The accrual method of accounting requires you to record revenue and expenses as they are incurred, regardless of whether the cash moves in or out of your account. Often, this leads to transactions starting in one accounting period and ending in another.
To recognize these transactions properly, you need to record a special type of journal entry called an adjusting entry. Below, we discuss the definition, importance, and types of adjusting entries.
What Are Adjusting Entries in Bookkeeping?
Adjusting entries are entries you record in your general journal at the end of an accounting period to recognize revenue earned or expenses incurred from a transaction that began in a previous accounting period. Typically, this occurs during the following scenarios:
- Accrued Revenues: You render a service or sell a product and sell an invoice or bill to the customer. You provide value in the present but will only receive payment in the future.
- Accrued Expenses: You are billed for a service or product that you recently used. You receive value in the present but pay later.
- Deferred Revenues: A customer pays for a product or service in advance. You receive payment in the present but provide value later.
- Deferred Expenses: You pay a vendor for a product or service in advance. You incur an expense in the present but receive value later.
Adjusting entries primarily accounts for the delays in value exchanged. However, they can also be used to record changes in value that cannot be easily calculated, such as depreciation expenses.
You will first record adjusting entries as debits and credits in your general journal. Then, you post the transactions to the appropriate sub-ledgers in your general ledger.
Importance of Adjusting Entries in Bookkeeping
To understand the importance of adjusting entries, we need to outline two key principles of accrual accounting:
- The revenue recognition principle dictates that revenue should be recognized when the company successfully delivers a product or service to a customer rather than when it receives cash.
- The matching principle dictates that revenues and associated costs should be reported in the same accounting period. For example, if your current accounting period’s revenue stems from employee labor, you should report salary expenses within the same period.
However, not all companies pay for expenses within the same accounting period in which they earn related revenues.
For example, you hired a contractor for a service that she performed in January but didn’t pay her invoice until its deadline in February. You would need to record the expense in January since it helped you generate revenue within that month. You must also account for the change in your cash account balance in February.
The same principle applies to accrued revenues, deferred expenses, and deferred revenues. The adjusting entry helps you account for the mismatch in transactions and cash account balances.
Types of Adjusting Entries in Bookkeeping
There are multiple types of adjusting entries. We’ll go over each one and provide context and examples for added clarity.
Adjusting Entries for Accrued Expenses
Adjusting entries is necessary when you generate expenses in one accounting period and provide cash payment at a later date. These expenses typically occur when you make purchases on credit or when your vendor bills you for a product or service later than you incurred it. Utility bills, salaries, and taxes are common examples of incurred expenses.
Let’s use two examples:
1. Salaries
Next month, you must pay your secretary $3,000 for the services rendered last April. Their contract states that they should receive payment on the 15th and 30th of each month.
The revenue recognition principle states that you should record expenses within the same accounting period that they helped generate revenue. Because your salary contributed to April’s revenue, you should list the expenses in your April journal.
| Date | Account | PR | Debit | Credit |
| 04-31-2024 | Wage Expense (Expenses) | $3,000 | ||
| Wages Payable (Liabilities) | $3,000 | |||
| Secretary rendered April services |
Once the cash transactions take effect, you need to make adjusting entries for the two salary payments. You debit wages payable to decrease the liability, then credit cash to indicate the loss of assets.
| Date | Account | PR | Debit | Credit |
| 05-15-2024 | Wages Payable (Liabilities) | $1,500 | ||
| Cash (Assets) | $1,500 | |||
| Secretary’s wages first payment |
| Date | Account | PR | Debit | Credit |
| 05-30-2024 | Wages Payable (Liabilities) | $1,500 | ||
| Cash (Assets) | $1,500 | |||
| Secretary’s wages second payment |
2. Utilities
The electricity company bills you $600 for your April usage. The bill isn’t due for another month. You make your payment for the accounting period of May but recognize the expense for the accounting period of April. Your initial entry will look like this:
| Date | Account | PR | Debit | Credit |
| 04-12-2024 | Utilities Expense (Expenses) | $600 | ||
| Accounts Payable (Liabilities) | $600 | |||
| Electricity expense |
Once you make the cash payment, you need to acknowledge the loss of cash and the elimination of your accounts payable liability. This means debiting liabilities and crediting cash. The adjusting entry will look like this:
| Date | Account | PR | Debit | Credit |
| 05-02-2024 | Accounts Payable (Liabilities) | $600 | ||
| Cash (Assets) | $600 | |||
| Paid electricity bill |
Adjusting Entries for Accrued Revenue
Companies accrue revenue when they provide products or services to customers who promise to pay in the future. Examples of accrued revenue include sales on credit and installments.
Let’s illustrate the concept with the following examples:
1. Accounts Receivable
Last April, you billed your customer $1,000 for printing services. The invoice you created indicated a payment deadline of May. You acknowledge the revenue generated but cannot record it as a cash asset yet. Therefore, you debit accounts receivable and credit sales revenue.
| Date | Account | PR | Debit | Credit |
| 04-20-2024 | Accounts Receivable (Assets) | $1,000 | ||
| Sales Revenue (Revenue) | $1,000 | |||
| Rendered client service |
Once the customer pays, you will no longer have $1,000 in accounts receivable but instead have $1,000 in cash. You debit cash and credit accounts receivable.
| Date | Account | PR | Debit | Credit |
| 05-20-2024 | Cash (Assets) | $1,000 | ||
| Accounts Receivable (Assets) | $1,000 | |||
| Client paid |
2. Installments
You gave a customer the option to pay a $500 bill in four monthly installments of $125. To acknowledge that the service was rendered, you create an initial entry that debits accounts receivable and credits sales revenue.
| Date | Account | PR | Debit | Credit |
| 04-21-2024 | Accounts Receivable (Assets) | $500 | ||
| Sales Revenue (Revenue) | $500 | |||
| Rendered client service |
Then, you need to create a new adjusting entry for every payment the customer renders. This adjusting entry should transfer your accounts receivable balances to your cash account balances. This debits cash and credits accounts receivable.
| Date | Account | PR | Debit | Credit |
| 05-21-2024 | Cash (Assets) | $125 | ||
| Accounts Receivable (Assets) | $125 | |||
| Client paid first installment |
You will add new adjusting entries per payment the client makes.
