Adjusting Entries
A crucial accounting activity executed at the end of the accounting period to correct any material or immaterial errors in recording the transactions.
What Are Adjusting Entries?
Adjusting entries are crucial accounting activity executed at the end of the accounting period to correct any material or immaterial errors in recording the transactions in alignment with accrual accounting methodology.
This rectification of errors may also include recognizing any unrecognized accounting transaction and ensuring the transactions recorded in the accounting system are according to requirements of set accounting principles.
Adjusting entries ensures that the company records its business transactions on the accrual basis of accounting, which accounts for the time periods of each transaction.
There are four primary adjusting entries that you’re going to want to be familiar with if you wish to be successful in your “Intro to Financial Accounting” course at school:
- Prepaid Expenses (a.k.a. Deferred Expenses)
- Unearned revenue
- Accrued Revenue
- Accrued Expenses
Please keep reading if you don't know what these words/terms mean.
Below are sections on revenue and expense recognition principles, deferrals, and accruals, as well as examples.
Before continuing, however, it is recommended that you are familiar with the three main financial statements—if not, that’s okay!
The following section below gives you a concise intro to each statement you should be aware of.
Before we continue, you may want to check out a YouTube video that briefs you on journaling the adjusting entries.
Key Takeaways
- Adjusting entries are journal entries made at the end of an accounting period to update the accounts and ensure that revenues and expenses are recognized in the period they occur.
- They are essential for adhering to the accrual basis of accounting, where transactions are recorded when they occur, not necessarily when cash changes hands.
- Adjusting entries helps ensure that financial statements reflect the true financial position and performance of a business by aligning income and expenses with the appropriate accounting periods.
- They ensure compliance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), particularly the matching principle and revenue recognition principle.
The Financial Statements
If you interview for an entry-level position in investment banking, equity research, or asset management, you will undoubtedly have to be familiar with the four financial statements.
While you are likely already familiar with the first three (i.e., the Income Statement, Balance Sheet, and Statement of Cash Flows), there is a fourth statement that not everyone in the business world uses—the retained earnings statement.
Below you’ll find a brief discussion of the financial statements.
The most common accounting question you are likely to receive in an interview is as follows: “Walk me through the three financial statements.” or at least some variation.
Here’s how you might respond to that common interview question:
“Yes, absolutely.”
Income Statement (IS)
The first statement is the income statement (IS) which shows a company’s revenues and expenses and goes all the way down to net income as the bottom line on the statement, which represents a company’s after-tax profits over a period of time.
Balance Sheet (BS)
Second, we have the balance sheet (BS), which shows a company’s assets (which are resources that it owns) as well as how it paid for those resources (which are its liabilities and equity) at a certain snapshot in time.
To differentiate the two, consider the company's liabilities to external parties such as lenders and suppliers. In contrast, equity represents the initial amount of capital contributed to starting the business plus cumulative after-tax profits the company saves over time.
In other words, equity would be returned to the owners and shareholders if the company was liquidated and all debts were paid off.
Finally, it’s called the balance sheet because, at all times, assets must equal liabilities plus equity.
Cash Flow Statement (CFS)
Lastly, the cash flow statement (CFS) shows a company’s cash inflows and outflows over time.
The CFS begins with the operating activities section, which starts with net income, adjusts for non-cash expenses, such as depreciation (PP&E) and amortization (intangibles), as well as changes in working capital (which is just current operating assets minus current liabilities).
From there, the CFS will show the company’s cash flow from investing and financing activities.
Finally, the last lines of the statement show the company’s beginning cash balance, the net change in cash, and the company’s ending cash balance.”
Retained Earnings
If, for whatever reason, you are asked about retained earnings or a 4th statement, say the following:
“While only three main financial statements are needed to estimate cash flow accurately, the optional 4th statement is the Retained Earnings Statement which shows how much of the company’s net income has been “saved up” over time.
To find retained earnings for THIS period, we take the retained earnings from the last period, add net income and subtract dividends to get to the retained earnings for THIS period.”
Now that you’re familiar with financial statements, we can discuss revenue and expense recognition principles.
Cash/Accrual-basis Accounting and Recognition Principles
First of all, you should be aware of the difference between cash and accrual-basis accounting.
Note
Cash-basis accounting involves companies recording revenue when they receive cash and expenses when they pay out money.
Essentially, under cash-basis accounting, the transaction will be recorded whenever cash is exchanged between 2 parties.
In theory, this seems like the best option, but because many large corporations have both receivables and payables, all companies under GAAP require the usage of accrual-basis accounting.
Note
On the contrary, under accrual-basis accounting, companies ONLY record the transaction when the event occurs!
Additionally, GAAP uses accrual-basis accounting because only small companies use cash-basis accounting because they have few receivables and payables.
Essentially, when an accountant journalizes an entry in the books, they will ensure that it follows accrual-basis accounting.
The accountants do this by utilizing the revenue and expense recognition principles.
