Why adjust?
Accrual accounting records revenue when earned and expenses when incurred, not when cash moves. At the end of a period, some accounts are out of date. Adjusting entries, made before the financial statements are prepared, bring them up to date. Each adjusting entry touches at least one income statement account (a revenue or expense) and one balance sheet account (an asset or liability). They never involve Cash.
Two families
Deferrals: cash moved first, recognition comes later.
- Prepaid expense (asset) becomes an expense as it is used up.
- Unearned revenue (liability) becomes revenue as the service is delivered.
Accruals: recognition comes first, cash moves later.
- Accrued expense: an expense incurred but not yet paid (wages, interest).
- Accrued revenue: revenue earned but not yet billed or collected.
The standard entries
| Situation | Adjusting entry |
|---|---|
| Prepaid insurance used up | Dr Insurance Expense / Cr Prepaid Insurance |
| Supplies used | Dr Supplies Expense / Cr Supplies |
| Equipment depreciation | Dr Depreciation Expense / Cr Accumulated Depreciation |
| Unearned revenue earned | Dr Unearned Revenue / Cr Service Revenue |
| Wages owed at period end | Dr Wages Expense / Cr Wages Payable |
| Interest owed | Dr Interest Expense / Cr Interest Payable |
| Revenue earned, not billed | Dr Accounts Receivable / Cr Service Revenue |
Worked examples
All adjustments are at December 31.
Prepaid insurance. On Dec 1 the firm paid $2,400 for 12 months of cover. One month has expired: 2,400 / 12 = 200. Entry: Dr Insurance Expense 200 / Cr Prepaid Insurance 200. The prepaid asset remaining is 2,200.
Supplies. The firm began with $900 of supplies and bought $400 more; a count shows $350 left. Used = 900 + 400 − 350 = 950. Entry: Dr Supplies Expense 950 / Cr Supplies 950.
Unearned revenue. On Nov 1, a client paid $3,000 in advance for six months of service. By Dec 31, two months are earned: 3,000 × 2/6 = 1,000. Entry: Dr Unearned Revenue 1,000 / Cr Service Revenue 1,000.
Accrued interest. A $10,000 note at 6 percent has been outstanding for 3 months. Interest = 10,000 × 0.06 × 3/12 = $150. Entry: Dr Interest Expense 150 / Cr Interest Payable 150.
Accrued wages. Employees earn $300 per day and 4 days are unpaid at year end: 4 × 300 = 1,200. Entry: Dr Wages Expense 1,200 / Cr Wages Payable 1,200.
Effect of leaving one out
If the insurance adjustment in example 1 were skipped, expenses would be understated by 200, net income overstated by 200, and assets overstated by 200. The balance sheet would still balance (the error sits on both sides), but both statements would be wrong.
Accumulated depreciation
Accumulated Depreciation is a contra-asset account with a credit balance. It reduces the equipment's book value without changing the original cost.
Common mistakes
- Including Cash in an adjusting entry.
- Mixing up deferrals and accruals.
- Forgetting that unearned revenue is a liability until earned.