How to Make Adjusting Entries in Accounting

Adjusting entries are performed at the close of an accounting period to ensure financial statements accurately reflect a company’s financial standing. They align revenues and expenses with the specific period in which they are earned or incurred, regardless of when cash is received or paid. This step is part of the accounting cycle, ensuring financial reports provide a true and fair view of an entity’s performance and position. Without these adjustments, financial statements could present a misleading picture of a business’s economic reality.

Foundational Concepts for Adjusting Entries

Adjusting entries are tied to the accrual basis of accounting, where revenues are recognized when earned and expenses when incurred, regardless of when cash changes hands. This provides a more comprehensive representation of a company’s financial activities. Cash basis accounting only records transactions when cash is received or paid, which can distort the timing of economic events.

The matching principle, a cornerstone of accrual accounting, dictates that expenses should be recognized in the same accounting period as the revenues they helped generate. For example, the cost of goods sold is matched with the revenue from those sales. This ensures a proper evaluation of profitability.

The revenue recognition principle states that revenue is recognized when it is earned. This means revenue is recorded when a company completes its obligation to deliver goods or services, even if the customer has not yet paid. This principle prevents companies from overstating or understating revenue.

Adjusting entries primarily affect temporary accounts, such as revenue and expense accounts, which are closed at the end of each accounting period. They also impact permanent accounts, like asset and liability accounts, which carry their balances forward. Adjustments ensure these accounts reflect their correct balances, providing accurate figures for financial statements.

Adjusting Entries for Deferrals

Deferrals involve situations where cash has been exchanged before a revenue is earned or an expense is incurred. These transactions require adjustments to properly allocate the revenue or expense to the correct accounting period. Without these adjustments, financial statements would misrepresent a company’s assets, liabilities, revenues, or expenses.

Prepaid Expenses

Prepaid expenses are payments made in advance for goods or services to be consumed in a future accounting period. Examples include rent, insurance premiums, and office supplies. Initially, when cash is paid, the amount is recorded as an asset.

Adjusting a prepaid expense involves determining the portion of the asset used or expired during the current period. For example, if a business pays $12,000 for a one-year insurance policy on January 1, one month of coverage is used by the end of January. The calculation is $12,000 divided by 12 months, equaling $1,000 per month.

The journal entry for a prepaid expense adjustment involves debiting an expense account and crediting the corresponding asset account. For instance, “Insurance Expense” would be debited for $1,000, and “Prepaid Insurance” would be credited for $1,000. This entry reduces the asset to its remaining value and recognizes the expense incurred.

Unearned Revenue

Unearned revenue represents cash received by a company for goods or services not yet delivered or performed. This commonly arises with magazine subscriptions, gift cards, or advance payments. When cash is initially received, it is recorded as a liability because the company owes a service or product.

Adjusting unearned revenue means determining what portion of the service or good has been delivered or earned during the current period. For example, if a company receives $600 for a six-month service contract on October 1, one month of service is rendered by the end of October. The calculation is $600 divided by six months, equaling $100 per month.

The adjusting journal entry for unearned revenue involves debiting the liability account and crediting a revenue account. “Unearned Service Revenue” would be debited for $100, and “Service Revenue” would be credited for $100. This entry reduces the liability as the obligation is fulfilled and recognizes the revenue as it is earned.

Adjusting Entries for Accruals

Accruals address situations where revenues have been earned or expenses incurred, but the cash exchange has not yet occurred. These adjustments recognize economic events in the period they happen, even if payment or receipt is delayed. Without these entries, revenues or expenses could be understated, leading to inaccurate profitability reporting.

Accrued Expenses

Accrued expenses are costs incurred during an accounting period but not yet paid or formally recorded. Examples include salaries earned by employees but not yet paid, or utilities used but not yet billed. These expenses represent obligations a company owes, even if an invoice has not been received.

Adjusting an accrued expense involves recognizing that a benefit has been received, creating an obligation. For instance, if employees earn $5,000 in wages for the last week of December, but payday is in January, those wages are an accrued expense for December. The full $5,000 is the amount to be accrued.

The journal entry for an accrued expense involves debiting an expense account and crediting a liability account. For the wages example, “Salaries Expense” would be debited for $5,000, and “Salaries Payable” would be credited for $5,000. This adjustment increases expenses on the income statement and establishes a liability on the balance sheet.

Accrued Revenue

Accrued revenue represents income a company has earned by providing goods or services, but for which cash has not yet been received. This often occurs when services are performed over time or goods are delivered, but the customer has not yet been billed. Examples include interest earned on investments not yet collected or services completed but not yet invoiced.

Adjusting accrued revenue requires recognizing that the earning process is complete, even without a cash receipt. For instance, if a consulting firm completes $3,000 worth of services by December 31 but will not invoice the client until January, this revenue is accrued for December. The full $3,000 is the amount to be accrued.

The adjusting journal entry for accrued revenue involves debiting an asset account and crediting a revenue account. For the consulting example, “Accounts Receivable” would be debited for $3,000, and “Service Revenue” would be credited for $3,000. This adjustment increases assets on the balance sheet, reflecting the right to receive cash, and increases revenue on the income statement.

Finalizing the Adjustment Process

After all individual adjusting entries are identified, calculated, and recorded, they are posted to the respective general ledger accounts. This updates each account balance to reflect the adjustments. Every debit and credit from the adjusting entries is transferred to the appropriate ledger account, which maintains a running balance.

Following the posting of all adjusting entries, an adjusted trial balance is prepared. This document lists all general ledger accounts and their balances after adjustments. Its purpose is to verify that total debits still equal total credits, ensuring the accounting equation remains in balance. This serves as an internal check of mathematical accuracy before formal financial statements are generated.

Adjusting entries significantly impact a company’s financial statements, enhancing their accuracy. On the income statement, these adjustments ensure revenues are recognized when earned and expenses when incurred, aligning with the matching principle. For example, accrued salaries expense increases total expenses and reduces net income, while recognizing earned unbilled revenue increases reported income. This provides a more accurate measure of profitability.

On the balance sheet, adjusting entries ensure assets and liabilities are reported at their correct values. For instance, reducing prepaid expenses accurately reflects the remaining asset value, while recognizing unearned revenue as it is earned reduces a liability. Recording accrued expenses establishes new liabilities. This process ensures financial statements provide a true and fair view of the entity’s financial performance and position.