How to Record Adjusting Journal Entries

Adjusting journal entries are internal accounting records made at the close of an accounting period, such as a month, quarter, or year. These entries are fundamental for businesses operating under the accrual basis of accounting. Their purpose is to ensure that a company’s financial statements accurately reflect its financial performance and position at a point in time.

Adjustments are necessary because financial events, like consuming prepaid services or earning revenue received earlier, often occur continuously rather than in discrete transactions. Without adjusting entries, financial reports would not align with accrual accounting principles. This process ensures that revenues and expenses are recognized in the period they are earned or incurred, regardless of when cash changes hands.

Understanding Core Accounting Concepts

Accrual basis accounting is a principle for recognizing revenues and expenses. Under this method, revenues are recorded when they are earned, when goods or services are delivered, regardless of cash receipt. Similarly, expenses are recognized when they are incurred, when resources are used or liabilities arise, even if unpaid. This contrasts with cash basis accounting, which records transactions only when cash is exchanged.

The matching principle works with accrual accounting, requiring expenses to be recognized in the same period as the revenues they helped generate. For instance, the cost of goods sold is matched against the revenue from those sales. Adjusting entries achieve this matching, ensuring financial statements provide a comprehensive and accurate view of operations.

Common Categories of Adjusting Entries

Prepaid expenses represent payments made for goods or services that will be consumed or used in a future accounting period. Examples include insurance premiums paid in advance, rent paid for several months ahead, or office supplies purchased but not yet used. An adjustment recognizes the consumed or expired portion of the prepaid asset as an expense.

Unearned revenues, also known as deferred revenues, occur when a company receives cash for goods or services before they have been delivered or performed. This creates a liability, as the company owes the customer a service or product. A common example is a subscription service where a customer pays for a year in advance. An adjustment recognizes the earned revenue portion, reducing the liability and increasing revenue.

Accrued expenses are costs that have been incurred during the current accounting period but have not yet been paid or formally recorded. These include expenses that accumulate over time, such as employee salaries earned but not yet paid, utility services used but not yet billed, or interest owed on a loan. An adjustment records these incurred expenses and corresponding liability, ensuring costs are recognized in the period they arise.

Accrued revenues represent income that has been earned by a business but has not yet been received in cash or formally billed to the customer. This can happen when services have been performed or goods delivered, but an invoice has not yet been issued. An example might be consulting services rendered throughout a month that will be billed at the end of the month. An adjustment recognizes this earned revenue and establishes a corresponding receivable.

Depreciation is the systematic allocation of the cost of a tangible long-lived asset over its useful life. Assets such as buildings, machinery, and vehicles lose value or utility over time due to wear and tear, obsolescence, or usage. Rather than expensing the entire cost of the asset at the time of purchase, a portion of its cost is recognized as an expense in each period it benefits the business. This adjustment reflects the asset’s consumed economic benefits.

Recording Adjusting Entries Step-by-Step

Recording adjusting entries begins with identifying accounts needing adjustment at period-end. Next, determine the exact adjustment amount, often involving calculations of consumed, earned, or incurred portions. Apply proper debit and credit rules to record the entry, ensuring the accounting equation remains balanced. Finally, post these entries to the general ledger, updating affected account balances.

For prepaid expenses, such as a company having initially paid $12,000 for a one-year insurance policy on January 1, the initial entry would have debited Prepaid Insurance for $12,000 and credited Cash for $12,000. By January 31, one month of insurance has expired, meaning $1,000 ($12,000 / 12 months) of the prepaid amount has been used. The adjusting entry debits Insurance Expense for $1,000 and credits Prepaid Insurance for $1,000, reducing the asset and recognizing the expense.

When a business receives unearned revenue, for example, collecting $6,000 in advance for six months of service beginning January 1, the initial recording would have debited Cash for $6,000 and credited Unearned Service Revenue for $6,000. By the end of January, one month of service has been delivered, meaning $1,000 ($6,000 / 6 months) has been earned. The adjustment debits Unearned Service Revenue for $1,000 to decrease the liability and credits Service Revenue for $1,000 to recognize the earned income.

Accrued expenses often involve situations like employee salaries. If a company’s employees earn $5,000 in salaries for the last week of January, but payday is not until February 3, the salaries expense for January needs to be recognized. The adjusting entry debits Salaries Expense for $5,000 to record the cost and credits Salaries Payable for $5,000, establishing the liability. This ensures the expense is captured in the correct period.

Accrued revenues occur when services are provided but not yet billed. Consider a law firm that completed $3,500 worth of legal services for a client in December, but the invoice will not be sent until January. At the end of December, the firm needs to recognize this earned revenue. The adjusting entry debits Accounts Receivable for $3,500, reflecting the amount owed, and credits Service Revenue for $3,500, recognizing the income earned.

Depreciation systematically allocates the cost of an asset over its useful life. For an asset costing $60,000 with an estimated useful life of five years and no salvage value, using the straight-line method, the annual depreciation would be $12,000 ($60,000 / 5 years). The monthly depreciation would then be $1,000 ($12,000 / 12 months). The adjusting entry debits Depreciation Expense for $1,000 and credits Accumulated Depreciation for $1,000, a contra-asset account.

Completing the Accounting Cycle

After all adjusting entries are recorded and posted, an adjusted trial balance is prepared. This step ensures total debits equal total credits after incorporating period-end adjustments. The adjusted trial balance verifies balances before the next accounting cycle phase.

The adjusted trial balance forms the basis for preparing a company’s financial statements. The income statement, reporting revenues and expenses to determine net income or loss, is derived from the adjusted trial balance. The balance sheet, presenting assets, liabilities, and equity, is constructed using the relevant accounts.

After financial statements are prepared, the accounting cycle concludes with closing entries. These entries reset temporary accounts—revenues, expenses, and dividends—to zero for the next period. Their balances are then transferred to a permanent equity account, typically retained earnings.