How to Properly Journalize Adjusting Entries

Understanding Adjusting Entries

Adjusting entries are a fundamental part of the accounting cycle, ensuring a company’s financial statements accurately reflect its financial position and performance at the end of an accounting period. These entries are crucial under the accrual basis of accounting, which recognizes revenues when earned and expenses when incurred, regardless of when cash is exchanged. This approach provides a realistic picture of a business’s economic activities.

The purpose of adjusting entries is to update general ledger accounts before financial statements are prepared. They are necessary because certain transactions impact multiple accounting periods but are not recorded daily. For instance, using a prepaid asset or earning revenue for which cash was received in advance requires an adjustment to properly allocate economic activity to the correct period.

Adjusting entries are made at the end of an accounting period, such as monthly, quarterly, or annually. This timing ensures all revenues and expenses are properly matched to the period in which they occurred. These adjustments impact both income statement accounts (revenues and expenses) and balance sheet accounts (assets and liabilities) to ensure their balances are correct.

Classifying Adjusting Entries

Adjusting entries are categorized into four main types, each addressing a specific timing difference between cash flow and revenue or expense recognition. Understanding these classifications is important for accurately reflecting a business’s financial activities.

Deferred expenses, also known as prepaid expenses, represent payments for goods or services consumed in a future accounting period. An example is paying for a year of insurance coverage in advance, where the initial payment creates an asset. As time passes, a portion of that prepaid amount expires, requiring an adjustment to reduce the asset and record an expense.

Deferred revenues, also called unearned revenues, occur when a company receives cash for goods or services before delivery. For instance, a software company might receive upfront payment for a one-year subscription. Initially, this creates a liability; as the service is delivered, a portion of the unearned revenue is recognized as earned revenue.

Accrued expenses are expenses incurred but not yet paid or recorded. This includes obligations like employee salaries earned but not yet paid, or accumulated interest on a loan. An adjusting entry records the expense and corresponding liability, ensuring all costs incurred during the period are recognized.

Accrued revenues represent revenues earned but not yet received in cash or formally billed. For example, a consulting firm might complete services by month-end but not invoice until the next month. An adjusting entry recognizes this earned revenue and establishes a receivable, reflecting the company’s right to receive payment.

Steps to Journalizing Adjusting Entries

Journalizing adjusting entries involves a systematic process to ensure accuracy and adherence to accounting principles. The first step is identifying the specific accounts needing adjustment at the close of an accounting period. This often involves reviewing unrecorded transactions, examining the trial balance for accounts like prepaid expenses or unearned revenues, and considering physical counts of inventory or supplies.

Once accounts are identified, the next step is determining the precise adjustment amount. This involves calculating how much of a prepaid asset has been consumed, how much unearned revenue has been earned, or the exact amount of an incurred but unrecorded expense. For example, if a business paid for a year of insurance, the monthly expense would be one-twelfth of the total prepaid amount.

Next, pinpoint the two specific accounts impacted by the adjustment. One account will be an income statement account (expense or revenue), and the other a balance sheet account (asset or liability). For instance, an adjustment for consumed supplies affects both a supplies expense account and a supplies asset account.

Applying the rules of debit and credit is the fourth step. Assets and expenses increase with a debit and decrease with a credit, while liabilities, equity, and revenues increase with a credit and decrease with a debit. Understanding these rules is important for correctly recording the adjustment’s impact. Finally, the adjusting entry is recorded in the general journal, including the date, debited account, credited account, and a brief explanation.

Journalizing Specific Adjusting Entry Types

Journalizing specific adjusting entry types involves applying general steps to distinct scenarios, ensuring financial records accurately reflect economic events. Each type requires a precise approach to record the movement of value between accounts.

Deferred Expense Example

Consider a company that paid $2,400 for a one-year insurance policy on October 1, 2025. By December 31, 2025, three months of coverage have been used. The adjustment recognizes the expired portion as an expense, meaning $600 ($2,400 / 12 months 3 months) of insurance has been consumed.

The journal entry debits Insurance Expense for $600 and credits Prepaid Insurance for $600. This decreases the asset account (Prepaid Insurance) on the balance sheet and increases the expense account (Insurance Expense) on the income statement.

Deferred Revenue Example

For deferred revenue, imagine a business received $1,200 on November 1, 2025, for a six-month service contract. By December 31, 2025, two months of service have been provided. The adjustment recognizes the earned portion, so $400 ($1,200 / 6 months 2 months) of revenue has been earned.

The journal entry debits Unearned Service Revenue for $400 and credits Service Revenue for $400. This reduces the liability account (Unearned Service Revenue) on the balance sheet and increases the revenue account (Service Revenue) on the income statement.

Accrued Expense Example

For an accrued expense, consider a company paying employees $5,000 every Friday for a five-day work week. If December 31, 2025, falls on a Wednesday, employees earned three days of wages not yet paid. The adjustment records the incurred wages, so $3,000 ($5,000 / 5 days 3 days) has been accrued.

The journal entry debits Wages Expense for $3,000 and credits Wages Payable for $3,000. This increases the expense account (Wages Expense) on the income statement and creates a liability account (Wages Payable) on the balance sheet.

Accrued Revenue Example

Finally, for accrued revenue, assume a consulting firm completed $7,500 worth of services by December 31, 2025, but will not bill the client until January 10, 2026. The adjustment recognizes the revenue earned but not yet collected or billed.

The journal entry debits Accounts Receivable for $7,500 and credits Service Revenue for $7,500. This increases the asset account (Accounts Receivable) on the balance sheet and increases the revenue account (Service Revenue) on the income statement.