When Are Adjusting Entries Made in Accounting?

Adjusting entries are a core component of financial accounting, ensuring a company’s records accurately reflect its economic activities. These entries are essential for preparing financial statements that provide a fair representation of an entity’s financial position and performance. By updating accounts, adjusting entries align reported financial data with the economic realities of a business, providing a clear picture of its financial health to stakeholders.

The Timing of Adjusting Entries

Adjusting entries are prepared at the end of an accounting period (monthly, quarterly, or annually), always before financial statements are finalized. This timing is rooted in the accrual basis of accounting, which dictates revenues be recognized when earned and expenses when incurred, regardless of when cash is exchanged. Unlike the cash basis, accrual accounting provides a more comprehensive view of an entity’s financial activities.

This approach is supported by the matching principle, which requires that expenses incurred to generate revenue be recognized in the same accounting period as that revenue. Many business transactions span multiple accounting periods. Period-end adjustments become essential to accurately allocate revenues and expenses to the period in which they belong. Without these adjustments, financial statements would misrepresent a company’s profitability and financial standing.

For example, a business might pay for a year of insurance coverage upfront, but only a fraction is consumed within a month. An adjusting entry at the end of that month would recognize the used portion as an expense, while the remainder continues to be reported as an asset. If services are performed but payment has not yet been received, an adjusting entry would recognize the earned revenue in the current period, even though the cash inflow will occur later.

Categories of Adjusting Entries

Adjusting entries fall into two main categories: deferrals and accruals. Depreciation is often considered a distinct but related type.

Deferrals

Deferrals involve cash transactions that have occurred, but the associated revenue or expense has not yet been fully recognized. Prepaid expenses are a common deferral, representing payments made in advance for goods or services that will be consumed in future periods, such as rent or insurance premiums. At the end of each period, an adjustment recognizes the portion of the prepaid asset that has been used or expired as an expense.

Unearned revenues are another type of deferral, occurring when a company receives cash for goods or services before they are delivered. Examples include customer deposits or subscriptions paid in advance. An adjusting entry recognizes the portion of the revenue that has been earned during that period as the service is provided.

Accruals

Accruals involve revenues earned or expenses incurred for which no cash has yet been exchanged. Accrued expenses are costs that have been incurred but not yet paid, such as salaries earned by employees or utility services consumed but not yet billed. An adjusting entry recognizes these expenses and establishes a corresponding liability.

Accrued revenues are earned but not yet received or recorded, such as services performed for a client that have not yet been invoiced. An adjusting entry recognizes this earned revenue and establishes a corresponding receivable.

Depreciation

Depreciation is a routine adjusting entry that allocates the cost of a tangible asset, such as equipment or buildings, over its estimated useful life. This periodic adjustment recognizes a portion of the asset’s cost as an expense, reflecting its consumption or decline in value.

Purpose of Adjusting Entries

Adjusting entries ensure that financial statements present an accurate and complete picture of an entity’s financial performance and position. These entries are indispensable for adherence to Generally Accepted Accounting Principles (GAAP), specifically the revenue recognition principle and the expense recognition principle. The revenue recognition principle dictates that revenue should be recognized when it is earned, meaning when goods or services have been delivered or performed, regardless of when cash is received. The expense recognition principle, often called the matching principle, requires that expenses be recognized in the same period as the revenues they helped generate.

Without adjusting entries, financial statements would be misleading, as they would not properly match revenues with their corresponding expenses, nor would they accurately reflect assets and liabilities. For instance, the income statement would misstate profitability, and the balance sheet would inaccurately report asset and liability balances. This distortion would significantly impair the usefulness of financial reports for all stakeholders.

Accurate financial statements, enabled by the meticulous application of adjusting entries, are vital for various critical functions. Internal management relies on these reports for informed decision-making regarding operations, budgeting, and strategic planning. External stakeholders, including investors, creditors, and regulatory bodies, depend on reliable financial information to assess a company’s financial health, evaluate investment opportunities, and ensure compliance with financial reporting standards. Therefore, making timely and correct adjusting entries is fundamental to maintaining the integrity and credibility of financial reporting.