Question

While you are having a discussion with a colleague, she mentions that she believes it would be much easier and would have a minimal effect on the financial statements if we eliminated all adjusting entries. Do you agree or disagree and why?

Answer 1

The statement should be completely DISAGREED with.

Adjusting entries are very much important and are required in the accounting cycle.
Usually, journal entry is recorded when a transaction takes place. However there are various instances when a journal entry is required but no actual transaction took place. This is done through adjusting entries only.

Adjusting entries affect the balance of expense account, revenue accounts, and assets, liabilities and Equity gets affected too. Hence they are vital for correct information in the financial statements.

Adjusting entries are required mainly due to the accrual system of accounting, where expenses and revenues are to be recorded when they are are incurred or earned (respectively) whether cash has been received/paid or not.

Lets take up a small adjusting entry and evaluate its affect.
Example: Prepaid Rent balance existing is $ 50,000, Rent expired for the period is $ 30,000.
Now the adjusting entry would involve a 'debit' to Rent Expense for $ 30,000 and credit to Prepaid Rent for $ 50,000.
Hence, expense got increased by $ 50,000 and Assets decreased by $ 50,000

If this adjusting entry has not been recorded, the Net Income would have been over-stated by $ 50,000. This would mean that Retained earnings and Stockholder's Equity would also have been overstated. The Assets on the balance sheet would also have been overstated.

Therefore, if adjusting entries are eliminated, there will be effects on financial statements that can be severe.