Where Do You Make Adjusting Entries?

Adjusting entries are foundational in financial accounting, ensuring a company’s financial statements accurately reflect its financial position and performance. Essential for businesses using the accrual basis of accounting, which recognizes revenues when earned and expenses when incurred regardless of when cash changes hands, their primary purpose is to align transaction timing with the correct accounting periods. Without these adjustments, financial statements might present a misleading view of a business’s financial health.

The Timing of Adjusting Entries

Adjusting entries are made at the end of an accounting period (monthly, quarterly, or annually) before financial statements are issued. They fit into the accounting cycle after the initial trial balance but before final financial statements are generated. Their role is to update account balances to reflect economic activities that have occurred but have not yet been fully recorded. This process ensures revenues and expenses are properly matched to the period in which they were earned or incurred, adhering to the matching principle.

The Accounting Records Involved

Adjusting entries are formally recorded in the company’s accounting system. They are first entered into the general journal, the book of original entry for all financial transactions. Each entry details the accounts affected, along with corresponding debit and credit amounts.

After being recorded, these entries are posted to the respective accounts in the general ledger, which contains individual accounts for all assets, liabilities, equity, revenues, and expenses. Posting ensures account balances are updated to reflect the adjustments. Adjusting entries typically affect at least one income statement account (revenue or expense) and one balance sheet account (asset or liability), but they almost never involve the cash account directly.

Common Categories of Adjusting Entries

Adjusting entries address situations where revenue or expense recognition does not coincide with cash flow. These fall into categories like accruals, deferrals, and depreciation.

Accruals involve economic activities that have occurred, but cash has not yet been exchanged. Accrued revenues represent income earned for goods or services delivered but not yet billed or received. For example, if a service business completes a project in December but won’t invoice until January, an adjusting entry in December recognizes the revenue and establishes a receivable. Similarly, accrued expenses are costs incurred but not yet paid, such as employee wages earned in one period but paid in the next. An adjusting entry recognizes the expense and establishes a payable.

Deferrals relate to cash transactions that occurred before the related revenue or expense is recognized. Prepaid expenses are payments made in advance for goods or services consumed in a future period. An initial payment for a year of insurance, for instance, is recorded as an asset, then a portion is expensed each month as coverage is used. Deferred revenues occur when cash is received for goods or services not yet delivered. This initial cash receipt creates a liability, and an adjusting entry recognizes revenue as the service is performed or goods are delivered.

Depreciation is another common adjusting entry for long-term assets like equipment or buildings. Instead of expensing the entire cost of an asset when purchased, its cost is systematically allocated as an expense over its useful life. An adjusting entry is made periodically to record depreciation expense, reflecting the portion of the asset’s cost consumed, and increases accumulated depreciation, a contra-asset account.