What Is the Correct Time to Make an Adjusting Entry?

Accurate financial records are essential for any business, providing a clear picture of its financial health, guiding informed decisions, and ensuring compliance. They help businesses track performance and understand their financial position.

The Role of Adjusting Entries in Accounting Accuracy

Adjusting entries are fundamental to accrual basis accounting, which records revenues when earned and expenses when incurred, regardless of cash flow. This differs from cash basis accounting, where transactions are recorded only when cash is received or paid. Accrual accounting provides a more accurate depiction of a company’s financial activities over a period.

A core concept necessitating these adjustments is the matching principle. This principle requires that expenses be recognized in the same accounting period as the revenues they helped generate. For example, the cost of goods sold is matched with the revenue from those sales. Without adjusting entries, financial statements might not truly reflect the economic reality of a period, leading to misstated profits or inaccurate asset and liability values.

Adjusting entries ensure financial statements comply with generally accepted accounting principles (GAAP), which mandate accrual accounting for most businesses. They update account balances for transactions that have occurred but have not yet been fully recorded or recognized, such as the consumption of prepaid assets or the earning of unbilled revenue.

The Critical Timing for Adjusting Entries

Adjusting entries are made at the end of an accounting period, which can be monthly, quarterly, or annually. They must be completed before financial statements, such as the income statement and balance sheet, are prepared.

This timing is important because it ensures that all revenues earned and expenses incurred within that specific period are accurately captured. For instance, if a service was provided in December but the invoice won’t be sent until January, an adjusting entry is needed in December to recognize that revenue. Similarly, expenses like utility usage or employee wages incurred but not yet paid by the period’s end must be recorded.

Completing these adjustments before financial statement preparation allows for a precise cutoff, ensuring financial reports accurately reflect the company’s financial position as of the period’s end. The adjusted trial balance, generated after these entries, serves as the final internal document from which the formal financial statements are built.

Understanding Different Adjusting Entry Categories

Adjusting entries fall into several common categories, each addressing specific timing differences between cash flows and the recognition of revenues or expenses. These categories ensure that financial records align with the accrual basis of accounting.

Prepaid Expenses

Prepaid expenses involve payments made in advance for goods or services that will be consumed or used in future periods. Initially, these payments are recorded as assets because they represent future economic benefits. As the benefit is utilized over time, an adjusting entry is made to reduce the asset account and recognize the corresponding expense. For example, if a business pays $12,000 for a one-year insurance policy upfront, $1,000 would be recognized as insurance expense each month, decreasing the prepaid insurance asset.

Unearned Revenue

Unearned revenue, also known as deferred revenue, occurs when a business receives cash from customers before delivering the goods or services. This prepayment creates a liability, as the business has an obligation to fulfill in the future. As the services are performed or goods delivered, an adjusting entry reduces the unearned revenue liability and recognizes the earned revenue. For instance, if a software company receives an annual subscription fee of $600, it would recognize $50 as revenue each month as the service is provided, decreasing the unearned revenue liability.

Accrued Expenses

Accrued expenses are expenses that have been incurred but not yet paid or recorded. These are financial obligations that accumulate over time. An adjusting entry is necessary to recognize the expense in the period it was incurred and to record a corresponding liability. A common example is accrued salaries, where employees have earned wages by the end of an accounting period, but payment will occur in the subsequent period. The adjusting entry would debit salary expense and credit salaries payable.

Accrued Revenue

Accrued revenue, also called accrued income, refers to revenue that has been earned but not yet received in cash or recorded. This typically happens when services have been performed or goods delivered, but the customer has not yet been billed. An adjusting entry is made to recognize the revenue and record a receivable, indicating money owed to the business. For example, a consulting firm that completes a project in December but won’t invoice the client until January would record accrued revenue in December.

Depreciation

Depreciation is an adjusting entry that systematically allocates the cost of a long-lived asset, like equipment or buildings, over its useful life. Assets gradually lose value due to wear and tear or obsolescence. The annual depreciation expense is recognized to match the cost of using the asset with the revenues it helps generate. This entry involves debiting depreciation expense and crediting accumulated depreciation, a contra-asset account that reduces the asset’s book value on the balance sheet.

Steps for Making Adjusting Entries

Making adjusting entries involves reviewing the unadjusted trial balance, which lists all general ledger account balances. This review helps identify accounts that may require updates for the period.

Next, transactions that need adjustment are identified. This includes looking for revenues earned but not yet billed, expenses incurred but not yet paid, or the consumption of prepaid items. The amount of each adjustment is then calculated, often based on a specific period of time, usage, or an estimated allocation.

Once the necessary adjustments and their amounts are determined, journal entries are prepared. Each adjusting entry must impact at least one income statement account (revenue or expense) and one balance sheet account (asset or liability), ensuring the double-entry accounting system remains balanced. These entries are then posted to the general ledger, updating the account balances.

Finally, an adjusted trial balance is prepared. This internal document lists all account balances after the adjusting entries have been posted. Its purpose is to verify that total debits equal total credits before the formal financial statements are generated.