Adjusting Entries: Making Your Numbers Accurate Under Accrual Accounting
At the end of every accounting period, certain account balances do not yet reflect reality — even if every transaction has been recorded correctly. Adjusting entries fix this by recognising revenues earned or expenses incurred that have not yet been captured, and removing amounts that have been recorded but not yet earned or incurred.
Why Adjusting Entries Are Necessary
The accrual principle requires revenue to be recognised when earned and expenses when incurred. But many transactions span multiple accounting periods. A 12-month insurance policy, for example, covers both this year and next. Without adjustments, financial statements for any given month would be inaccurate.
The Four Types of Adjusting Entries
1. Accrued Revenues (Revenue Earned, Not Yet Received)
Services have been delivered but not yet invoiced or paid for.
Example: A consulting firm completed $30,000 of work in December but will invoice in January.
Dr. Accounts Receivable $30,000
Cr. Service Revenue $30,000
2. Accrued Expenses (Expense Incurred, Not Yet Paid)
A cost has been incurred but not yet recorded because no invoice has arrived or no cash has been paid.
Example: Employees earned $45,000 in December wages but will be paid on 5 January.
Dr. Salaries Expense $45,000
Cr. Salaries Payable $45,000
3. Deferred Revenue (Cash Received, Revenue Not Yet Earned)
Cash has been collected in advance, but the service has not yet been delivered.
Example: A gym collects $12,000 for a 12-month membership in January. By January 31, only one month has been earned ($1,000).
Dr. Unearned Revenue $1,000
Cr. Service Revenue $1,000
4. Prepaid Expenses (Cash Paid, Expense Not Yet Incurred)
Cash has been paid in advance for a future benefit. Each period, the used portion is moved from the asset account to an expense account.
Example: $24,000 rent was prepaid for 12 months. Each month, $2,000 is expensed.
Dr. Rent Expense $2,000
Cr. Prepaid Rent $2,000
Depreciation: A Special Adjusting Entry
When a business buys equipment for $500,000 with a 5-year life, it would be misleading to record $500,000 as an expense in year one. Instead, the cost is spread over the asset’s useful life via depreciation.
Dr. Depreciation Expense $100,000
Cr. Accumulated Depreciation $100,000
Accumulated Depreciation is a contra-asset account — it reduces the carrying value of the asset on the balance sheet.
Impact on Financial Statements
After adjusting entries, both the income statement and balance sheet change. Accrued expenses reduce profit; accrued revenues increase it. Getting these right is critical because adjusting entries directly determine reported profit — the number every investor watches most closely.
Lesson Summary
- Adjusting entries are made at period end to align reported results with accrual-basis accounting.
- Four types: accrued revenues, accrued expenses, deferred revenues, and prepaid expenses.
- Depreciation spreads the cost of long-lived assets over their useful life.
The Four Types of Adjusting Entries — With Examples
Adjusting entries are made at period-end to bring accounts in line with the accrual basis. There are exactly four types:
| Type | What It Fixes | Debit | Credit | Example |
|---|---|---|---|---|
| Deferred Expense (Prepaid) | Asset consumed that was paid for in advance | Expense | Asset | $2,400 prepaid insurance: record $200/month as expense |
| Deferred Revenue | Revenue received in advance, now earned | Liability (Unearned) | Revenue | $6,000 retainer: client uses $2,000 worth this month |
| Accrued Expense | Expense incurred but not yet paid | Expense | Liability | Employees earned $4,000 wages not paid until next month |
| Accrued Revenue | Revenue earned but not yet received | Asset (Receivable) | Revenue | Completed $1,500 of consulting — client hasn’t paid yet |
Comprehensive Example: Westfield Consulting, Dec 31
At year-end, the accountant reviews the trial balance and identifies four adjustments needed:
| # | Situation | Entry Required | Amount |
|---|---|---|---|
| 1 | Office supplies: bought $900, counted $200 remaining | Dr Supplies Expense / Cr Supplies | $700 |
| 2 | Annual insurance premium of $2,400 paid Jan 1 (11 months used) | Dr Insurance Expense / Cr Prepaid Insurance | $2,200 |
| 3 | Employees worked Dec 26–31 ($3,000 wages payable Jan 5) | Dr Wages Expense / Cr Wages Payable | $3,000 |
| 4 | Received $8,000 advance for a 4-month project; 1 month completed | Dr Unearned Revenue / Cr Service Revenue | $2,000 |
Without these four entries, the December financial statements would be off by:
- Expenses understated by $5,900 (omitting supplies, insurance, wages)
- Revenue understated by $2,000 (omitting earned portion of advance)
- Net income overstated by $7,900
Every adjusting entry is the matching principle at work: making sure revenue appears in the period it was earned and expenses appear in the period they were incurred. The timing of cash has nothing to do with when items appear on accrual-basis statements.
Adjusting Entries Practice Worksheet — Download, print, and complete to reinforce this lesson.