What Is an Adjusting Journal Entry? Explained With Examples

Financial accounting aims to provide a clear and accurate picture of a business’s financial health and performance. Businesses engage in numerous transactions daily, but not all financial events involve immediate cash exchanges. Some revenues are earned before cash is received, and some expenses are incurred before they are paid. These timing differences create a challenge in financial reporting. Adjusting journal entries ensure that financial statements reflect a company’s financial position and operational results during a specific period. They bridge the gap between cash transactions and economic events.

The Purpose of Adjusting Journal Entries

Adjusting journal entries are fundamental to accrual basis accounting, the standard method for most businesses. Accrual accounting recognizes revenues when earned and expenses when incurred, regardless of when cash changes hands. This contrasts with cash basis accounting, which only records transactions when cash is received or paid. Accrual accounting provides a more comprehensive view of a company’s financial performance over time.

Accrual accounting is guided by the revenue recognition principle, which states revenue is recognized when earned, usually when goods or services are delivered. The matching principle requires expenses to be recorded in the same period as the revenues they helped generate. Adjusting entries ensure financial statements accurately match earned revenues with incurred expenses. These entries are prepared at the end of an accounting period, such as monthly, quarterly, or annually, before financial statements are issued. This updates financial records for transactions that have occurred but are not yet formally recorded.

Categories of Adjusting Journal Entries

Adjusting entries fall into two categories: accruals and deferrals. Accruals involve economic events that have occurred but for which cash has not yet been exchanged. This ensures that earned revenues and incurred expenses are recognized in the proper period, even if the cash transaction has not yet happened.

Accrued revenues represent income earned by providing goods or services but not yet received or billed. Accrued expenses are costs incurred during an accounting period but not yet paid. Deferrals relate to situations where cash has been exchanged, but the corresponding revenue has not yet been fully earned or the expense has not yet been fully incurred.

Deferred revenues, also known as unearned revenues, occur when a business receives cash upfront for goods or services to be provided in a future period. This initial cash receipt is a liability until the revenue is earned. Prepaid expenses, or deferred expenses, arise when a business pays cash for an expense that will benefit multiple future accounting periods. The amount paid is initially recorded as an asset and then gradually expensed over the periods it benefits.

Common Examples of Adjusting Journal Entries

Adjusting entries are necessary for common business scenarios, ensuring financial records align with economic activity.

Accrued expenses involve obligations like salaries or interest. For instance, if employees earn wages for the last few days of a month, but payday falls in the next month, an accrued salaries expense entry is made. This recognizes the expense in the month the labor was performed, even if payment occurs later. Similarly, interest on a loan accrues daily, requiring an adjusting entry for accrued interest expense at period-end to record interest incurred but not yet paid. This ensures the income statement reflects the full cost of operations.

Accrued revenues arise when services are rendered or goods are delivered before an invoice is sent or payment is received. A consulting firm, for example, might complete a project in December but not bill the client until January. An adjusting entry for accrued service revenue would be made in December to recognize the revenue earned that month. Similarly, a business might earn interest on a bank account or investment not received until the following period, requiring an accrued interest revenue adjustment.

Prepaid expenses involve payments made in advance for services or assets consumed over time. When a company pays for a 12-month insurance policy upfront, the entire amount is initially recorded as a prepaid asset. Each month, an adjusting entry recognizes one-twelfth of the premium as insurance expense, reducing the prepaid asset balance. Similarly, office supplies purchased are initially recorded as an asset, and at period-end, an adjusting entry expenses the cost of supplies actually used. Prepaid rent functions similarly, with a portion recognized as rent expense each month.

Unearned revenue occurs when cash is received before goods or services are delivered. A software company selling annual subscriptions receives full payment at the start of the year. This payment is initially recorded as unearned revenue, a liability, because the service has not yet been provided. Each month, as the company provides software access, an adjusting entry recognizes one-twelfth of the subscription fee as earned revenue, reducing the unearned revenue liability. A gym collecting membership fees in advance for a future period is another example.

Depreciation expense is a deferred expense that allocates the cost of a tangible long-term asset, like machinery or buildings, over its useful life. Assets lose value over time due to wear, obsolescence, or usage. Instead of expensing the entire cost when purchased, its cost is systematically spread as an expense over the years it generates revenue. An adjusting entry for depreciation records a portion of the asset’s cost as an expense for the current period, reflecting its consumption. This ensures the asset’s value on the balance sheet and the expense on the income statement accurately reflect its usage.

Recording Adjusting Journal Entries and Their Financial Statement Impact

Recording adjusting journal entries adheres to double-entry accounting principles, where every transaction affects at least two accounts. Each adjusting entry involves one income statement account (revenue or expense) and one balance sheet account (asset or liability). This dual impact ensures the accounting equation (Assets = Liabilities + Equity) remains balanced and that both the income statement and balance sheet are updated accurately.

For example, an accrued expense entry increases an expense account (income statement) and a liability account (balance sheet), reflecting an incurred cost and an outstanding obligation. Conversely, an accrued revenue entry increases an asset account (balance sheet) and a revenue account (income statement), recognizing earned income and a receivable. Prepaid expense adjustments decrease an asset account and increase an expense account as the prepaid item is consumed. Unearned revenue adjustments decrease a liability account and increase a revenue account as the service is delivered. Depreciation adjustments increase an expense account and increase a contra-asset account (accumulated depreciation), which reduces the asset’s book value.

Properly recording adjusting entries is important for generating financial statements that accurately reflect a company’s financial activities. Without these adjustments, the income statement would misrepresent net income by failing to match revenues and expenses to the correct periods. The balance sheet would also inaccurately report asset and liability balances. These inaccuracies could lead to misleading financial data, potentially resulting in poor business decisions by management, investors, or creditors. Adjusting entries are a necessary step in the accounting cycle, ensuring compliance with accrual accounting principles and enhancing financial reporting reliability.