The Adjustment Process and Common Types of Adjusting Entries
Adjusting entries exist to solve a timing problem: cash often changes hands in a different period than when revenue is actually earned or an expense is actually incurred. Without adjustments at the end of each period, your financial statements would misstate revenues, expenses, net income, and the balance sheet. The adjustment process ensures everything lands in the correct accounting period before you prepare financial statements.
There are four main types of adjusting entries, and they all fall into two categories: deferrals (cash moved first, recognition comes later) and accruals (recognition comes first, cash moves later).
Purpose of Adjusting Entries
- Ensure financial statements are accurate and up-to-date at the end of an accounting period
- Match revenues and expenses to the correct period, following the revenue recognition and expense recognition principles
- Record transactions that have occurred but haven't yet been journalized (accrued revenues, accrued expenses, deferred revenues, deferred expenses)
- Prevent misstatement of revenues, expenses, net income, and retained earnings
Every adjusting entry affects at least one income statement account and one balance sheet account. Adjusting entries never involve the Cash account, which is a useful check if you're unsure whether an entry qualifies.
Types of Adjusting Entries
The four types split neatly into two groups:
Deferrals delay the recognition of a revenue or expense that has already involved a cash transaction.
- Deferred (unearned) revenues occur when a company receives cash before providing goods or services. The payment is initially recorded as a liability called Unearned Revenue. As the company delivers on its obligation over time, it shifts the amount from the liability to a revenue account.
- Example: A magazine publisher collects $1,200 for a 12-month subscription on January 1. At that point, the full $1,200 is credited to Unearned Subscription Revenue. Each month, the company makes an adjusting entry to recognize $100 of subscription revenue earned that month.
- Deferred (prepaid) expenses occur when a company pays cash before consuming a good or service. The payment is initially recorded as an asset called a Prepaid Expense. As the benefit is used up, the company shifts the amount from the asset to an expense account.
- Example: A business pays $2,400 for a 12-month insurance policy on March 1. The full amount is debited to Prepaid Insurance. Each month, an adjusting entry moves $200 from Prepaid Insurance to Insurance Expense.
Accruals record revenues or expenses that have been earned or incurred but not yet recorded because no cash has changed hands.
- Accrued revenues arise when a company has earned revenue but hasn't yet received payment or billed the customer. The adjusting entry records an asset (a receivable) and recognizes the revenue.
- Example: A company earns $500 of interest on an investment during December, but the cash won't arrive until January. On December 31, the company debits Interest Receivable $500 and credits Interest Revenue $500.
- Accrued expenses arise when a company has incurred an expense but hasn't yet paid for it. The adjusting entry records a liability (a payable) and recognizes the expense.
- Example: Employees earn $3,000 in salaries during the last week of December, but payday falls in January. On December 31, the company debits Salaries Expense $3,000 and credits Salaries Payable $3,000.
Recognition Principles in Adjustments
Two principles drive every adjusting entry:
The revenue recognition principle states that revenue should be recognized when it is earned, regardless of when cash is received. This is why you adjust for both accrued and deferred revenues:
- Accrued revenue adjustment: debit Accounts Receivable (or a specific receivable), credit the revenue account
- Deferred revenue adjustment: debit Unearned Revenue, credit the revenue account
The expense recognition (matching) principle states that expenses should be recognized in the same period as the revenues they help generate, regardless of when cash is paid. This is why you adjust for both accrued and deferred expenses:
- Accrued expense adjustment: debit the expense account, credit a payable (e.g., Salaries Payable, Interest Payable)
- Deferred expense adjustment: debit the expense account, credit the prepaid asset (e.g., Prepaid Insurance, Prepaid Rent)
Quick reference for common adjusting entries:
| Type | Debit | Credit |
|---|---|---|
| Accrued interest revenue | Interest Receivable | Interest Revenue |
| Accrued salaries expense | Salaries Expense | Salaries Payable |
| Deferred rent revenue | Unearned Rent Revenue | Rent Revenue |
| Deferred insurance expense | Insurance Expense | Prepaid Insurance |
Fundamental Concepts in the Adjustment Process
- Accrual basis accounting: Records economic events in the period they occur, regardless of when cash is exchanged. This is the foundation that makes adjusting entries necessary in the first place.
- Matching principle: Expenses should be recognized in the same period as the revenues they help generate. If you use supplies to earn December revenue, the supplies expense belongs in December.
- Periodicity assumption: A company's economic life can be divided into artificial time periods (months, quarters, years) for reporting purposes. Without this assumption, there would be no "end of period" requiring adjustments.
- Materiality principle: Only items significant enough to influence the decisions of financial statement users need to be reported with precision. Very small amounts might not require a formal adjusting entry if omitting it wouldn't change anyone's decision.