How to Make Adjusting Entries With Examples

Accounting is the systematic process of recording financial transactions, providing information about an entity’s financial performance and position. Accurate financial reporting helps businesses make informed decisions. Adjusting entries are a crucial step in the accounting cycle, necessary under the accrual basis of accounting to ensure financial statements reflect a company’s financial status and operational results.

Understanding Adjusting Entries

An adjusting entry is a specific type of journal entry prepared at the close of an accounting period. Its primary objective is to update account balances so that revenues and expenses are recognized in the period they are earned or incurred, regardless of when cash changes hands. This practice adheres to the accrual basis of accounting, which mandates that financial events are recorded when they happen, not just when cash is received or paid.

This approach is governed by two principles: the revenue recognition principle and the expense recognition principle. The revenue recognition principle dictates that revenue is recognized when it is earned, meaning when goods or services have been provided, not necessarily when cash is collected. The expense recognition principle, often called the matching principle, requires expenses to be recorded in the same period as the revenues they helped generate.

Adjusting entries are made at the end of regular accounting periods (monthly, quarterly, or annually). This timing allows businesses to prepare financial statements that accurately reflect the economic activities within that period. Without these adjustments, financial statements might misrepresent a company’s profitability or financial standing.

Common Types of Adjusting Entries

One common type of adjustment involves deferred expenses, also known as prepaid expenses. These are payments made for goods or services that will be consumed or used in a future accounting period. Initially recorded as an asset, such as prepaid rent or insurance, they become expenses over time as their benefit is utilized. An adjustment is necessary to reclassify the portion of the asset that has been consumed during the period as an expense.

Conversely, deferred revenues, or unearned revenues, represent cash received from customers for goods or services that have not yet been delivered. When a business receives payment in advance, it incurs an obligation to perform, and this is initially recorded as a liability. As the business fulfills its obligation by providing the goods or services, the liability is reduced, and the corresponding amount is recognized as revenue.

Accrued expenses are costs that have been incurred during an accounting period but have not yet been paid. Examples include salaries earned by employees but not yet paid, or utility services used but for which a bill has not yet been received. An adjustment is required to recognize these expenses in the period they were incurred, establishing a liability for the amount owed.

Accrued revenues are revenues that have been earned by a business but for which cash has not yet been received. This often occurs when services have been rendered to a client on credit. An adjustment is needed to record this earned revenue in the current period and establish a receivable from the customer.

Depreciation is another type of adjusting entry for long-term tangible assets like buildings or equipment. It represents the systematic allocation of an asset’s cost over its estimated useful life. Rather than expensing the entire cost of a long-lived asset at the time of purchase, depreciation gradually recognizes a portion of that cost as an expense in each period the asset is used. This adjustment reflects the asset’s consumption.

Recording Adjusting Entries

Recording adjusting entries involves applying debits and credits to update account balances. Debits increase asset and expense accounts while decreasing liability, equity, and revenue accounts. Conversely, credits increase liability, equity, and revenue accounts while decreasing asset and expense accounts.

To construct a journal entry for an adjustment, for instance, to record the consumption of a prepaid expense, you would debit an expense account, such as Rent Expense or Insurance Expense, to increase the expense recognized for the period. Concurrently, you would credit the corresponding prepaid asset account, like Prepaid Rent or Prepaid Insurance, to decrease the asset’s balance.

When adjusting for deferred revenue, the process involves debiting the unearned revenue liability account to reduce the obligation. Simultaneously, a revenue account, such as Service Revenue or Sales Revenue, is credited to recognize the revenue earned during the period.

For accrued expenses, which are expenses incurred but not yet paid, you would debit an expense account, such as Salaries Expense or Utilities Expense, to reflect the cost incurred. A liability account, like Salaries Payable or Accounts Payable, is credited, acknowledging the amount owed.

Recording accrued revenues, which are revenues earned but not yet collected, requires debiting an asset account, typically Accounts Receivable, to reflect the right to receive cash. A revenue account, such as Service Revenue, is credited to recognize the income earned.

Finally, to record depreciation, you would debit Depreciation Expense to recognize the portion of the asset’s cost allocated to the current period. The credit is made to Accumulated Depreciation, a contra-asset account that reduces the book value of the asset on the balance sheet.