Understanding Adjusting Entries: A Guide to Accurate Financial Reporting

Adjusting entries are required at the end of each fiscal period to align the revenues and expenses to the “right” period, in accord with the matching principleMatching PrincipleThe matching principle is an accounting concept that dictates that companies report expenses at the same time as the revenues they are related in accounting. In general, there are two types of adjusting journal entries: accruals and deferrals. Adjusting entries are booked before financial statementsThree Financial StatementsThe three financial statements are the income statement, the balance sheet, and the statement of cash flows. These three core statements are are released.

The two main categories where adjustments arise are:

• Accruals: Revenues earned or expenses incurred that have not been previously recorded
• Deferrals: Receipts of assetsTypes of AssetsCommon types of assets include current, non-current, physical, intangible, operating, and non-operating. Correctly identifying and or payments of cash in advance of revenue or expense recognition

 

An example of adjusting entries

Imagine there is a company called XYZ Company that took out a loan from a bank on December 1, 2017. The first interest payment is to be made on June 30, 2018, and the company is preparing its financial statements for the year ending December 31, 2017.

Even though the interest payment is to be made on June 30 in the following year, to properly report the company’s financial status, the company must accrue the interest expenseInterest ExpenseInterest expense arises out of a company that finances through debt or capital leases. Interest is found in the income statement, but can also for the month of December and include that value even though the expense was not actually paid (i.e., an exchange in cash).

This is an accounting system called the accrual basis of accounting. The accrual basis of accounting states that expenses are matched with related revenues and are reported when the expense is incurred, not when cash changes hand. Therefore, adjusting entries are required because of the matching principle in accounting.

 

 

Four Types of Adjusting Journal Entries

There are four specific types of adjustments:

• Accrued expenses
• Accrued revenues
• Deferred expenses
• Deferred revenues

These adjusting entries are depicted in the following tables with specific examples and journal entries.

 

Deferred and accrued revenue

 

Deferred RevenueAccrued RevenueDefinition:

When cash is received prior to earning revenue by delivering goods or services, the company records a journal entry to recognize unearned revenue.

Definition:

When revenues are earned but not yet recorded at the end of the accounting period because an invoice has not yet been issued, nor has cash payment been received.

Examples:

• Gift cards
• Airline miles
• Subscriptions to newspaper and magazines

Situational Examples:

• A company provided a portion of consulting services but has not billed the customer until the following month.
• A company earned interest revenue from the bank on its checking account and had not yet recorded it.

Adjustment Journal Entry:

 

XYZ Company received an $800 deposit for work not yet completed.

 

DR Cash                                             800

CR Deferred Sales Revenue            800

Adjustment Journal Entry:

 

XYZ Company delivered services on the last day of the month and sent an invoice for $4,400 the following week.

 

DR Accounts (Accrued) Receivable     4,400

CR Sales Revenue                 4,400

 

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Deferred and Accrued Expenses

 

Deferred ExpenseAccrued ExpenseDefinition:

Amount paid for in advance of using assets that benefit more than one period.

Definition:

The process of recognizing expenses before cash is paid.

Situational Examples:

• Prepayment of advertising, insurance, or rent becomes used up over time

Situational Examples:

• Utility expenses, the bill for the month hasn’t been received
• Employees earned wages before the month ended, to be paid in the following month

Adjustment Journal Entry:

 

One month of XYZ Company’s insurance expired in June. The original payment of $800 covers June through September.

 

DR Insurance Expense       200

DR Prepaid Insurance        600

CR Cash                                800

Adjustment Journal Entry:

 

XYZ Company’s employees earned $550 during June and are paid in July.

 

DR Wages Expense         550

CR Wages Payable           550

 

DR Wages Payable          550

CR Cash                           550

 

Additional Resources

Hopefully this has been a helpful guide to adjusting entries, and in particular, the journal entries that are required.  To keep learning and developing your career we recommend the additional CFI resources below:

• Journal EntriesJournal Entries GuideJournal Entries are the building blocks of accounting, from reporting to auditing journal entries (which consist of Debits and Credits)
• T AccountsT Accounts GuideIf you want a career in accounting, T Accounts may be your new best friend. The T Account is a visual representation of individual accounts
• Income statement templateIncome StatementThe Income Statement is one of a company's core financial statements that shows their profit and loss over a period of time. The profit or
• How to link the 3 statementsHow the 3 Financial Statements are LinkedHow are the 3 financial statements linked together? We explain how to link the 3 financial statements together for financial modeling and