Adjusting entries
Adjusting entries update accounts at the end of each period so the financial statements reflect accrual accounting accurately.
Why adjustments are needed
Some transactions affect more than one period, and some events are not recorded day to day. At period end, adjusting entries ensure revenues and expenses appear in the correct period and that assets and liabilities are correctly stated. Each adjustment affects at least one income statement account and one balance sheet account, and never cash.
Deferrals: prepaid expenses
Prepaid expenses are costs paid in advance, such as insurance, rent, and supplies, initially recorded as assets. As they are used up, an adjusting entry moves the used portion to expense. For a 12-month insurance policy bought for 2,400 dollars, each month's adjustment debits Insurance Expense 200 and credits Prepaid Insurance 200.
Deferrals: unearned revenues
Unearned revenues are cash received before goods or services are provided, recorded initially as liabilities. As the business delivers, an adjustment moves the earned portion to revenue: debit Unearned Revenue, credit Service Revenue.
Accruals: accrued revenues
Accrued revenues are earned but not yet billed or received, such as interest earned or services performed but not yet invoiced. The adjustment debits a receivable (such as Accounts Receivable or Interest Receivable) and credits revenue.
Accruals: accrued expenses
Accrued expenses are incurred but not yet paid or recorded, such as wages earned by employees but not yet paid, interest owed, or utilities used. The adjustment debits an expense and credits a liability (such as Wages Payable or Interest Payable).
Depreciation
Depreciation allocates the cost of a long-term asset over its useful life. Under the straight-line method, annual depreciation = (cost - residual value) / useful life. The adjustment debits Depreciation Expense and credits Accumulated Depreciation, a contra-asset account that reduces the asset's book value without changing its original cost record.
Supplies and other adjustments
Supplies bought are recorded as an asset; at period end, a count shows what remains, and the used amount is expensed: debit Supplies Expense, credit Supplies. Other adjustments include estimates such as bad debts expense, covered in the assets unit.
Worked example
Employees earn 500 dollars per day, paid every Friday. The year ends on a Wednesday, with three days worked since the last payday. The adjusting entry debits Wages Expense 1,500 and credits Wages Payable 1,500, recording this year's cost even though cash is paid next year.
Key takeaways
Adjusting entries assign revenues and expenses to correct periods and never involve cash. Deferrals include prepaid expenses (asset to expense) and unearned revenues (liability to revenue). Accruals include accrued revenues (receivable and revenue) and accrued expenses (expense and payable). Straight-line depreciation is (cost - residual value) / useful life, credited to accumulated depreciation, a contra-asset. Supplies adjustments expense what was used.
Flashcard
Period-end updates for accrual accounting
Check your understanding
Equipment costs 50,000 dollars, has a residual value of 5,000, and a useful life of 9 years. What is annual straight-line depreciation?