How to Make an Adjusting Journal Entry

An adjusting journal entry modifies a company’s financial records at the end of an accounting period to accurately reflect its true financial performance and position. These entries are fundamental to accrual basis accounting, which records revenues when earned and expenses when incurred, regardless of when cash changes hands. Adjustments provide a precise picture of financial activities, aiding informed decision-making.

Understanding the Need for Adjusting Entries

Adjusting entries are necessary due to timing differences between cash exchange and when revenues are earned or expenses incurred. This distinction is central to accrual accounting, which contrasts with cash basis accounting. Under cash basis, transactions are recorded only when cash is received or paid, potentially misrepresenting a company’s financial status.

Accrual accounting, widely adopted for financial reporting, relies on two principles: revenue recognition and expense matching. Revenue recognition dictates revenue is recorded when earned, meaning when goods or services have been delivered, regardless of cash receipt. Expense matching requires expenses be recognized in the same period as the revenues they helped generate. This ensures costs associated with earning revenue are accounted for in the same period, providing a clearer view of profitability.

For instance, a business paying for a year of insurance upfront expenses only the portion used during the current period under accrual accounting, treating the remainder as a prepaid asset. Conversely, if services are performed but not billed until the next month, adjusting entries ensure revenue is recognized in the period the service was provided. These adjustments bridge the gap between cash flows and economic events, leading to financial statements that truly reflect a period’s activities.

Types of Adjusting Entries

Adjusting entries fall into four categories, each addressing timing differences between cash transactions and the recognition of revenues or expenses. These categories ensure financial records align with accrual accounting principles.

Prepaid expenses, also known as deferred expenses, occur when a business pays cash for an expense before it is incurred. These payments are initially recorded as assets because they represent a future benefit. For example, paying for six months of office rent in advance means only one month’s rent is expensed each month, with the remaining five months carried as a prepaid asset.

Unearned revenue, or deferred revenue, arises when a company receives cash for goods or services before they are delivered. When cash is received, it creates a liability because the company has an obligation to provide future services. A software company receiving an annual subscription upfront recognizes revenue gradually as the service is provided.

Accrued expenses are incurred but not yet paid or recorded. These represent obligations for goods or services already received. Employee salaries earned at the end of an accounting period but not paid until the next payday are an example. The expense is recognized in the period the work was performed.

Accrued revenues are earned but not yet received or recorded. This occurs when a service is performed or goods delivered, creating a right to receive payment. For instance, a consulting firm completing a project at month-end but billing next month recognizes revenue when work is done, creating an accounts receivable.

Steps to Create an Adjusting Journal Entry

Creating an adjusting journal entry involves a systematic process. Each entry impacts at least one income statement account (revenue or expense) and one balance sheet account (asset or liability); cash is never directly involved.

First, identify the need for an adjustment by reviewing accounts that require periodic adjustments, such as prepaid assets, unearned liabilities, or outstanding revenues and expenses. Look for transactions where cash changed hands but the associated revenue or expense has not been fully earned or incurred.

Next, determine the specific accounts affected.
For prepaid expenses: an expense account and the prepaid asset account.
For unearned revenue: a revenue account and the unearned revenue liability account.
For accrued expenses: an expense account and a payable liability account.
For accrued revenues: a receivable asset account and a revenue account.

Once accounts are identified, calculate the precise dollar amount. This calculation depends on the transaction. For example, a $12,000 annual insurance payment means a $1,000 monthly adjustment. For accrued salaries, it is the total wages earned by employees but not yet paid by period-end.

Finally, record the adjusting entry using debits and credits.
For prepaid expenses: Debit the expense account (e.g., Insurance Expense) and credit the prepaid asset account (e.g., Prepaid Insurance).
For unearned revenue: Debit the unearned revenue liability account (e.g., Unearned Service Revenue) and credit the revenue account (e.g., Service Revenue).
For accrued expenses: Debit the expense account (e.g., Salaries Expense) and credit a payable liability account (e.g., Salaries Payable).
For accrued revenues: Debit the receivable asset account (e.g., Accounts Receivable) and credit the revenue account (e.g., Service Revenue).