Estimated reading time: 8 minutes
Key Takeaways
- Adjusting entries ensure account balances reflect a company’s true financial position at period end.
- They uphold accrual accounting and the matching principle, recognising revenues when earned and expenses when incurred.
- Four core categories: accrued revenues, accrued expenses, deferred revenues, and prepaid expenses.
- Clear steps include identifying items, determining amounts, preparing journal entries, and posting to the ledger.
- Good practice involves checklists, documentation, software automation, review, and a structured month-end timetable.
Table of Contents
Introduction
Adjusting entries are journal entries recorded at the end of an accounting period to update account balances and ensure financial statements reflect a company’s true financial position. These entries act as a bridge between routine bookkeeping and the preparation of accurate financial statements that present a business’s economic reality.
In the accounting cycle, adjusting entries appear after the unadjusted trial balance but before the financial statements. They serve as the final checkpoint for confirming that records follow accrual accounting principles.
Accrual accounting, unlike cash-based accounting, recognises revenues when earned and expenses when incurred, irrespective of cash movement. This method relies on the matching principle, which states that expenses should be recorded in the same period as the revenues they help create.
Without precise adjustments, financial reports can misstate performance and position, leading to flawed management decisions and compliance problems.
Understanding Adjusting Entries
Adjusting journal entries (AJEs) are vital to the period-end close. They keep records in line with generally accepted accounting principles (GAAP) by updating accounts that may not yet mirror the economic activity of the period.
The aim is to align the books with accrual principles: revenues when earned, expenses when incurred. Without these corrections, statements would contain inaccuracies that might mislead stakeholders.
Accountants usually post four categories of adjustments:
- Accrued revenues: income earned but not yet recorded or received
- Accrued expenses: costs incurred but not yet paid or recorded
- Deferred revenues: payments received in advance for goods or services not yet delivered
- Prepaid expenses: payments made for benefits that span several periods
Each category ensures the statements reflect economic reality. Knowing when and how to apply each adjustment is fundamental to sound reporting.
Types of Adjusting Entries
Accrued Revenues
Accrued revenues are earnings from goods or services provided that have not yet been recorded or collected. These adjustments make sure revenue recognition falls in the correct period, regardless of cash receipt.
Imagine a consulting firm that finishes a project worth £5,000 in December but will invoice in January. Without an adjustment, December revenue would be understated and January overstated. The December entry is:
31 December
Debit: Accounts Receivable £5,000
Credit: Service Revenue £5,000When payment arrives in January, record:
15 January
Debit: Cash £5,000
Credit: Accounts Receivable £5,000Other situations include interest earned but not received, rent earned but not collected, and unbilled professional work.
Accrued Expenses
Accrued expenses are costs incurred but not yet paid or recorded. These adjustments keep the matching principle intact.
Suppose staff earn £2,000 in the last week of December but will be paid on 5 January. Post on 31 December:
31 December
Debit: Wage Expense £2,000
Credit: Wages Payable £2,000On payment:
5 January
Debit: Wages Payable £2,000
Credit: Cash £2,000Common accrued expenses include loan interest, utilities consumed but not billed, and taxes owed but unpaid.
Deferred Revenues
Deferred or unearned revenues arise when payment is received before delivery. The receipt is a liability until the firm fulfils its obligation.
A software company takes £12,000 on 1 December for a one-year subscription beginning immediately:
1 December
Debit: Cash £12,000
Credit: Unearned Revenue £12,000By 31 December, one month of service has been delivered:
31 December
Debit: Unearned Revenue £1,000
Credit: Service Revenue £1,000Each month, £1,000 moves from liability to revenue. Advance rent, deposits for future work, and prepaid membership fees follow the same logic.
Prepaid Expenses
Prepaid expenses are payments made in advance for benefits that extend into future periods. They start as assets, then shift to expenses as the benefit is consumed.
A firm pays £6,000 for a one-year insurance policy on 1 July:
1 July
Debit: Prepaid Insurance £6,000
Credit: Cash £6,000After six months, half the coverage has expired:
31 December
Debit: Insurance Expense £3,000
Credit: Prepaid Insurance £3,000Depreciation is another form of prepaid expense allocation. Purchase equipment for £10,000 with a five-year life:
31 December
Debit: Depreciation Expense £2,000
Credit: Accumulated Depreciation £2,000Rent paid in advance, prepaid advertising, and stocks of office supplies work similarly.
The Adjusting Entries Process
Creating accurate adjustments demands a systematic approach that identifies, measures, and records every required change.
Step 1: Identify Items Needing Adjustment
Review accounts to spot events that occurred but remain unrecorded or partially recorded, such as:
- Services delivered but not billed
- Expenses incurred but unpaid
- Revenue received in advance but not earned
- Expenses paid in advance but not yet used
- Assets requiring depreciation or amortisation
Step 2: Determine the Correct Amounts
After identification, calculate the amounts for the current period. Tasks include:
- Pro-rating annual payments (insurance, rent)
- Calculating depreciation based on cost, useful life, and chosen method
- Reviewing contracts for completion percentages
- Checking timesheets for accrued wages
- Computing interest under loan terms
Step 3: Prepare the Journal Entries
Draft entries that reflect each adjustment:
- Keep debits and credits in balance
- Write clear descriptions explaining each entry’s purpose
- Reference supporting documents
- Use standardised templates for recurrent items
Step 4: Post to the Ledger
Post entries to the general ledger so the trial balance used for statements contains every adjustment.
Best Practices for Adjusting Entries
To streamline work and reduce errors:
- Maintain a detailed checklist tailored to the business
- Utilise accounting software to automate recurring adjustments
- Document calculation methods for complex items
- Implement a review where another person verifies each entry
- Keep an audit trail with all backup material
- Set a month-end close timetable assigning tasks and deadlines to ensure every adjustment is recorded before the books close
Precise adjusting entries safeguard the integrity of financial statements and provide managers, investors, and regulators with dependable information.
FAQs
What are adjusting entries and when are they recorded?
Adjusting entries are journal entries recorded at the end of an accounting period to update account balances so financial statements reflect a company’s true financial position.
Why are adjusting entries necessary under accrual accounting?
They ensure revenues are recognised when earned and expenses when incurred, upholding the matching principle and preventing misstated performance and position.
What are the four main types of adjusting entries?
The four categories are accrued revenues, accrued expenses, deferred revenues, and prepaid expenses.
Can you give an example of an accrued expense adjustment?
If staff earn £2,000 in the last week of December to be paid in January, record Wage Expense £2,000 and Wages Payable £2,000 on 31 December.
How do deferred revenues affect the accounts?
Cash received before delivery is recorded as Unearned Revenue (a liability) and then recognised as Service Revenue as the obligation is fulfilled.
What steps help ensure accurate adjusting entries?
Identify items needing adjustment, determine correct amounts, prepare journal entries, and post to the ledger, supported by checklists, documentation, and review.
