The accounting adjusting process is where many students lose their footing, because it asks for a judgment (“how much of this has been earned or used up?”) instead of just recording something that happened. Adjusting entries bring your books up to date at the end of an accounting period so the financial statements show what really occurred, not just what cash moved.
Why adjusting entries exist
Companies use the accrual basis of accounting. Revenue is recorded when it’s earned and expenses when they’re incurred, whether or not cash changed hands that day. This follows the matching principle: expenses belong in the same period as the revenue they helped produce. Cash timing and earning timing often differ, and adjusting entries fix the gap. You make them after preparing the unadjusted trial balance and before the financial statements.
The four types of adjustment (plus depreciation)
- Prepaid expenses — cash paid first, expense later. Debit the expense, credit the asset.
- Unearned revenue — cash received first, revenue later. Debit the liability, credit revenue.
- Accrued expenses — expense incurred, cash paid later. Debit the expense, credit a payable.
- Accrued revenues — revenue earned, cash received later. Debit a receivable, credit revenue.
- Depreciation — spreading a long-term asset’s cost over its life. Debit depreciation expense, credit accumulated depreciation.
Step-by-step method
- Start from the unadjusted trial balance and look at each account that might be out of date.
- Ask what has actually been earned, used up, or incurred by the end of the period.
- Calculate the amount for the partial period, not the full amount.
- Record the entry. Each adjusting entry touches one income statement account and one balance sheet account.
- Post the entries and prepare the adjusted trial balance.
Worked examples (year-end December 31)
Prepaid insurance. Paid $2,400 on October 1 for 12 months. Three months have been used: 2,400 ÷ 12 × 3 = 600. Debit Insurance expense 600; credit Prepaid insurance 600.
Unearned revenue. Received $1,200 on November 1 for six months of service. Two months are earned: 1,200 ÷ 6 × 2 = 400. Debit Unearned revenue 400; credit Service revenue 400.
Accrued wages. Employees earned $3,000 that hasn’t been paid yet. Debit Wages expense 3,000; credit Wages payable 3,000.
Depreciation. Equipment cost $12,000 with a five-year life and no salvage value, using straight-line depreciation: 12,000 ÷ 5 = 2,400 per year. Debit Depreciation expense 2,400; credit Accumulated depreciation 2,400.
Common mistakes
Putting cash in an adjusting entry. Adjusting entries never involve cash. If you’re debiting or crediting Cash, it isn’t an adjusting entry.
Recording the full amount instead of the part of the period that has passed. In the insurance example, the expense is 600, not 2,400.
Reversing the debit and the credit. Check by asking whether the entry should increase or decrease the income statement account. A missing accrued wage should increase expenses, so the expense gets the debit.
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