What Is a Balance Adjustment in Accounting?

Financial records must accurately reflect a company’s financial health. Balance adjustments are an accounting process designed to ensure this accuracy. They help businesses align financial data with the correct reporting periods, providing a clear picture of financial performance.

Understanding Balance Adjustments

A balance adjustment is an accounting entry made at the end of an accounting period to ensure revenues and expenses are recorded in the correct period, and that asset and liability accounts show true balances. These adjustments are fundamental to accrual basis accounting, which recognizes revenues when earned and expenses when incurred, regardless of when cash changes hands. Balance adjustments are internal entries that do not involve cash transactions at the time they are made. They impact both income statement accounts (revenues and expenses) and balance sheet accounts (assets and liabilities).

Common Scenarios for Adjustments

Accrued expenses are costs incurred by a business but not yet paid, such as salaries earned by employees at month-end. Accrued revenues are earnings generated but not yet received, like services provided to a client. Deferred expenses, also known as prepaid expenses, involve cash paid in advance for goods or services not yet used, such as prepaid rent or insurance premiums, which are expensed over time as they are consumed.

Deferred revenues, or unearned revenues, represent cash received for goods or services not yet delivered or performed. Revenue is recognized only as the service is delivered. Depreciation allocates the cost of long-lived assets over their useful lives to reflect their consumption. Adjustments also correct errors or omissions discovered during reconciliation, ensuring transactions are properly accounted for.

Recording Balance Adjustments

Balance adjustments are formally entered into accounting records through “adjusting journal entries,” typically prepared at the end of an accounting period. These entries involve at least one income statement account (revenue or expense) and one balance sheet account (asset or liability). Adjusting entries never involve the cash account directly. For example, if a business uses $500 of office supplies that were initially recorded as an asset, an adjusting entry would decrease the asset account (Supplies) and increase an expense account (Supplies Expense) by $500, reflecting the consumption. These adjusting entries are then posted to the general ledger, updating account balances to their accurate figures before financial statements are prepared.

The Importance of Adjustments

Adjustments are crucial for producing financial statements that accurately portray a company’s financial performance and position. They uphold fundamental accounting principles: accrual basis accounting, revenue recognition, and the matching principle. Revenue recognition dictates that revenue is recognized when earned, regardless of when cash is received. The matching principle ensures expenses are recorded in the same period as the revenues they helped generate, providing a clear picture of profitability.

Without these adjustments, financial reports could be misleading, potentially overstating or understating income, expenses, assets, or liabilities. Accurate financial statements are vital for internal decision-making, including budgeting and performance evaluation. They are also important for external stakeholders, such as investors, lenders, and tax authorities, who rely on reliable financial data.