Adjusting Entries – why do we need adjusting journal entries?

Adjusting entries are required at the end of each fiscal period to align the revenues and expenses to the “right” period due to the matching principle in accounting. In general, there are two types of adjusting journal entries: accruals and deferrals. Adjusting entries generally occur before financial statements 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 assets or payments of cash in advance of revenue or expense recognition

To learn by example, begin our free accounting courses now!

 

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 expense 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 its 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.

 

adjusting entries matching principle

 

 

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 Revenue
Definition:

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 cash changes hands after the service is performed or goods are delivered.

Situational Examples:

  • Gift cards
  • Airline miles
  • Subscriptions to newspaper and magazines
Situational Examples:

  • A customer acquired goods and agreed to pay 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 delivered services in September for an $800 payment that was made three months ago.

 

DR Unearned Revenue      800

CR Sales Revenue            800

Adjustment Journal Entry:

 

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

 

DR Accounts Receivable     4,400

CR Sales Revenue                 4,400

 

To learn more, start our accounting courses now!

 

Deferred and accrued expenses

 

Deferred ExpenseAccrued Expense
Definition:

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 bill received in the mail for the month just completed
  • 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

CR Prepaid Insurance           200

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

 

To learn more, launch our accounting courses now!

 

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 these additional resources below: