the accounting records.

The entries include capturing transactions not yet recorded that belong to the accounting period, such as expenses incurred but not yet paid or recorded, revenue received in advance of providing goods or services, and adjustments for prepaid expenses like insurance premiums.

Tax adjustments are typically made annually as part of adjusting entries. The process of making these entries, also known as adjusting journal entries, involves analyzing the current account balance, determining the desired balance for the period’s end, and recording the adjustment.

Generally, an accountant or Certified Public Accountant is responsible for preparing adjustments. A bookkeepers role is to implement the suggested adjustments by recording the adjusting journal entries. Matching principle

Revenues and their associated expenses should be recognized in the same reporting period.

Types of adjustments

In accrual accounting, adjusting entries are essential for applying the matching principle, which involves aligning expenses with revenues in the period they occur, rather than when cash is exchanged. These entries are crucial for synchronizing expenses with revenues during the accounting period.

Record revenues when they are earned, regardless of when the business receives the money.  Record expenses when they are incurred, regardless of when the business pays them.

Adjusting entries reflect the actual exchange of money and modify real-time entries to align revenue and expenses with the period they occur. They encompass various types of entries.

Deferrals remove transactions that should be allocated to a different time period. For instance, if a business purchases a new lawn mower but hasn't used it yet, its value shouldn't be attributed to the revenue earned in the current period.

Similarly, if a client pays in advance for a job that hasn't been completed, the revenue should be adjusted to correspond with the actual completion of the job. Likewise, when a business pre-pays for insurance costs, those expenses should be adjusted to fit the appropriate period. Overall, deferrals ensure that revenues and expenses are correctly matched to the relevant time period.

Accruals, in contrast, are the opposite of deferrals. They involve transactions that include future payments or expenses. For example, a business completes a job and invoices the customer, but the payment hasn't been received yet. In this scenario, the revenue has been earned during the accounting period and should be matched with expenses like labor costs necessary to complete the job.

It's crucial to record the revenue and expenses in the period they occur, rather than waiting for the customer’s payment. Often, accruals involve adjusting entries to account for wages or salaries that haven't been paid yet because payroll periods don't align with the accounting period. Entries can also account for missing or improperly recorded transactions, like bank fees charged on the last day of the month but not yet recorded.

Tax adjustments typically occur annually. For example, if the business files a return and receives a tax credit, that credit is recorded as an adjustment. Another type of tax adjustment is depreciation. It is a method to evenly spread the cost of an asset over its expected lifespan. When an expensive item, like a vehicle purchased for $50,000, is acquired, the full amount is recorded as an asset. However, through depreciation, the expense of the item can be distributed over multiple accounting periods to reflect the item's useful life and to match the expense of the item with the revenue it helps generate.

For example, if the vehicle's expected life is 5 years, $10,000 would be recognized as an expense each year the vehicle is used until its full value has been expensed. This gradual recognition of expenses reduces the immediate impact on net profit, as only a portion of the cost is recorded as an expense in each period.

Remember, adjustments aim to align revenue and expenses within the accounting period to provide a more accurate representation of the business's financial health.

STEP 5: PREPARE ADJUSTED TRIAL BALANCE To ensure accurate financial records, your bookkeeper will record adjusting entries in both the journal and the ledger. Start from the unadjusted balance.

Your bookkeeper will begin with the unadjusted balance, and make sure each account has a current balance in their respective accounts. These are the numbers from your drafted financials before any adjustments are made. Make the adjustments, marking all clearly.

Next, your bookkeeper adds the adjusting entries. All entries should be clearly marked to indicate the affected accounts and the amount involved.  Prepare the adjusted balance.

Once the adjustments have been made, they will prepare the adjusted balance. This balance reflects the final balances of all accounts at the end of the accounting period, including the adjustments. These would be your final financials.

Adjusting entries affect profitability, the financial statements, and can have tax implications for a business. Depreciation entries reduce profits by recording additional expenses, while recording prepaid expenses as assets increases profitability. Consistency in applying adjustments is therefore crucial for reliable records and financial statements.

It is typically the CPA or Accountant who will identify the needed adjusting entries to be made. Then it is the bookkeeper who will typically make the requested adjustments.