How to Record Adjusting Entries: A Step-by-Step Process

Adjusting entries are a fundamental component of accrual basis accounting, aligning a company’s financial records with the economic reality of its operations at the close of an accounting period. They ensure revenues are recognized when earned and expenses when incurred, regardless of when cash changes hands. By adhering to the revenue recognition principle (revenue recorded when services are performed or goods delivered) and the matching principle (expenses recognized in the same period as related revenues), adjusting entries provide an accurate depiction of financial performance. This process is important for generating financial statements that reflect a company’s financial position and operational results.

Types of Adjusting Entries

Adjusting entries fall into several categories, each addressing timing differences between economic activity and cash flow. These adjustments are important for accurate financial reporting.

Accrued Revenues

Accrued revenues represent income earned but not yet received in cash or formally recorded. For example, a consulting firm might complete a project in December but invoice in January; an adjusting entry recognizes the December revenue.

Accrued Expenses

Accrued expenses are costs incurred but not yet paid in cash or formally recorded. A common example involves employee wages earned in the last few days of a month but paid in the following month. An adjusting entry ensures these wages are recognized as an expense in the period they were incurred.

Deferred Revenues

Deferred revenues, also known as unearned revenues, occur when a company receives cash for services or goods before they have been delivered or earned. For instance, a software company might receive an annual subscription fee upfront. Until the service is provided, the upfront payment is recorded as a liability.

Deferred Expenses

Deferred expenses, often called prepaid expenses, involve cash paid for expenses not yet incurred or used. This includes items like paying an annual insurance premium in advance. The initial payment creates an asset, and as the benefit is consumed, a portion is recognized as an expense.

Depreciation Expense

Depreciation expense allocates the cost of a tangible asset, such as machinery or buildings, over its estimated useful life. Instead of expensing the entire purchase price at once, a portion is recognized as an expense each accounting period. This systematic write-down reflects the asset’s gradual consumption or wear and tear.

Bad Debt Expense

Bad debt expense accounts for the estimated portion of accounts receivable a company expects to be uncollectible. This estimate is recorded to ensure revenue is not overstated and accounts receivable are presented at their net realizable value on the balance sheet.

Information Needed to Prepare Adjusting Entries

Before preparing adjusting entries, specific financial data and supporting documents must be gathered to ensure accuracy. This preparatory phase is essential for correctly calculating and recording the necessary adjustments.

Unadjusted Trial Balance

The unadjusted trial balance lists all general ledger accounts and their balances at the end of an accounting period before any adjustments. This balance provides a snapshot of the company’s financial position from which adjustments will be identified and calculated. It serves as the starting point for the adjustment process.

Source Documents

Various source documents related to transactions that have occurred but may not yet be fully recorded are important. These can include utility bills, interest statements for loans, and contracts for prepaid services. Loan agreements, for instance, help determine accrued interest expenses.

Depreciation Schedule

For fixed assets, a depreciation schedule tracks the allocation of an asset’s cost over its useful life, detailing the depreciation expense for each period and the accumulated depreciation to date. It contains information such as the asset’s purchase date, cost, estimated useful life, and salvage value.

Estimates for Uncollectible Accounts

Estimates for uncollectible accounts, which contribute to bad debt expense, require data. Businesses typically use historical data, such as the percentage of past credit sales that proved uncollectible, or an aging schedule of accounts receivable. An aging schedule categorizes receivables by how long they have been outstanding, with different percentages applied to older categories to estimate uncollectible amounts.

Recording Adjusting Entries

The process of recording adjusting entries involves several steps to ensure financial statements accurately reflect a company’s performance. These entries are typically made at the end of an accounting period, after the unadjusted trial balance has been prepared.

Identify Accounts

The first step involves identifying the specific accounts affected by the adjustment. Every adjusting entry impacts at least one income statement account (revenue or expense) and one balance sheet account (asset or liability). Adjusting entries rarely involve the cash account directly.

Determine Amount

Next, the correct amount of the adjustment must be determined. This calculation relies on gathered information, such as the portion of a prepaid expense used, revenue earned but not yet billed, or depreciation for the period. For instance, if a business paid $6,000 for a 12-month insurance policy in January, the monthly adjustment would be $500.

Apply Debit and Credit Rules

Once accounts and amounts are identified, the rules of debit and credit are applied to record the entry in the general journal. Debits increase asset and expense accounts, while credits increase liability, equity, and revenue accounts. For example, to record the monthly portion of a prepaid insurance policy, the insurance expense account is debited, and the prepaid insurance account is credited. For accrued wages, the wages expense account is debited, and wages payable is credited. When unearned revenue is earned, the unearned revenue account is debited, and the service revenue account is credited.

Post to General Ledger

Finally, after the journal entries are prepared, they are posted to the general ledger. This involves transferring the debit and credit amounts from the journal entries to their respective ledger accounts. This posting process ensures all accounts reflect the impact of the adjustments, preparing the financial records for accurate financial statements.