How to Do Adjusting Entries in Accounting

Adjusting entries are internal transactions recorded at the close of an accounting period. These entries are essential for businesses employing the accrual basis of accounting. Their primary function is to accurately align revenues and expenses with the periods in which they occur, rather than when cash changes hands. This process ensures that financial statements provide a true and fair view of a company’s financial performance and position. Without these adjustments, financial reports could misrepresent a company’s profitability and financial health.

Why Adjusting Entries Are Necessary

Adjusting entries are essential because they ensure financial reporting adheres to the accrual basis of accounting. Accrual accounting recognizes revenues when earned and expenses when incurred, regardless of when cash is received or paid. This differs from cash basis accounting, which records transactions only when cash is exchanged.

The necessity for adjustments stems from two core accounting principles: the revenue recognition principle and the matching principle. The revenue recognition principle requires that revenue be recorded in the accounting period when it is earned, meaning when the goods or services have been delivered or performed. Similarly, the matching principle mandates that expenses be recognized in the same period as the revenues they helped generate. For instance, if a business incurs an expense in December but pays for it in January, the expense must still be recorded in December to properly match it with December’s revenues.

These principles ensure financial statements accurately reflect a company’s economic activities. Many transactions span across accounting periods, so cash flows might not coincide with revenue earning or expense incurring. Adjusting entries bridge this timing gap, ensuring economic events are allocated to the correct reporting period.

Types of Adjusting Entries

Adjusting entries fall into two categories: deferrals and accruals. Each addresses situations where the timing of cash exchange differs from revenue or expense recognition. Understanding these types is fundamental to accurately preparing financial statements.

Deferrals involve cash exchanged before an expense is incurred or revenue earned. Prepaid expenses are payments made in advance for goods or services to be consumed in future periods. Examples include paying for a year of insurance or rent upfront; the expense is recognized gradually over the benefit period. Unearned revenue occurs when a business receives cash before delivering goods or services. This creates a liability, and revenue is recognized only as the service is rendered or product delivered.

Accruals involve transactions where an expense is incurred or revenue earned, but cash has not yet been exchanged. Accrued expenses are costs accumulated but not yet paid, such as salaries earned by employees or interest accrued on a loan. These expenses are recognized in the period incurred, even if payment occurs later. Accrued revenues are earned by providing goods or services, but cash has not yet been received or billed, such as services completed for a client without an invoice or interest earned on an investment. These revenues are recognized when earned, creating a receivable asset.

Making Adjusting Journal Entries

Making adjusting journal entries occurs at the end of an accounting period, after the unadjusted trial balance but before final financial statements. The initial step involves reviewing accounts to identify those that require adjustments, such as prepaid assets, unearned revenue liabilities, and unrecorded expenses or revenues.

Once accounts needing adjustment are identified, the next step is to determine the precise amount of the adjustment. This calculation involves assessing how much of a prepaid asset has been used, how much unearned revenue has now been earned, or the exact value of expenses incurred or revenues earned but not yet recorded. For instance, if a company paid for a six-month insurance policy, the monthly portion that has expired needs to be calculated. Similarly, for accrued salaries, the amount earned by employees up to the period end must be computed.

After determining the correct amount, the specific journal entry is recorded. Each adjusting entry impacts at least one income statement account (revenue or expense) and one balance sheet account (asset or liability), but never involves the cash account. For example, to recognize the portion of a prepaid expense that has been used, an expense account would be debited, and the prepaid asset account would be credited. Conversely, for unearned revenue that has now been earned, the unearned revenue liability account would be debited, and a revenue account would be credited.

Finally, post these adjusting entries to the general ledger. This updates affected account balances, ensuring they accurately reflect the financial position and performance at period end. The updated general ledger balances then form the basis for preparing the adjusted trial balance, which is the source for accurate financial statements.

How Adjusting Entries Affect Financial Reports

Adjusting entries are fundamental to the accuracy of a company’s financial reports. These adjustments directly influence both the income statement and balance sheet, ensuring they present a true and fair view of the business. Without them, financial statements would not comply with accrual accounting, leading to misstated performance and position.

On the income statement, adjusting entries ensure all revenues earned and expenses incurred within a period are recognized. Recording accrued revenues includes income for services rendered, even if cash is not received. Recognizing accrued expenses matches costs like utility usage or employee wages to their period, regardless of payment date. This leads to a more accurate net income or loss calculation.

The balance sheet is also impacted by adjusting entries, which update asset and liability accounts. For example, entries for prepaid expenses reduce the asset as the benefit is consumed, while unearned revenue entries reduce the liability as services are performed. Accrued expenses increase liabilities, reflecting obligations owed but not yet paid. Accrued revenues increase assets by recognizing amounts due from customers. These adjustments provide a snapshot of the company’s financial position.

The accuracy from adjusting entries benefits various stakeholders. Management relies on financial statements for informed decision-making. Investors use these reports to evaluate profitability and financial health, while creditors assess creditworthiness. Accurate financial reporting depends on diligent application of adjusting entries.