How to Make Adjusting Entries in Accounting

Adjusting entries are a foundational component of financial reporting for businesses that follow the accrual basis of accounting. These entries are made at the close of an accounting period to ensure a company’s financial statements accurately reflect its economic activities. The purpose of these adjustments is to align revenues with the period in which they are earned and expenses with the period in which they are incurred. This practice ensures that the financial position and performance presented are a true representation of the entity’s standing. Without these adjustments, financial statements would misrepresent a company’s financial health and operational results.

Fundamentals of Adjusting Entries

The necessity of adjusting entries stems directly from the accrual basis of accounting. This method dictates that financial transactions are recorded when they occur, regardless of when cash changes hands. This contrasts with the cash basis, where transactions are only recorded upon the receipt or disbursement of cash. The accrual basis provides a more comprehensive view of a business’s financial activities.

A core principle underlying accrual accounting is the matching principle. This principle requires that expenses be recognized in the same accounting period as the revenues they help generate. For instance, the cost of goods sold is matched against the revenue from those sales in the same period. Adjusting entries facilitate this matching, ensuring all revenues earned and all expenses incurred within a specific period are accurately recorded.

Adjusting entries are accounting entries made at the end of an accounting period, such as monthly, quarterly, or annually, but always before the preparation of financial statements. These entries are necessary to record revenues and expenses that have not been captured through daily transactions. They update account balances to reflect events that have occurred but have not yet been formally recognized.

Common Categories of Adjusting Entries

Deferred expenses, often referred to as prepaid expenses, represent payments made for goods or services that will be consumed in a future accounting period. Examples include prepaid rent, prepaid insurance, or office supplies purchased in bulk. An adjustment is necessary to recognize the portion of the expense that has been consumed or expired during the current period, moving it from an asset account to an expense account. For instance, if a business pays for a year of insurance coverage in advance, a portion of that payment becomes an expense each month.

Deferred revenues, also known as unearned revenues, occur when a business receives cash for goods or services before they have been delivered or performed. This situation creates a liability because the business owes the customer the goods or services. An adjustment is required to recognize the portion of the revenue that has been earned during the period, shifting it from a liability account to a revenue account. For example, a software company receiving a payment for a one-year subscription creates unearned revenue, which is then recognized monthly as the service is provided.

Accrued expenses are costs that have been incurred by a business but have not yet been paid or recorded. These often include expenses like salaries earned by employees but not yet disbursed, interest on loans that has accumulated, or utilities consumed but not yet billed. An adjustment is needed to recognize these expenses in the period they were incurred, even though the cash payment will occur later. This ensures that all obligations are reflected on the financial statements for the current period.

Accrued revenues represent revenues that a business has earned but has not yet received cash for or formally billed. This scenario arises when services have been rendered or goods delivered, but payment collection is pending. An adjustment is required to recognize this earned revenue in the current period, which also creates a receivable. For example, a consulting firm might complete a project for a client at the end of a month but not issue an invoice until the following month, necessitating an accrual of the revenue.

Depreciation systematically allocates the cost of a tangible long-lived asset, such as equipment or buildings, over its estimated useful life. Assets like machinery or vehicles lose value over time due to wear and tear, obsolescence, or usage. An adjustment is necessary to recognize a portion of the asset’s cost as an expense in each accounting period it is used. This process ensures that the expense of using the asset is matched with the revenues it helps generate throughout its service life.

Recording Adjusting Journal Entries

Recording adjusting entries involves specific debit and credit actions for each category to ensure financial accuracy. For deferred expenses, such as prepaid insurance, the adjustment recognizes the portion of the asset that has been consumed. For instance, if a business had a prepaid insurance balance of $12,000 for a 12-month policy and one month has passed, the entry would involve debiting Insurance Expense for $1,000 and crediting Prepaid Insurance for $1,000. This action increases the expense and decreases the asset to reflect its consumption.

When addressing deferred revenues, like unearned service revenue, the adjustment recognizes the income earned during the period. If a company received $6,000 for services to be delivered over six months and one month of service has been provided, the entry would debit Unearned Service Revenue for $1,000 and credit Service Revenue for $1,000. This process reduces the liability and increases the revenue, reflecting the portion of the obligation that has been fulfilled.

Accrued expenses, such as salaries earned by employees but not yet paid, require an entry to record the expense and the corresponding liability. If employees have earned $5,000 in salaries at the end of the period but payment will occur in the next period, the adjustment would debit Salaries Expense for $5,000 and credit Salaries Payable for $5,000. This action increases both the expense and the liability, accurately reflecting the current period’s obligations.

For accrued revenues, like services performed but not yet billed, the adjustment recognizes the revenue earned and establishes a receivable. If a consulting firm completed a $3,000 project that has not yet been invoiced, the entry would debit Accounts Receivable for $3,000 and credit Service Revenue for $3,000. This increases both the asset and the revenue, ensuring proper income recognition.

Depreciation entries account for the portion of a long-lived asset’s cost allocated to the current period. Using a common method like straight-line depreciation, if equipment costing $60,000 with a useful life of 10 years has been in use for one month, the monthly depreciation would be $500 ($60,000 / 120 months). The adjusting entry would debit Depreciation Expense for $500 and credit Accumulated Depreciation for $500. This increases the expense and increases a contra-asset account, systematically reducing the asset’s book value over time.

Financial Statement Impact

Adjusting entries play a fundamental role in ensuring the accuracy and reliability of financial statements. On the income statement, these entries ensure that revenues and expenses are matched to the correct accounting period, adhering to the matching principle. This precise allocation means that the reported net income or loss accurately reflects the company’s operational performance for that specific timeframe. Without these adjustments, the income statement could overstate or understate earnings, leading to an inaccurate portrayal of profitability.

On the balance sheet, adjusting entries ensure that asset, liability, and equity accounts reflect their true values at the end of the accounting period. For instance, prepaid expenses are reduced to their unexpired portion, and unearned revenues are decreased as services are performed. Similarly, accrued expenses and revenues are recognized, ensuring that all obligations and receivables are properly recorded. This meticulous updating of account balances provides a more accurate snapshot of the company’s financial position.

The absence of adjusting entries would result in financial statements that do not conform to the accrual basis of accounting. This would lead to misstated assets, liabilities, revenues, and expenses. Such inaccuracies could significantly impair the ability of stakeholders, including management, investors, and creditors, to make informed decisions regarding the business’s financial health and future prospects.