Adjusting Entries

Why This Matters

Adjusting entries are where the accrual basis of accounting actually happens. You're being tested on your understanding of two foundational principles: the revenue recognition principle (record revenue when earned, not when cash arrives) and the matching principle (record expenses in the same period as the revenues they helped generate). Every adjusting entry you'll encounter on exams traces back to one of these ideas—if you understand why the adjustment is needed, the journal entry writes itself.

These entries also reveal how financial statements connect. An adjusting entry never touches just one statement—it always links the income statement to the balance sheet through deferrals, accruals, or estimates. Don't just memorize which accounts to debit and credit; know what category of adjustment you're making and what accounting principle demands it.

---

Deferrals: Cash First, Recognition Later

Deferrals occur when cash changes hands before the related revenue or expense should be recognized. The key mechanism: you initially record an asset or liability, then systematically transfer it to the income statement as time passes or services are delivered.

Prepaid Expenses

• Asset-to-expense conversion—cash paid in advance creates an asset that's "used up" over time, requiring periodic adjustments to recognize the expense
• Common examples include insurance, rent, and supplies; the adjusting entry always debits an expense and credits the prepaid asset
• Matching principle in action—you're allocating the cost to the periods that benefit from the prepayment, not the period you wrote the check

Unearned Revenues

• Liability-to-revenue conversion—cash received before earning it creates an obligation to perform; as you deliver, the liability shrinks
• Adjusting entry mechanics: debit the unearned revenue liability, credit revenue to reflect the portion now earned
• Revenue recognition principle—revenue isn't "real" until you've done what you promised, regardless of when the customer paid

---

Accruals: Recognition First, Cash Later

Accruals are the mirror image of deferrals—revenues are earned or expenses are incurred before any cash changes hands. The key mechanism: you record the revenue or expense now and create a corresponding receivable or payable to capture the future cash flow.

Accrued Revenues

• Revenue earned but not yet billed or collected—common with services performed near period-end or interest earned on investments
• Adjusting entry: debit accounts receivable (or interest receivable), credit revenue to capture what you've earned
• Revenue recognition principle—earning the revenue triggers recognition, not receiving the cash

Accrued Expenses

• Expenses incurred but not yet paid—think wages owed to employees, utilities consumed, or interest accumulating on loans
• Adjusting entry: debit the expense, credit a payable (wages payable, utilities payable, interest payable)
• Matching principle—the expense belongs in the period when you used the resource, even if the bill hasn't arrived

Interest Expense Accrual

• Time-based accumulation—interest accrues continuously based on the formula $\text{Interest} = \text{Principal} \times \text{Rate} \times \text{Time}$
• Adjusting entry: debit interest expense, credit interest payable for the portion of interest incurred but unpaid at period-end
• FRQ favorite—exams often test whether you can calculate partial-period interest and record the correct accrual

---

Systematic Allocations: Spreading Costs Over Time

Some adjustments don't fit neatly into the cash-timing framework—they're about allocating the cost of long-term assets to the periods that benefit from their use. The mechanism: systematically reduce the asset's carrying value while recognizing expense each period.

Depreciation

• Tangible asset allocation—the cost of buildings, equipment, and vehicles is spread over their useful lives using methods like straight-line or declining balance
• Contra-asset approach: debit depreciation expense, credit accumulated depreciation—the asset account itself stays at historical cost
• Balance sheet impact—book value (cost minus accumulated depreciation) declines each period, reflecting the asset's consumption

Amortization of Intangible Assets

• Intangible asset allocation—patents, copyrights, and trademarks with finite lives are expensed over their useful or legal life, whichever is shorter
• Adjusting entry: debit amortization expense, credit the intangible asset directly (no contra account typically used)
• Key distinction from depreciation—applies to non-physical assets; goodwill and indefinite-life intangibles are not amortized but tested for impairment

---

Estimates: Adjusting for Uncertainty

Some adjustments require judgment because the exact amount isn't known at period-end. The mechanism: use historical data, industry benchmarks, or management judgment to estimate amounts that ensure proper matching and asset valuation.

Bad Debt Expense

• Allowance for uncollectible accounts—estimates the portion of accounts receivable that customers won't pay, ensuring receivables aren't overstated
• Adjusting entry: debit bad debt expense, credit allowance for doubtful accounts (a contra-asset that reduces net receivables)
• Matching principle application—recognize the estimated loss in the same period you recorded the credit sale, not when you confirm non-payment

Inventory Adjustments

• Physical count reconciliation—adjusts recorded inventory to match what's actually on hand, capturing shrinkage, theft, or obsolescence
• Adjusting entry varies: typically debit cost of goods sold (or a loss account), credit inventory when actual is less than recorded
• Income statement effect—understated inventory increases COGS and reduces net income; accurate inventory is essential for gross profit calculations

---

Complex Adjustments: Timing Differences

Some adjustments address sophisticated timing differences between financial accounting and other frameworks, particularly tax reporting.

Deferred Tax Adjustments

• Temporary differences—arise when book income differs from taxable income due to different recognition rules (e.g., depreciation methods)
• Deferred tax assets represent future tax benefits; deferred tax liabilities represent future tax obligations
• Balance sheet focus—these adjustments establish assets or liabilities reflecting the tax consequences of current transactions that will reverse in future periods

---

Quick Reference Table

---

Self-Check Questions

1. Which two adjusting entries both involve converting a liability into revenue, and what distinguishes when each would be used?

2. If a company paid $12,000$ for a 12-month insurance policy on October 1, what adjusting entry is needed on December 31, and which accounting principle requires it?

3. Compare and contrast the balance sheet presentation of depreciation versus amortization—why does one typically use a contra account while the other doesn't?

4. An FRQ describes a company that performed services in December but won't bill the client until January. What type of adjustment is needed, and what accounts are affected?

5. Both bad debt expense and inventory adjustments involve estimates. How do their adjusting entries differ in terms of the accounts credited, and why?