How to Prepare Adjusting Journal Entries

Journal entries are the initial records of financial transactions within an accounting system, capturing the financial impact of events as they occur. These entries document every transaction, from sales and purchases to payments and receipts, providing a chronological record of a business’s financial activities. They serve as the foundation for creating comprehensive financial statements, offering a detailed view of a company’s financial position and performance.

Adjusting journal entries are a particular type of entry made at the end of an accounting period, before financial statements are prepared. These entries update accounts that have changed over time or that reflect transactions not yet fully recorded. Their purpose is to ensure that all revenues earned and expenses incurred during a specific period are accurately reflected. This process is fundamental to presenting an accurate financial picture of a business.

Understanding the Purpose of Adjusting Entries

Adjusting entries are necessary due to the application of the accrual basis of accounting, which dictates that financial transactions are recorded when they occur, regardless of when cash changes hands. This contrasts with the cash basis, where transactions are only recorded upon the receipt or disbursement of cash. The accrual method provides a more accurate representation of a company’s financial performance and position over time.

A core principle underlying the accrual basis is the matching principle, which requires that expenses be recognized in the same period as the revenues they helped generate. For instance, if a company incurs advertising costs in January that contribute to sales in February, the matching principle suggests those advertising expenses should be recorded in February, alongside the related revenue. This ensures that the true profitability for a period is accurately measured.

Without adjusting entries, financial statements might misrepresent a company’s profitability or financial health. Revenues could be understated if services have been performed but not yet billed, or expenses could be overlooked if they have been incurred but not yet paid. Adjustments ensure that the income statement accurately reflects revenues earned and expenses incurred, and that the balance sheet presents assets, liabilities, and equity at their correct values at the end of the period.

Identifying Common Adjusting Entry Categories

Several common scenarios necessitate adjusting entries to ensure financial records adhere to the accrual basis of accounting. Prepaid expenses represent payments made in advance for goods or services that will be consumed or used in a future accounting period. An example includes paying a six-month insurance premium upfront, where the benefit of the insurance expires over time. The initial payment creates an an asset, which then needs to be gradually recognized as an expense as the service is utilized.

Unearned revenues, also known as deferred revenues, occur when a business receives cash for goods or services before they have been delivered or performed. A typical instance is a customer paying for a one-year subscription service upfront. At the time of receipt, the cash creates a liability because the business owes the customer a service or product. As the service is delivered over the subscription period, this liability transforms into earned revenue.

Accrued expenses are expenses that have been incurred but not yet paid or recorded. This often happens with services that are consumed continuously over time, such as utility usage or employee wages. For example, employees may earn wages for work performed in the last few days of a month, but payment might not be due until the following month. These expenses must be recognized in the period they were incurred to accurately reflect the cost of operations.

Accrued revenues, conversely, are revenues that have been earned but not yet received in cash or recorded. This situation arises when a service has been provided or goods have been delivered, but the customer has not yet been billed, or the payment is not yet due. An example might be a consulting firm completing a project for a client in December, but the invoice will not be sent until January. The revenue is earned in December, even if the cash receipt is delayed.

Depreciation is the systematic allocation of the cost of a tangible asset over its useful life. Assets like buildings, machinery, and vehicles lose value or utility over time due to wear and tear or obsolescence. Rather than expensing the entire cost of a long-lived asset in the year it is purchased, a portion of its cost is recognized as an expense each accounting period. This process matches the expense of using the asset with the revenues it helps generate.

Recording Adjusting Entries

For example, if a company paid $6,000 for a one-year insurance policy on December 1, by December 31, one month of insurance has been used. The adjusting entry would debit Insurance Expense for $500 ($6,000 / 12 months) and credit Prepaid Insurance for $500, reducing the asset and recognizing the expense.

If a company receives $1,200 on December 1 for a two-month service contract, by December 31, one month of service has been rendered. The adjusting entry would debit Unearned Revenue for $600 ($1,200 / 2 months) and credit Service Revenue for $600, decreasing the liability and increasing revenue.

Consider a business that owes its employees $2,500 in wages for work performed in the last week of December, with payment due in January. The adjusting entry on December 31 would debit Wages Expense for $2,500 and credit Wages Payable for $2,500, recognizing the expense and the obligation.

If a consulting firm completes $3,000 worth of services for a client in December but will not bill them until January, the revenue must be recognized in December. The adjusting entry would debit Accounts Receivable for $3,000 and credit Service Revenue for $3,000, creating a claim to cash and recording the earned income.

Assuming a piece of equipment costing $10,000 has an estimated useful life of 10 years and no salvage value, the annual straight-line depreciation would be $1,000. The monthly depreciation would be approximately $83.33. The adjusting entry would debit Depreciation Expense for $83.33 and credit Accumulated Depreciation for $83.33, recording the expense and accumulating the reduction in the asset’s book value.