What Are Accounting Adjustments? Types and Examples

Accounting adjustments are modifications made to a company’s financial records at the close of an accounting period. These changes ensure that financial statements accurately reflect all revenues earned and expenses incurred during that specific period.

Why Adjustments are Essential

Adjustments are necessary because they uphold the accrual basis of accounting, a fundamental principle in financial reporting. This basis requires revenues to be recognized when they are earned, regardless of when cash is received, and expenses to be recognized when they are incurred, regardless of when cash is paid. Many businesses are required to adhere to these principles under generally accepted accounting principles (GAAP) in the United States.

These adjustments also support the matching principle, which dictates that expenses should be recognized in the same accounting period as the revenues they help generate. For example, the cost of supplies used to provide a service in July should be recorded as an expense in July, even if the supplies were paid for in June. Financial statements, such as the income statement and balance sheet, provide a true and fair view of an entity’s financial health and operational outcomes for a given period only when these principles are applied. Without adjustments, financial reports would present an incomplete picture, potentially misrepresenting profitability and financial standing.

Categories of Adjusting Entries

Adjusting entries broadly fall into categories based on when the cash transaction occurs relative to the revenue being earned or expense being incurred. These categories ensure that the financial effects of transactions are recognized in the proper accounting period.

Deferrals

Deferrals involve situations where a cash transaction takes place before the corresponding revenue is earned or expense is incurred. A common example is prepaid expenses, which are payments made in advance for goods or services to be received in the future. For instance, paying $12,000 for a one-year insurance policy creates an asset, Prepaid Insurance. As each month passes, $1,000 of that prepaid amount is consumed and recognized as an insurance expense.

Unearned revenues represent cash received from customers for services or goods that will be provided later. When a customer pays $600 for a six-month subscription service, the company initially records this as a liability, Unearned Revenue. As each month of service is delivered, $100 of the unearned amount is recognized as actual revenue.

Accruals

Accruals address situations where revenues are earned or expenses are incurred before any cash changes hands. Accrued expenses are costs that have been incurred but not yet paid or recorded. For instance, if employees earn $8,000 in salaries during the last week of a month, but payday falls in the next month, that $8,000 is recognized as an accrued expense, creating a liability for salaries payable.

Accrued revenues are revenues that have been earned but not yet received or recorded. An example includes interest earned on a loan provided to another party, where the interest has accumulated but the payment is not yet due. If a company earns $150 in interest on a note receivable by the end of the month, this amount is recognized as accrued revenue, even if the cash will not be collected until a later date.

Depreciation

Depreciation is a method used to allocate the cost of a tangible asset over its useful life. This systematic allocation recognizes that assets like machinery or buildings lose value and contribute to revenue generation over multiple accounting periods. For example, a delivery truck purchased for $50,000 with an estimated useful life of five years might be depreciated by $10,000 annually.

Recording Adjustments

Adjusting entries are formal journal entries prepared at the end of an accounting period, such as monthly, quarterly, or annually. This timing aligns with the reporting cycles required for financial statement preparation, whether for internal management or external regulatory bodies like the Securities and Exchange Commission (SEC). Each adjusting entry always impacts one income statement account, which is either a revenue or an expense, and one balance sheet account, which is either an asset or a liability.

A distinguishing characteristic of adjusting entries is that they never involve the cash account. Instead, they reallocate or recognize amounts that have already been part of a cash transaction or are yet to involve cash. For example, to record the consumption of prepaid rent, an adjusting entry would debit Rent Expense and credit Prepaid Rent. This action reduces the asset and recognizes the cost incurred for the period.

The immediate impact of these entries is a modification of the affected account balances, ensuring they accurately reflect the economic activities of the period. These updated balances then flow into the financial statements, allowing them to present a precise picture of the company’s profitability and financial position. The meticulous recording of these adjustments is a fundamental step in producing reliable financial reports.