4.3 Record and Post the Common Types of Adjusting Entries

Adjusting entries ensure that revenues and expenses land in the correct accounting period, following the matching principle and accrual basis of accounting. Without them, financial statements would misrepresent a company's actual financial position and performance. This section covers the five common types of adjusting entries, how to record and post them, and why they matter.

Common Types of Adjusting Entries and Their Impact

Types of adjusting entries

There are five common types of adjusting entries. They fall into two broad categories: deferrals (cash was exchanged first, but the revenue or expense belongs to a later period) and accruals (the revenue or expense has already occurred, but cash hasn't changed hands yet). Depreciation is its own special case.

• Prepaid expenses (deferral)
  • These are expenses paid in advance, like rent or insurance. When you first pay, you record an asset (e.g., Prepaid Insurance) because the benefit hasn't been used up yet.
  • At period-end, the adjusting entry moves the portion that has been used from the asset account into an expense account.
  • Effect: decreases assets, increases expenses.
  • Example: A company pays $12{,}000$ for a 12-month insurance policy on January 1. Each month, the adjusting entry debits Insurance Expense for $1{,}000$ and credits Prepaid Insurance for $1{,}000$.
• Unearned revenues (deferral)
  • These are payments received before the company delivers goods or services, like magazine subscriptions or customer deposits. The cash received is initially recorded as a liability (e.g., Unearned Revenue) because the company still owes the customer something.
  • At period-end, the adjusting entry transfers the portion that has been earned from the liability account into a revenue account.
  • Effect: decreases liabilities, increases revenues.
  • Example: A company receives $6{,}000$ on October 1 for six months of consulting services. Each month, the adjusting entry debits Unearned Revenue for $1{,}000$ and credits Service Revenue for $1{,}000$.
• Accrued expenses (accrual)
  • These are expenses that have been incurred but not yet paid, like salaries owed to employees at period-end or interest that has accumulated on a loan.
  • The adjusting entry records both the expense and the corresponding liability.
  • Effect: increases expenses on the income statement, increases liabilities on the balance sheet.
  • Example: Employees have earned $3{,}000$ in wages by December 31 but won't be paid until January 5. The adjusting entry debits Salaries Expense for $3{,}000$ and credits Salaries Payable for $3{,}000$.
• Accrued revenues (accrual)
  • These are revenues that have been earned but not yet received in cash, like interest income earned on a loan you made to someone else, or services you've performed but haven't billed yet.
  • The adjusting entry records the revenue and a corresponding receivable.
  • Effect: increases assets (Accounts Receivable), increases revenues.
  • Example: A company has earned $500$ in interest by December 31 but won't receive the cash until January 15. The adjusting entry debits Interest Receivable for $500$ and credits Interest Revenue for $500$.
• Depreciation (special case)
  • Long-term assets like equipment and buildings lose value over time. Depreciation spreads the cost of these assets across their useful lives rather than expensing the full cost in the year of purchase.
  • The adjusting entry debits Depreciation Expense and credits Accumulated Depreciation, which is a contra-asset account. The original asset account itself is not directly credited.
  • Effect: increases expenses on the income statement, reduces the book value (cost minus accumulated depreciation) of the asset on the balance sheet.
  • Example: Equipment costing $24{,}000$ with a 10-year useful life and no salvage value has annual straight-line depreciation of $2{,}400$. Each year, the adjusting entry debits Depreciation Expense for $2{,}400$ and credits Accumulated Depreciation for $2{,}400$.

Recording and Posting Adjusting Entries

Recording adjusting entries

Using the general journal:

1. Identify which accounts are affected and determine whether each account needs a debit or a credit.
2. Calculate the correct dollar amount for the adjustment.
3. Record the adjusting entry in the general journal. The debit is listed first, the credit is indented below it, and a brief explanation is included.
4. Verify that total debits equal total credits for the entry.

Posting to T-accounts (or the general ledger):

1. For each account in the adjusting entry, locate (or create) the corresponding T-account.
2. Enter the debit amount on the left side or the credit amount on the right side of the appropriate T-account.
3. Recalculate the ending balance of each affected account.
4. Confirm that the accounting equation ($\text{Assets} = \text{Liabilities} + \text{Equity}$) still balances after all adjusting entries are posted.

Purpose of adjusting entries

• Matching principle: Revenues and the expenses incurred to generate them should be recognized in the same period. Adjusting entries make this happen by recording revenues and expenses when they are earned or incurred, not when cash moves.
• Accrual basis of accounting: Transactions are recorded when they occur, regardless of when cash is exchanged. Adjusting entries are the mechanism that keeps the books on an accrual basis at period-end.
• Accurate financial statements: Without adjusting entries, the balance sheet and income statement would be incomplete or misleading. Investors, creditors, and management all rely on accurate statements to make decisions.

The Adjusting Process and Accounting Periods

• The adjusting process happens at the end of each accounting period as part of the accounting cycle, right before financial statements are prepared.
• Accounting periods are the specific time frames (monthly, quarterly, annually) for which a company reports financial information. The periodicity assumption says that a company's economic activity can be divided into these artificial time periods.
• Adjusting entries are made at the close of each period to update account balances so they comply with the matching principle and accrual accounting.
• The materiality principle helps determine which items actually need adjusting entries. If an amount is too small to influence a user's decision, it may not require a separate adjustment.