Adjusting Entries for Deferred Expenses
Deferred expenses, also known as prepaid expenses, are expenses incurred for future access to a product or service. They occur when you pay for a product or service in advance. Examples of deferred expenses include prepaid rent, insurance, reservations, and annual subscription payments. Below, we illustrate the concept with concrete examples:
1. Subscription Payments
Last January, you paid EpicBooks $1,800 upfront for a full year of access to expert bookkeeping services. Your initial entry credits assets to acknowledge the loss of cash and debits expenses to acknowledge the prepaid expense.
| Date | Account | PR | Debit | Credit |
| 01-25-2024 | Prepaid Expense (Expenses) | $1,800 | ||
| Cash (Assets) | $1,800 | |||
| Paid annual subscription to bookkeeping services |
Each month, you acknowledge that the service has been rendered by moving $150 from the prepaid expense account balance to your bookkeeping expense account balance. This debits bookkeeping expenses and credits prepaid expenses.
| Date | Account | PR | Debit | Credit |
| 02-25-2024 | Bookkeeping Expense (Expenses) | $300 | ||
| Prepaid Expense (Expenses) | $150 | |||
| Bookkeepers rendered service |
2. Reservations
You paid a hotel $400 to reserve a conference room for a future date. This is a debit to prepaid expenses and a credit to cash.
| Date | Account | PR | Debit | Credit |
| 01-25-2024 | Prepaid Expense (Expenses) | $400 | ||
| Cash (Assets) | $400 | |||
| Reserved conference room |
Once you use the conference room, use the adjusting entry to debit rent expenses and credit prepaid expenses.
| Date | Account | PR | Debit | Credit |
| 02-25-2024 | Rent Expense (Expenses) | $400 | ||
| Prepaid Expense (Expenses) | $400 | |||
| Held conference in reserved room |
Adjusting Entries for Deferred Revenue
In turn, you incur deferred revenues when customers pay you in advance. Adjusting entries are necessary for recognizing products or services once they are provided. Below are a few examples.
1. Commission
A customer commissions you $250 for a graphic design piece. To note that the service has yet to be performed, create an account called unearned revenue. Debit $250 to cash and credit the same amount to unearned revenue.
| Date | Account | PR | Debit | Credit |
| 01-05-2024 | Cash (Assets) | $250 | ||
| Unearned Revenue (Revenue) | $250 | |||
| Received commission |
Once you complete the commission, move the balance of the unearned revenue account to the sales revenue account.
| Date | Account | PR | Debit | Credit |
| 02-05-2024 | Unearned Revenue (Revenue) | $250 | ||
| Sales Revenue (Revenue) | $250 | |||
| Completed commission |
2. Subscription
You publish magazines once a month. Your customer pays an annual subscription worth $120. To record the revenue from the upfront payment, you debit cash and credit unearned revenue.
| Date | Account | PR | Debit | Credit |
| 01-03-2024 | Cash (Assets) | $120 | ||
| Unearned Revenue (Revenue) | $120 | |||
| Customer subscribed to magazine |
Each month, you note that the service has been provided by debiting unearned revenue 1/12th of the upfront payment and crediting sales revenue the equivalent amount.
| Date | Account | PR | Debit | Credit |
| 02-03-2024 | Unearned Revenue (Revenue) | $10 | ||
| Sales Revenue (Revenue) | $10 | |||
| Sold magazine to subscriber |
Adjusting Entries for Estimates
You can use adjusting entries to update account balances with changes in value that are less straightforward to calculate. Typically, bookkeepers use adjusting entries to account for depreciation expenses. Below, we provide an example.
You bought office furniture worth $4,000. It is projected to depreciate by $250 per year. To record depreciation expenses, debit $250 to depreciation expenses and credit the same amount to accumulated depreciation, which is considered a contra asset.
| Date | Account | PR | Debit | Credit |
| 12-30-2024 | Depreciation Expense (Expense) | $250 | ||
| Contra Assets (Asset) | $250 | |||
| Furniture depreciation |
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Frequently Asked Questions
What is the basic purpose of adjusting entries?
Adjusting entries exist to update account balances once transactions are completed. They allow you to record changes in account balances without having to amend previous journal entries.
What happens when adjusting entries are not recorded?
Should you fail to record adjusting entries for transactions that occur, you will end up with erroneous account balances. For example, an accrued revenue transaction would first be recorded as a debit to accounts receivable and a credit to revenue. Once the customer pays their bill, you’ll receive a cash payment. Without an adjusting entry, you’ll fail to update your cash account balance.
What is the difference between adjusting entries and closing entries?
Adjusting entries are journal entries recorded at the end of a transaction period to update previous entries as changes in value take effect.
Meanwhile, closing entries transfer balances from temporary accounts (which reflect balances over a specific accounting period) to permanent accounts (which reflect long-term financial status). Closing entries reset temporary account balances to accurately reflect financial health for the upcoming accounting period.
