What Is an Adjusting Journal Entry & Why Does It Matter?

Adjusting journal entries are internal accounting records made at the close of an accounting period. These entries ensure that a company’s financial statements accurately reflect its financial performance and position. They align the timing of revenues and expenses with the period in which they truly belong. Adjusting entries are a fundamental aspect of accrual basis accounting, allowing for a more precise representation of a business’s economic activities.

The Accounting Basis for Adjustments

Adjusting entries are necessary due to the principles of accrual basis accounting. Unlike cash basis accounting, which records transactions only when cash is exchanged, accrual accounting recognizes revenues when earned and expenses when incurred, regardless of when cash changes hands. This method provides an accurate picture of a company’s financial health.

Central to accrual accounting is the Matching Principle, which dictates that expenses must be recorded in the same accounting period as the revenues they help generate. This ensures costs associated with earning revenue are recognized concurrently. For example, if a company earns revenue from a sale in December, the associated sales commissions, even if paid in January, must be recognized as an expense in December.

Complementing this is the Revenue Recognition Principle, which states that revenue should be recognized when earned, typically when goods or services are delivered. This principle applies even if cash payment is received at a different time. Adherence to these principles ensures financial reports are consistent and reliable.

Types of Adjusting Entries

Adjusting entries fall into two categories: deferrals and accruals. Deferrals involve situations where cash has been exchanged, but the associated revenue has not yet been earned or the expense has not yet been incurred. These adjustments reallocate amounts initially recorded as assets or liabilities to their proper expense or revenue accounts over time.

Prepaid expenses are a common deferral, representing advance payments for goods or services consumed in future periods. Examples include prepaid rent, insurance premiums, or office supplies. An adjustment recognizes the portion of the prepaid asset used during the period as an expense.

Unearned revenues, also known as deferred revenues, occur when a company receives cash from customers for goods or services it has not yet delivered. This creates a liability, as the company has an obligation to provide future services. Adjustments recognize revenue as services are performed or goods delivered, reducing the liability.

Accruals, conversely, involve situations where an expense has been incurred or revenue has been earned, but no cash has been exchanged. These adjustments record economic activities that have occurred but have not yet been formally documented through a cash transaction.

Accrued expenses are costs that a business has incurred but has not yet paid or recorded. Common examples include salaries earned by employees but not yet paid, interest owed on loans, or utility services received but not yet billed. An adjusting entry recognizes the expense and corresponding liability.

Accrued revenues represent income that a business has earned by providing goods or services but has not yet received payment or formally recorded. This often occurs when services are completed, but an invoice has not yet been issued. An adjustment recognizes the revenue and corresponding asset, such as accounts receivable.

Recording Adjusting Entries

Recording adjusting entries involves using debits and credits to update account balances at the end of an accounting period. Each entry impacts at least one income statement account (revenue or expense) and one balance sheet account (asset or liability), but never cash.

For prepaid expenses, if a business paid $6,000 for a six-month insurance policy on December 1, and one month ($1,000) expired by December 31, the entry debits Insurance Expense for $1,000 and credits Prepaid Insurance for $1,000.

For unearned revenues, if a company received $1,200 on December 1 for a two-month service contract, and $600 was earned by December 31, the adjusting entry debits Unearned Revenue for $600 and credits Service Revenue for $600.

Accrued expenses often arise from services received but not yet billed. If employees earned $2,500 in salaries in December but payday is in January, the entry debits Salaries Expense for $2,500 and credits Salaries Payable for $2,500.

Accrued revenues occur when services are performed but not yet invoiced. If a consulting firm completed $1,500 worth of services in December but will not bill until January, the entry debits Accounts Receivable for $1,500 and credits Consulting Revenue for $1,500.

Effect on Financial Reporting

Adjusting entries are essential for preparing accurate financial statements. By ensuring revenues are recognized when earned and expenses when incurred, these entries allow the income statement to present a precise measure of a company’s profitability and operational performance.

Adjusting entries also ensure the balance sheet accurately reflects assets, liabilities, and equity at the end of the period. For example, they adjust prepaid expenses to reflect only the unused portion and unearned revenues to show only the portion still owed. Without these adjustments, financial statements would misstate a company’s financial position and results.

Accurate financial statements are important for internal management and external stakeholders. Management relies on this data to make informed decisions regarding operations, budgeting, and strategy. External parties, such as investors, creditors, and regulatory bodies, depend on these statements to assess financial health and evaluate performance.