How to Do Adjusting Entries in Accounting

Adjusting entries are specialized journal entries made at the close of an accounting period to ensure a business’s financial statements accurately reflect its economic activity. They are necessary because some transactions occur continuously but are not recorded daily. These entries update account balances for revenues earned and expenses incurred that have not yet been formally recognized through a cash transaction or other initial recording.

Underlying Accounting Principles

The need for adjusting entries arises from the accrual basis of accounting. This method recognizes revenues when they are earned and expenses when they are incurred, regardless of when cash is exchanged. For example, revenue is recorded when services are performed or goods are delivered, not necessarily when payment is received. Similarly, expenses are recognized when a benefit is consumed, even if the payment for it happens later.

The accrual basis works in conjunction with the matching principle. This principle dictates that expenses should be recognized in the same accounting period as the revenues they helped generate. For instance, the cost of goods sold should be matched against the revenue from those sales in the same period. This ensures that financial statements accurately portray the profitability of a company’s operations by associating all related costs with the income they produced.

Without adjusting entries, financial statements could be misleading. They would only show cash transactions, failing to account for earned revenues not yet collected or incurred expenses not yet paid. This could distort reported profits and misrepresent the true financial health of a business at any given time. Adjusting entries bridge this gap, allowing for a more faithful representation of a company’s financial reality.

Common Adjusting Entries and Their Application

Adjusting entries typically involve one income statement account (revenue or expense) and one balance sheet account (asset or liability) to ensure proper recognition. These adjustments ensure that income and expenses are allocated to the correct accounting period.

Accrued Expenses

Accrued expenses represent expenses incurred but not yet paid or recorded. A common example is salaries earned by employees at the end of an accounting period but not paid until the next period. To record this, a company debits Salaries Expense to recognize the cost and credits Salaries Payable to record the liability owed to employees.

Accrued Revenues

Accrued revenues are revenues earned but not yet received in cash or billed to the customer. This can happen when a service has been provided, but an invoice has not yet been sent. An adjusting entry debits Accounts Receivable to show the money owed to the company and credits Service Revenue to recognize the income earned.

Deferred Expenses

Deferred expenses, often called prepaid expenses, are payments made in advance for goods or services consumed in future periods. Examples include prepaid rent, prepaid insurance, or office supplies purchased in bulk. As the benefit is consumed over time, an adjusting entry recognizes the expense. For instance, if a company paid $12,000 for a year of insurance on January 1, each month it debits Insurance Expense for $1,000 and credits Prepaid Insurance for $1,000 to reduce the asset and recognize the monthly cost.

Deferred Revenues

Deferred revenues, also known as unearned revenues, occur when a company receives cash for goods or services before they have been delivered or performed. This creates a liability because the company owes the customer the product or service. A typical scenario might involve a client paying $6,000 in advance for six months of consulting services. As each month of service is completed, an adjusting entry debits Unearned Revenue for $1,000 to reduce the liability and credits Service Revenue for $1,000 to recognize the earned income.

Depreciation and Amortization

Depreciation and amortization are methods of systematically allocating the cost of long-term assets over their useful lives. Depreciation applies to tangible assets like equipment or buildings, while amortization applies to intangible assets such as patents or copyrights. For example, if a piece of equipment costing $100,000 has an estimated useful life of 10 years and no salvage value, using the straight-line method, the annual depreciation expense would be $10,000. The adjusting entry debits Depreciation Expense for $10,000 and credits Accumulated Depreciation for $10,000. This accumulated depreciation account is a contra-asset account, reducing the book value of the asset on the balance sheet.

Effect on Financial Statements

Adjusting entries play a role in ensuring the accuracy of a company’s financial statements. By recognizing all revenues earned and expenses incurred within an accounting period, they enable the income statement to present a true net income or loss. This comprehensive reporting allows stakeholders to understand the profitability derived from the period’s operations.

These adjustments ensure the balance sheet accurately reflects a company’s assets, liabilities, and equity at a specific point in time. For example, recording accrued expenses ensures that all outstanding obligations are included, while adjusting for prepaid expenses accurately portrays the remaining asset value. Without these adjustments, the financial statements would only provide an incomplete or distorted view of the company’s financial health.