How to Post Adjusting Entries in Accounting

Adjusting entries are used in accrual basis accounting to align financial records with a business’s economic reality. They ensure revenues are recognized when earned and expenses when incurred, regardless of when cash changes hands. This method, unlike cash basis accounting, provides a more accurate picture of a company’s financial performance and position, adhering to generally accepted accounting principles (GAAP). Adjusting entries facilitate the revenue recognition principle, which records revenue when a performance obligation is satisfied, and the matching principle, which recognizes expenses in the same period as the revenue they generate. Without these adjustments, financial statements would misrepresent a company’s profitability and financial health.

Categorizing Adjusting Entries

Adjusting entries fall into categories: accrued items, deferred items, and depreciation. Each category deals with situations where the timing of cash flow differs from the timing of revenue or expense recognition. Understanding these distinctions is fundamental for accurately preparing financial statements.

Accrued items involve revenues earned or expenses incurred that have not yet been recorded. Accrued revenues represent income a business has earned by providing goods or services, but for which cash has not yet been received. For example, a consulting firm might complete a project in December, but not receive payment until January; the revenue is earned in December and must be recognized then.

Accrued expenses are costs a business has incurred but has not yet paid or recorded. A common instance is employee salaries earned in the last days of an accounting period, with payment occurring in the subsequent period. The expense for these wages must be recognized in the period the employees performed the work, even if payment is delayed.

Deferred items involve cash transactions that occurred before the corresponding revenue was earned or expense was incurred. Deferred revenues, also known as unearned revenues, occur when a business receives cash from a customer for goods or services it has not yet delivered. An example is a software company receiving a full year’s subscription payment upfront; the cash is received immediately, but the revenue is earned gradually over the subscription period.

Deferred expenses, or prepaid expenses, arise when a business pays cash for an expense that will be consumed or benefit future accounting periods. Common examples include paying for insurance premiums or office rent in advance. The cash outflow happens at the time of payment, but the expense is recognized systematically over the period the insurance coverage or rental space is utilized.

Depreciation is a specific adjusting entry that allocates the cost of a long-lived asset, such as equipment or a building, over its useful life. This systematic allocation reflects the gradual consumption of the asset’s economic benefits. For instance, a delivery truck’s cost is spread across its many years of service rather than expensed entirely in the year of purchase.

Gathering Information for Adjustments

Before recording adjusting entries, accountants gather and analyze information. This preparatory phase involves reviewing financial records and external documents to identify necessary adjustments and accurately quantify their amounts. The goal is to ensure that all financial activities spanning multiple accounting periods are properly recognized.

A primary step involves examining the unadjusted trial balance, which lists all general ledger account balances before adjustments. Accounts like “Supplies,” “Prepaid Insurance,” “Unearned Revenue,” or “Salaries Expense” often signal the need for adjustments. A non-zero balance in these accounts indicates a portion of the asset or liability has been consumed, earned, or incurred, requiring an adjustment.

Source documents provide evidence for calculating adjustment amounts. For instance, utility bills confirm accrued utility expenses, and lease agreements specify prepaid rent terms. Customer contracts detail revenue recognition schedules for unearned revenue.

Physical counts and internal records are also sources of information. A physical count of office supplies reveals the amount on hand, allowing calculation of consumed supplies. Payroll records determine accrued salaries payable, and depreciation schedules provide depreciation expense amounts. For prepaid insurance, the policy document specifies the premium and coverage period for calculation. For accrued interest payable, the loan agreement outlines the principal, interest rate, and payment schedule.

Recording Adjusting Journal Entries

Once information is gathered and adjustment amounts determined, record these changes through journal entries. Adjusting entries always impact at least one income statement account (revenue or expense) and one balance sheet account (asset or liability). A key rule is they never involve the cash account, as they recognize revenues and expenses independent of immediate cash flow.

The process begins by analyzing the unadjusted balance of the account needing adjustment. For instance, if “Prepaid Rent” shows an initial balance, it represents total rent paid in advance. The next step is to calculate the amount of adjustment needed to bring the account to its correct balance at period-end. If one month’s rent has been used, that amount becomes the adjustment.

Identify the specific accounts involved. For prepaid rent, the consumed portion becomes “Rent Expense” (income statement) and reduces “Prepaid Rent” (balance sheet). Apply debit and credit rules: expenses increase with a debit, and assets decrease with a credit. Therefore, for consumed rent, Rent Expense is debited, and Prepaid Rent is credited.

The journal entry includes the date, debited and credited accounts, corresponding amounts, and a brief explanation. For example, an entry for prepaid rent consumed shows a debit to Rent Expense and a credit to Prepaid Rent for the amount used.

After preparing the journal entry, post the information to the general ledger accounts. This transfers debit and credit amounts from the journal entry to the individual T-accounts or ledger accounts. For the prepaid rent example, the debit increases Rent Expense, and the credit decreases Prepaid Rent, updating account balances.

For instance, if a company paid $6,000 for a year of insurance on January 1, by January 31, one month has expired. The adjustment debits Insurance Expense for $500 ($6,000 / 12 months) and credits Prepaid Insurance for $500. For accrued salaries, if employees earned $3,000 by December 31 but will be paid January 5, the adjustment debits Salaries Expense for $3,000 and credits Salaries Payable for $3,000. These entries ensure financial statements accurately reflect the period’s economic activities.

Preparing the Adjusted Trial Balance

After all adjusting entries are recorded and posted, the next step in the accounting cycle is preparing the adjusted trial balance. This financial document confirms that the equality of debits and credits is maintained after all period-end adjustments. It acts as a comprehensive list of all account balances, now updated to reflect the full economic activity of the accounting period.

The primary purpose of the adjusted trial balance is to provide a reliable and accurate source for preparing the financial statements: the income statement, the statement of owner’s equity, and the balance sheet. By summarizing all account balances post-adjustment, it ensures that revenues and expenses are appropriately matched and that assets, liabilities, and equity are reported at their correct, updated values. This step is crucial for generating financial reports that faithfully represent the company’s financial position and performance.

The process begins by listing every account from the general ledger, including those that previously appeared on the unadjusted trial balance and any new accounts created by the adjusting entries, such as “Salaries Payable” or “Accumulated Depreciation.” Each account’s adjusted balance is then determined by taking its original unadjusted balance and incorporating the effects of any debits or credits from the adjusting entries. For example, if “Prepaid Insurance” had an unadjusted balance of $6,000 and was credited for $500 due to an adjustment, its adjusted balance would be $5,500.

After all account balances have been updated, they are placed in either the debit or credit column of the adjusted trial balance, based on their normal balance. All debit balances are summed, and all credit balances are summed. A fundamental check at this stage is to verify that the total debits exactly equal the total credits. If they do not, it signals an error in recording or posting the adjusting entries, requiring a thorough review to identify and correct the discrepancy before proceeding. The significance of an accurate adjusted trial balance cannot be overstated, as any errors carried forward will directly impact the reliability and integrity of financial reports.