When Are Adjusting Entries Prepared in Accounting?

Adjusting entries are a fundamental practice in accounting, serving to ensure that a company’s financial records accurately reflect its financial performance and position. These entries are internal transactions that update account balances at the end of an accounting period. Their primary purpose is to capture revenues earned and expenses incurred that may not yet be recorded through routine transactions. Without them, financial statements would present an incomplete and potentially misleading picture of a business’s true economic activity.

The Timing of Adjusting Entries

Adjusting entries are typically made at the close of an accounting period, which could be monthly, quarterly, or annually, depending on a business’s reporting frequency. This preparation occurs after all regular business transactions have been recorded and an unadjusted trial balance has been generated.

They allow for the recognition of financial events that have occurred but have not yet been formally documented through cash exchanges or invoices. For instance, an expense might have been incurred over time, like rent or utilities, but the payment is due later. Adjusting entries ensure these incurred expenses are properly attributed to the period in which they were used.

These entries must be completed before the financial statements are prepared. This sequence ensures that the final reported figures for revenues, expenses, assets, and liabilities are accurate and complete for that period.

The Purpose Behind Adjusting Entries

The fundamental reason for preparing adjusting entries lies in the application of the accrual basis of accounting. Unlike cash basis accounting, which records transactions only when cash changes hands, accrual accounting recognizes revenues when they are earned and expenses when they are incurred, regardless of when cash is received or paid.

Two principles underpin the accrual basis and necessitate adjusting entries: the revenue recognition principle and the matching principle. The revenue recognition principle dictates that revenue should be recorded when it is earned, meaning when goods or services have been delivered or performed. The matching principle requires that expenses be recognized in the same period as the revenues they helped generate. Adjusting entries align these economic events with the correct accounting period.

Common Categories of Adjusting Entries

Adjusting entries generally fall into categories that address transactions where cash has been exchanged at a different time than when the revenue was earned or the expense was incurred. These categories ensure that financial reporting adheres to the accrual basis of accounting.

Accrued Revenues: These represent revenues that have been earned by providing goods or services, but the cash has not yet been received, nor has the customer been billed. An example includes services completed for a client at the end of a month, with the invoice to be sent the following month. An adjustment records the revenue and establishes a receivable.
Accrued Expenses: These are expenses that have been incurred, meaning the benefit has been received, but the cash has not yet been paid. Common examples include salaries owed to employees for work performed but not yet paid, or interest incurred on a loan. An adjustment recognizes the expense and corresponding liability.
Deferred Revenues: Also known as unearned revenues, these occur when cash is received from a customer before the goods or services have been delivered or performed. A typical instance is a subscription payment received in advance for services to be provided over several months. The cash is initially recorded as a liability, then reduced as revenue is earned over time.
Deferred Expenses: Also known as prepaid expenses, these involve cash paid for an expense that will be incurred or used in a future accounting period. Examples include prepaid rent, insurance premiums, or office supplies purchased in bulk. An initial payment creates an asset, which is then reduced as the expense is consumed.
Depreciation: This allocates the cost of a long-term asset, like equipment or buildings, over its estimated useful life. Their cost is spread out as an expense over those periods rather than expensed entirely when purchased. This adjustment recognizes the portion of the asset’s cost consumed during the current period.

How Adjusting Entries Affect Financial Reports

Adjusting entries significantly impact a company’s primary financial statements. Every adjusting entry influences at least one income statement account and one balance sheet account. This dual effect is crucial for a coherent financial picture.

On the Income Statement, adjusting entries ensure that revenues earned and expenses incurred during the period are accurately reflected. Forgetting an adjusting entry can lead to either understated or overstated revenues and expenses, which directly distorts the net income figure. For example, recording accrued revenues increases income, while recognizing accrued expenses increases expenses, both refining the profitability calculation for the period.

For the Balance Sheet, adjusting entries ensure that assets, liabilities, and equity are presented at their correct values at the end of the accounting period. Adjustments for prepaid expenses reduce assets and increase expenses, while deferred revenues decrease liabilities and increase revenues. Similarly, depreciation reduces the book value of assets, impacting the company’s financial position.