How to Prepare Adjusting Entries in Accounting

Adjusting entries are a fundamental part of the accounting cycle, refining financial records at the close of an accounting period. Their purpose is to ensure a company’s financial statements accurately present its financial position and performance. These adjustments are necessary under the accrual basis of accounting, which recognizes revenues when earned and expenses when incurred, regardless of when cash changes hands. Without them, financial reports could misrepresent a business’s true economic activities and financial health.

Foundational Accounting Principles

Adjusting entries stem from core accounting principles, particularly the accrual basis of accounting. This method records economic events when they occur, not when cash is exchanged. Revenue is recognized when earned, and expenses when incurred. This contrasts with the cash basis, which records revenues when cash is received and expenses when cash is paid. The cash basis may not accurately reflect a company’s financial performance, especially for businesses with credit transactions or long-term assets.

The revenue recognition principle dictates that revenue is recorded when earned and realized, meaning goods or services have been delivered or performed, and payment is reasonably assured. This occurs regardless of cash receipt. For example, if a service is completed in December but payment is in January, revenue is still recognized in December. This principle matches revenue with the period of the economic activity.

The expense recognition principle, often referred to as the matching principle, requires expenses to be recorded in the same accounting period as the revenues they helped generate. This ensures costs are recognized in the same period as the revenue they supported. For instance, utility costs incurred in December to generate December revenue are recorded in December, even if paid in January. This matching provides a more accurate picture of profitability.

Categories of Adjusting Entries

Adjusting entries fall into categories addressing transactions where cash was exchanged at a different time than the revenue was earned or expense incurred. These categories ensure financial statements align with accrual accounting. They typically involve one balance sheet account and one income statement account, never directly involving cash.

Deferrals

Deferrals are transactions where cash has been received or paid, but the corresponding revenue or expense has not yet been recognized. These entries postpone recognition until a future period. Prepaid expenses represent assets paid for in advance but not yet consumed or expired. Examples include prepaid rent, insurance, or supplies. As time passes or the asset is used, a portion of the prepaid amount becomes an expense, necessitating an adjustment. For instance, if a business pays for a year of insurance upfront, a monthly adjusting entry allocates one-twelfth of that payment to insurance expense.

Unearned revenues, another type of deferral, occur when a company receives cash for goods or services before they have been delivered or performed. This cash creates a liability, as the company owes the customer the service or product. As the service is rendered or the product delivered, the unearned revenue liability is reduced, and actual revenue is recognized. A common example is a subscription service where a customer pays for an entire year upfront, but the revenue is earned gradually as the service is provided each month.

Accruals

Accruals involve revenues earned or expenses incurred for which cash has not yet been exchanged. These entries record revenues or expenses that have accumulated over time but have not yet been formally billed or paid. Accrued expenses are costs incurred by a business that have not yet been paid or recorded. Examples include salaries earned by employees but not yet paid, interest owed on a loan, or utilities used but for which a bill has not yet been received. An adjusting entry recognizes these expenses in the period they were incurred, establishing a liability for the amount owed.

Accrued revenues represent revenues earned through providing goods or services but for which cash has not yet been received or billed. This often arises when services are completed towards the end of an accounting period, but the invoice is issued in the subsequent period. An adjusting entry is made to record the revenue earned and establish a receivable from the customer.

Depreciation

Depreciation systematically allocates the cost of a tangible long-lived asset, such as equipment or buildings, over its estimated useful life. This matches the expense of using the asset to the revenues it helps generate over time. Instead of expensing the entire cost of a large asset in the year of purchase, depreciation spreads that cost as an expense across the years the asset is expected to provide economic benefit. This entry reflects the consumption of the asset’s economic benefits and reduces its book value on the balance sheet.

Process for Creating Adjusting Entries

Preparing adjusting entries involves a methodical approach to ensure financial transactions are accurately reflected at the end of an accounting period. The process begins with a thorough review of the unadjusted trial balance, which lists all accounts and their balances before adjustments. Accountants examine each account to identify those that may not accurately reflect the period’s economic activity, looking for items like prepaid assets that have been partially consumed or revenues earned but not yet recorded.

Once accounts needing adjustment are identified, the next step is to determine the specific amount of the adjustment. This calculation often involves reviewing source documents, contracts, or internal records. For example, for prepaid rent, one would calculate the portion of the rent that has expired during the period. Similarly, for unearned revenue, the amount earned during the period must be calculated based on the services delivered.

The third step is to record the adjusting journal entry in the general journal. Each adjusting entry impacts at least one income statement account (revenue or expense) and one balance sheet account (asset or liability), and it never involves cash. For prepaid rent, the entry would be a debit to Rent Expense and a credit to Prepaid Rent. For unearned revenue, the entry would be a debit to Unearned Revenue and a credit to Service Revenue. For accrued salaries, the entry would be a debit to Salaries Expense and a credit to Salaries Payable. For depreciation, the entry would be a debit to Depreciation Expense and a credit to Accumulated Depreciation.

Finally, after recording all necessary adjusting journal entries, these entries are posted to the respective general ledger accounts. This process updates the balances of the affected asset, liability, equity, revenue, and expense accounts. Following this, an adjusted trial balance is prepared, which serves as a comprehensive list of all account balances after adjustments. This adjusted trial balance is then used as the foundation for preparing the formal financial statements.

Effect on Financial Reporting

Correctly prepared adjusting entries are fundamental to the accuracy and reliability of a company’s financial statements. Without them, financial reports would not truly reflect the economic reality of the business’s operations. These adjustments ensure information presented to users, such as investors, creditors, and management, is complete and credible.

On the income statement, adjusting entries ensure revenues are recognized when earned and expenses when incurred. This timing leads to a more accurate calculation of net income or loss. Recognizing accrued revenues and expenses prevents understatement or overstatement of profit, providing a clear picture of operational performance.

Adjusting entries also impact the balance sheet, ensuring assets, liabilities, and equity accounts display correct balances at period-end. Recording depreciation expense reduces asset book value, while accruing expenses increases liabilities. This refinement means the balance sheet accurately portrays the company’s financial position, including what it owns, owes, and the owner’s stake. Financial statements, with proper adjusting entries, provide a consistent and reliable basis for informed decision-making.