Accounting Concepts and Practices

How to Make an Adjusting Entry in Accounting

Ensure your financial statements truly reflect business activity. Discover the process for making essential accounting adjustments.

Adjusting entries are a fundamental component of accurate financial reporting, bringing a company’s accounting records up to date at the close of an accounting period. These entries ensure financial statements reflect all economic activities within a specific timeframe, regardless of when cash was exchanged. They are important under the accrual basis of accounting, which recognizes revenues when earned and expenses when incurred.
Without these adjustments, financial statements could misrepresent a company’s profitability or its assets and liabilities. This accuracy is paramount for stakeholders, including management, investors, and creditors, who rely on financial statements to make informed decisions.

Understanding Adjusting Entries

The accrual basis of accounting forms the foundation for preparing financial statements that accurately reflect a company’s economic activities. This method operates on two core principles: the revenue recognition principle and the matching principle. The revenue recognition principle dictates that revenue should be recorded when it is earned, meaning when a company has substantially completed the service or delivered the good, regardless of when cash is received. The matching principle requires that expenses be recognized in the same period as the revenues they helped generate.

In contrast, the cash basis of accounting records revenues only when cash is received and expenses only when cash is paid. While simpler for very small businesses, this method often fails to provide a complete picture of a company’s financial performance. For instance, a large sale made on credit would not appear as revenue until the customer pays, potentially weeks or months later. This can lead to a disconnect between a business’s operational activity and its reported financial results.

Adjusting entries bridge this gap by ensuring financial records align with the accrual basis of accounting. An adjusting entry is a journal entry made at the end of an accounting period, typically monthly, quarterly, or annually, before financial statements are prepared. Its purpose is to record revenues earned but not yet recorded and expenses incurred but not yet recorded. These entries are necessary because certain transactions span multiple accounting periods or involve non-cash events.

Categories of Adjusting Entries

Adjusting entries fall into several common categories, each addressing a specific timing difference between cash flow and the recognition of revenue or expense. Understanding these categories is essential for maintaining accurate financial records.

Deferred Revenues (Unearned Revenues)

Deferred revenues, also known as unearned revenues, arise when a company receives cash for goods or services before they have been delivered or performed. This cash receipt creates a liability, as the company has an obligation to provide future goods or services. For instance, a software company receiving payment for a one-year subscription upfront has unearned revenue. As each month passes, a portion of this unearned revenue is recognized as earned revenue.

Deferred Expenses (Prepaid Expenses)

Deferred expenses, often called prepaid expenses, occur when a company pays cash for an expense that will benefit multiple future accounting periods. The initial cash payment creates an asset, representing the future economic benefit. A common example is paying for a six-month insurance policy in advance. Each month, as a portion of the insurance coverage is used, the prepaid asset decreases, and an expense is recognized.

Accrued Revenues (Accrued Income or Receivables)

Accrued revenues, also known as accrued income or receivables, represent revenues earned by a company but for which cash has not yet been received. This situation typically arises when services have been performed or goods delivered on credit, and the customer has not yet been billed or paid. For example, a consulting firm that completes a project at the end of the month but will not issue an invoice until the following month has accrued revenue. This revenue needs to be recognized in the period it was earned.

Accrued Expenses (Accrued Liabilities or Payables)

Accrued expenses, also known as accrued liabilities or payables, are expenses incurred by a company but for which cash has not yet been paid. This often includes expenses that accumulate over time, such as salaries earned by employees but not yet paid, or interest owed on a loan. A business that owes its employees for work performed during the last week of the month but pays them on the fifth of the next month has an accrued expense for salaries. This expense must be recognized in the period the work was performed.

Depreciation

Depreciation allocates the cost of a tangible long-lived asset, such as equipment or buildings, over its useful life. Instead of expensing the entire cost of the asset in the year it was purchased, depreciation systematically spreads this cost over the years the asset is expected to generate revenue. This ensures the expense of using the asset is matched with the revenues it helps produce during each accounting period.

Journalizing Adjusting Entries

Creating adjusting entries involves a systematic process to ensure financial records are updated accurately before statements are prepared. This includes identifying accounts needing adjustment, determining the precise amount, recording the entry in the general journal, and posting to ledger accounts.

Journalizing Deferred Revenues

For deferred revenues, the adjusting entry decreases the liability account and increases a revenue account. For example, if a software company received $1,200 for a one-year subscription, after one month, the company would debit Unearned Revenue by $100 ($1,200 / 12 months). Simultaneously, it would credit Subscription Revenue by $100, recognizing the portion earned.

Journalizing Deferred Expenses

For deferred expenses, the adjustment reduces an asset account and increases an expense account. Consider a business paying $6,000 for a six-month insurance policy in advance. At the end of the first month, the company would debit Insurance Expense by $1,000 ($6,000 / 6 months). Concurrently, it would credit Prepaid Insurance by $1,000, reducing the value of the remaining prepaid coverage.

Journalizing Accrued Revenues

Accrued revenues require an adjusting entry that increases an asset account, typically a receivable, and increases a revenue account. If a consulting firm completed a $5,000 project at the end of the month but had not yet billed the client, the firm would debit Accounts Receivable by $5,000. Simultaneously, it would credit Consulting Revenue by $5,000.

Journalizing Accrued Expenses

For accrued expenses, the adjustment increases an expense account and increases a liability account. If employees earned $10,000 in the last week of the month but will be paid in the next period, the company would debit Salaries Expense by $10,000. Correspondingly, it would credit Salaries Payable by $10,000.

Journalizing Depreciation

Depreciation adjustments involve increasing an expense account and increasing a contra-asset account. For instance, if equipment costing $50,000 is depreciated at $5,000 per year, the adjusting entry would debit Depreciation Expense by $5,000. The corresponding credit would be to Accumulated Depreciation, a contra-asset account that reduces the book value of the equipment.

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