Adjusting Journal Entries
Adjusting journal entries are period-end entries used to bring the financial statements onto the accrual basis. They ensure revenues and expenses are recognized in the proper period.
:::info Three rules
- Adjusting entries are recorded before the financial statements are issued.
- Adjusting entries never include cash.
- Each adjusting entry includes one income statement account and one balance sheet account.
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The Four Core Types
Accrued revenue
Revenue has been earned, but cash has not been received and the customer has not yet been billed.
Example: BIF Partners earns consulting revenue in December and bills the client in January.
Accrued expense
Expense has been incurred, but cash has not yet been paid.
Example: Kingfisher Industries owes employees for the last week of the year.
Deferred revenue
Cash has already been received, but revenue has not yet been earned.
Original receipt:
Year-end adjustment after three of twelve months are earned:
Deferred expense
Cash has already been paid, but part of the asset remains unexpired at year-end.
Original payment:
Year-end adjustment after six months expire:
Visual Summary
| Situation at year-end | Asset or liability needed? | Revenue or expense effect |
|---|---|---|
| Earned but not yet collected | Asset | Revenue increases |
| Incurred but not yet paid | Liability | Expense increases |
| Collected before earning | Liability decreases | Revenue increases |
| Paid before incurring | Asset decreases | Expense increases |
Why adjusting entries matter
Bear Co. pays $24,000 for annual insurance on July 1. If no adjusting entry is made on December 31, prepaid insurance is overstated and insurance expense is understated. That means both the balance sheet and income statement are wrong.
If cash moved on the transaction date but not at year-end, the year-end entry is often an adjusting entry.
Correcting entries are different
A correcting entry fixes an error. An adjusting entry updates timing. Correcting entries may involve cash; adjusting entries do not.
:::note Checklist
- Identify whether cash came first or performance came first.
- Decide whether the missing account is an asset or liability.
- Remember that adjusting entries always touch one balance sheet account and one income statement account.
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