Under the revenue recognition principle, the company will only acknowledge the business transaction as a revenue IF AND ONLY IF the service has been performed or the good has been delivered.
Under the expense recognition principle, companies will only record a transaction as a business expense in which they make efforts to generate revenues.
Again, because many large companies have various types of receivables and payables, they will ensure that they can record the transactions with the corresponding time periods via the revenue and expense recognition principles.
Now that you are familiar with cash and accrual-basis accounting and the revenue/expense recognition principles, I think it's appropriate to discuss accruals and then deferrals (the two types of adjusting entries) in the following sections.
Adjusting Entries: Deferrals
To defer means to postpone or delay; thus, a deferral is a revenue or expense recognized later than the original point at which the cash was originally exchanged.
Like there are two types of adjusting entries (deferrals and accruals), there are also two types of deferrals:
Definition
Prepaid expenses (a.k.a. Deferred expenses) are expenses that are paid in cash before they are completely used/consumed.
In Layman’s terms, prepaid expenses are things we pay for in advance before using them.
Definition
Deferred Revenue (a.k.a. Unearned Revenue) is a liability for companies because cash has been received before a service is performed or a product is delivered.
In Layman’s terms, we receive cash “up front” but have yet to deliver our product or perform our service for the customer.
Now that we have defined both types of deferrals let’s discuss the journalized entries for prepaid expenses and deferred revenue.
The most common examples of prepaid expenses include the following:
Supplies
First, supplies are items that a company uses to run daily operations.
Examples of supplies include paper, pens, pencils, shipping labels, etc.
How do supplies differ from inventory?
Inventory is typically anything involved in selling a good, whereas supplies can be considered items used daily.
It’s important to note that many service companies do not have inventory (to sell) because they typically lack goods or a manufacturing process.
Now that you understand what supplies are let’s jump into the journalizations:
Let’s suppose that we purchase supplies for $1,500 on account on October 5th.
As a result, we debited and increased the supplies account.
To balance, we credit accounts payable for the same $1,500.
On October 31st, we have $500 worth of supplies, so we will want to subtract 500 from that $1,500.
As a result, for the adjusted journal entry of supplies, we debited supplies expenses for $1,000 and credited supplies for $1,000.
If you ever have trouble determining what to debit and credit, remember that debits “go into the business” and credits “leave the business”.
Therefore, we can say that we debit supplies expense and not supplies themselves because we are incurring an expense and have declining supplies.
Insurance
Sometimes, insurance companies may offer us a discount on insurance premiums if we pay for the entire year upfront instead of making monthly payments.
For our initial journal entry, let’s say that on October 4th, Apple paid $600 for a one-year insurance policy for theft prevention.
As a result, the company will debit prepaid insurance for 600 and credit cash for 600.
However, because we use insurance every month, we have to make an adjusted entry for each month (in this case, October 31st) as we don’t fully use the entire insurance package on October 4th.
Remember, under accrual-basis accounting, companies will only record the insurance expense if and when the company uses it per month.
Therefore, we’ll need a journalized entry where we debit insurance expenses for 50 and credit prepaid insurance for 50 because $600 / 12 months = 50.
Depreciation (of PP&E)
Before we move forward, you should be aware of the definition of depreciation.
Note
Depreciation is the process of allocating the cost of an asset over its useful life.
We have to make an adjusted entry because when we buy something like a truck or equipment, we do not “use all of it” up front and have to allocate the cost each month.
For instance, let’s say we buy a piece of equipment for $480 each month; we have to record an adjusted entry because we must allocate the cost over each month.
Therefore, the correct adjusted entry is that we debit depreciation expense for 40 and credit accumulated depreciation - equipment for 40 ($480 / 12 months = 40).
The most common and straightforward example of deferred (or unearned) revenue has got to be that of an airline company.
For instance, let’s say that Delta Airlines collects Nabil's upfront payment before his trip to NYC on November 12th, which is not set until December 19th for $200.
Because Delta wants to record part of the revenue in November but fully deliver the service in December, Delta will still have to make an adjusted entry on Nov 31st.
As a result, Delta will have to make an adjusted entry that debits unearned service revenue and credits service revenue for $100 each.
Adjusting Entries: Accruals
Accruals are the second type of adjusted entry. They are journalized entries in which revenues or expenses are accumulated over time because cash was not exchanged at the initial event.
There are two types of accruals:
Definition
Accrued Revenue (a.k.a. Deferred expense) involves performing a service before the cash is received.
For example, at a restaurant, they deliver the food service, and you pay at the end of the meal.
The adjusted entry is to debit accounts receivable and credit service revenue (for whatever service price is).
Definition
Accrued Expense (a.k.a. Unearned revenue) is when expenses are incurred but have not yet been paid in cash.
For example, salaries and wages are among the most common types of accrued expenses.
You would want to debit salaries and wages expense and credit salaries and wages payable.
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