What Is an Adjustment in Accounting and Finance?

Adjustments ensure a business’s financial statements accurately reflect its financial position and performance. These modifications to accounting records are typically made at the end of an accounting period to account for economic events that have occurred but have not yet been fully recorded through routine transactions.

The Need for Adjustments

Adjustments are necessary due to the accrual basis of accounting. Unlike cash basis accounting, where transactions are recorded only when cash is received or paid, accrual accounting recognizes revenues when earned and expenses when incurred, regardless of when cash changes hands. This difference in timing necessitates adjustments to ensure financial records align with actual economic activity.

The matching principle mandates that expenses should be recognized in the same accounting period as the revenues they helped generate. For example, if a company earns revenue in December but incurs related expenses that won’t be paid until January, adjustments ensure these expenses are recorded in December to match the revenue. Without such adjustments, financial statements would misrepresent profitability.

The periodicity assumption requires businesses to divide their ongoing economic life into specific time intervals. These intervals are commonly months, quarters, or years. At the close of each period, adjustments properly allocate revenues and expenses to that specific timeframe, providing a consistent and comparable financial picture. This systematic approach ensures that financial reports are relevant and timely for decision-making.

Common Types of Adjustments

Adjusting entries fall into several categories, each addressing a specific timing difference between cash flow and economic activity. They typically involve one income statement account and one balance sheet account.

Accrued revenues represent revenues a business has earned by providing goods or services but has not yet received cash for. An example is a consulting firm completing a project for a client at the end of the month but not issuing the invoice until the following month. An adjustment is made to record the revenue earned and create an asset, such as Accounts Receivable.

Accrued expenses are expenses a business has incurred but has not yet paid cash for. For instance, employee wages earned in the last few days of a month but paid in the first week of the next month require an adjustment. This recognizes the expense in the current period and creates a liability, such as Wages Payable.

Deferred revenues occur when a business receives cash for goods or services before they have been delivered or earned. A common example is a customer paying for a one-year software subscription upfront. Initially, this cash is recorded as a liability because the service has not yet been provided. As the service is delivered over time, an adjustment is made to recognize the earned portion as revenue and reduce the liability.

Deferred expenses are payments made for expenses that will benefit future accounting periods. Rent paid in advance for several months is an example. The initial payment creates an asset, Prepaid Rent. As each month passes, an adjustment is made to recognize the portion of the rent that has been “used up” as an expense for that period, reducing the asset.

Depreciation expense is a non-cash adjustment that systematically allocates the cost of a tangible asset, such as equipment or buildings, over its useful life. Instead of expensing the entire cost of an asset when purchased, a portion of its cost is recognized as an expense in each period it is used. This adjustment reflects the asset’s wear and tear or obsolescence and reduces its book value on the balance sheet.

How Adjustments Affect Financial Reporting

Adjustments impact a company’s financial statements, ensuring the information presented is accurate and reliable. They ensure adherence to accounting principles and provide an accurate picture of financial performance and position.

On the income statement, adjustments ensure revenues and expenses are recognized in the correct accounting period, leading to a more accurate net income or loss. Accruing revenues increases reported revenue, reflecting income earned but not yet collected. Recording accrued expenses increases total expenses, ensuring all costs incurred to generate revenue are accounted for.

When previously deferred revenues are earned, they are moved from a liability account to a revenue account, increasing reported income. Similarly, as prepaid expenses are consumed, they become recognized as expenses, impacting profitability. Depreciation also increases expenses on the income statement, reflecting the systematic allocation of asset costs.

The balance sheet is also affected by adjustments, which ensure assets, liabilities, and equity are reported at their correct values at a specific point in time. Accrued revenues create an asset, such as Accounts Receivable, indicating money owed to the business. Accrued expenses establish a liability, like Wages Payable, representing obligations that need to be settled.

Deferred revenues are initially recorded as a liability, reflecting the company’s obligation to provide future goods or services. As these services are rendered, the liability is reduced. Prepaid expenses are recorded as assets, representing future economic benefits, and are reduced as the expense is recognized.

Accumulated depreciation, linked to depreciation expense, reduces the book value of assets on the balance sheet, reflecting their consumed economic utility. Without these adjustments, financial statements would misrepresent a company’s financial health, potentially leading to flawed operational and investment decisions.