How to Make Adjusting Journal Entries

Adjusting journal entries refine a company’s financial records at the close of an accounting period. They ensure financial statements, such as the income statement and balance sheet, accurately reflect a business’s financial position and operational performance before issuance.

Why Adjusting Entries Are Necessary

Adjusting entries align financial reporting with core accounting principles, capturing a business’s full economic reality beyond simple cash transactions. Accrual accounting, unlike cash basis accounting, recognizes revenues when earned and expenses when incurred, regardless of cash movement. This provides a more comprehensive portrayal of profitability and financial obligations than cash basis accounting, which only records transactions when cash is received or paid.

The matching principle mandates that expenses be recognized in the same accounting period as the revenues they helped generate. For instance, if a company incurs costs in December to earn December revenue, those costs must be recorded as expenses in December, even if payment is not made until January. This ensures the true cost of generating revenue is accurately reflected.

Complementing the matching principle are the revenue recognition and expense recognition principles. Revenue recognition requires revenue to be recorded when earned, typically when goods or services are delivered, regardless of cash receipt. Expense recognition dictates expenses are recognized when incurred, meaning when the benefit is consumed or obligation arises, not necessarily when cash is disbursed. Adherence to these principles ensures financial statements provide a consistent depiction of a company’s economic activities.

Major Types of Adjusting Entries

Adjusting entries are categorized into deferrals, accruals, and depreciation. Deferrals involve cash transactions occurring before the related revenue is earned or expense is incurred. Accruals involve revenues earned or expenses incurred before the associated cash transaction.

Prepaid expenses are deferrals where cash is paid in advance for goods or services consumed in future periods, such as rent, insurance, or supplies. An adjustment recognizes the portion of the asset used up as an expense. For instance, a one-year insurance policy paid upfront requires monthly adjustments to expense one-twelfth of the total cost each month.

Unearned revenue, another deferral, occurs when a company receives cash for services or goods before delivery. This creates a liability to provide future services or goods. As services are rendered or goods delivered, an adjusting entry reduces the liability and recognizes the earned revenue. A common example is a customer paying for an annual subscription; revenue is earned gradually over the subscription period.

Accrued expenses are incurred but not yet paid or recorded obligations, such as salaries earned by employees or utility services used but not yet billed. An adjusting entry recognizes these expenses in the period incurred and establishes a corresponding liability.

Accrued revenue is earned by providing goods or services, but cash has not yet been received or an invoice issued. This often arises when services are completed towards the end of an accounting period, but billing or collection occurs in the subsequent period. An adjusting entry recognizes this earned revenue and creates a receivable. For instance, a consulting firm completing a December project but billing in January recognizes revenue in December.

Depreciation systematically allocates the cost of a tangible asset, like equipment or buildings, over its estimated useful life. Since assets provide benefits for more than one accounting period, their entire cost is not expensed when purchased. The adjusting entry recognizes a portion of the asset’s cost as an expense in each period it is used, reflecting the consumption of its economic benefits.

Gathering Information for Adjustments

Accountants gather information for adjusting entries through a systematic review of financial records and internal documents. This includes source documents that provide evidence of transactions, even if not fully recorded in the general ledger.

This review includes invoices for unbilled services, bank statements for unrecorded interest or expenses, and contractual agreements for prepaid items. Payroll records are essential for identifying accrued salaries and wages. These documents provide the specific amounts and dates needed for accurate adjustments.

Analyzing the unadjusted trial balance and individual ledger accounts is another important step. Accountants scrutinize accounts like prepaid expenses, unearned revenue, and asset accounts for which depreciation may be applicable. This identifies balances needing updates to reflect consumed assets, satisfied liabilities, or earned revenue/incurred expenses. For example, a large prepaid insurance balance signals the need to expense the expired portion.

Internal schedules and company policies also play a role in gathering information. This includes depreciation schedules for fixed assets, amortization schedules for intangible assets, and policies for recurring expenses or revenues. These documents provide details for calculating and preparing routine adjusting entries, ensuring all economic events are accounted for at period end.

Recording Adjusting Entries

Recording adjusting entries translates identified information into formal accounting records. Each entry adheres to the standard journal format: date, debited and credited accounts, amounts, and a brief description. Understanding debits and credits is essential, as these entries impact both income statement and balance sheet accounts.

For a prepaid expense, such as supplies used, the adjusting entry debits an expense account (e.g., Supplies Expense) and credits an asset account (e.g., Prepaid Supplies). This reflects the asset’s consumption and conversion into an expense. If a company paid $1,200 for a year of insurance and one month passed, the entry debits Insurance Expense for $100 and credits Prepaid Insurance for $100.

When unearned revenue is recognized, the adjusting entry debits a liability account (e.g., Unearned Revenue) and credits a revenue account (e.g., Service Revenue). For example, if a client paid $600 for six months of service in advance and one month delivered, the entry debits Unearned Revenue for $100 and credits Service Revenue for $100. This shifts the earned portion of the advance payment from a liability to actual revenue.

Accrued expenses, like unpaid salaries at period-end, require an adjusting entry that debits an expense account (e.g., Salaries Expense) and credits a liability account (e.g., Salaries Payable). If employees earned $5,000 in wages to be paid next period, the entry debits Salaries Expense for $5,000 and credits Salaries Payable for $5,000. This matches expenses to the period in which the work was performed.

For accrued revenue, such as services completed but not yet billed, the adjusting entry debits an asset account (e.g., Accounts Receivable) and credits a revenue account (e.g., Service Revenue). If a business completed $700 of services for a client on credit not yet invoiced, the entry debits Accounts Receivable for $700 and credits Service Revenue for $700. This brings the revenue into the correct accounting period.

Depreciation entries debit Depreciation Expense to reflect asset usage cost and credit Accumulated Depreciation, a contra-asset account that reduces the asset’s book value. If annual depreciation for equipment is $2,400, the monthly entry debits Depreciation Expense for $200 and credits Accumulated Depreciation for $200. These entries ensure financial statements accurately reflect the economic impact of transactions spanning multiple periods.