Aligning revenues and expenses to the right accounting period
Adjusting Entries – Why Do We Need Adjusting Journal Entries?
Adjusting entries are required at the end of each fiscal period to align the revenues and expenses to the “right” period, in accord with the matching principle in accounting. In general, there are two types of adjusting journal entries: accruals and deferrals. Adjusting entries are booked before financial statements are released.
The two main categories where adjustments arise are:
- Accruals: Revenues earned or expenses incurred that have not been previously recorded
- Deferrals: Receipts of assets or payments of cash in advance of revenue or expense recognition
An example of adjusting entries
Imagine there is a company called XYZ Company that took out a loan from a bank on December 1, 2017. The first interest payment is to be made on June 30, 2018, and the company is preparing its financial statements for the year ending December 31, 2017.
Even though the interest payment is to be made on June 30 in the following year, to properly report the company’s financial status, the company must accrue the interest expense for the month of December and include that value even though the expense was not actually paid [i.e., an exchange in cash].
This is an accounting system called the accrual basis of accounting. The accrual basis of accounting states that expenses are matched with related revenues and are reported when the expense is incurred, not when cash changes hand. Therefore, adjusting entries are required because of the matching principle in accounting.
Four Types of Adjusting Journal Entries
There are four specific types of adjustments:
- Accrued expenses
- Accrued revenues
- Deferred expenses
- Deferred revenues
These adjusting entries are depicted in the following tables with specific examples and journal entries.
Deferred and accrued revenue
| Deferred Revenue | Accrued Revenue |
| Definition: When cash is received prior to earning revenue by delivering goods or services, the company records a journal entry to recognize unearned revenue. | Definition: When revenues are earned but not yet recorded at the end of the accounting period because an invoice has not yet been issued, nor has cash payment been received. |
Examples:
| Situational Examples:
|
| Adjustment Journal Entry: XYZ Company received an $800 deposit for work not yet completed. DR Cash 800 CR Deferred Sales Revenue 800 | Adjustment Journal Entry: XYZ Company delivered services on the last day of the month and sent an invoice for $4,400 the following week. DR Accounts [Accrued] Receivable 4,400 CR Sales Revenue 4,400 |
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Deferred and Accrued Expenses
| Deferred Expense | Accrued Expense |
| Definition: Amount paid for in advance of using assets that benefit more than one period. | Definition: The process of recognizing expenses before cash is paid. |
Situational Examples:
| Situational Examples:
|
| Adjustment Journal Entry: One month of XYZ Company’s insurance expired in June. The original payment of $800 covers June through September. DR Insurance Expense 200 DR Prepaid Insurance 600 CR Cash 800 | Adjustment Journal Entry: XYZ Company’s employees earned $550 during June and are paid in July. DR Wages Expense 550 CR Wages Payable 550 DR Wages Payable 550 CR Cash 550 |
Additional Resources
Hopefully this has been a helpful guide to adjusting entries, and in particular, the journal entries that are required. To keep learning and developing your career we recommend the additional CFI resources below:
- Journal Entries
- T Accounts
- Income statement template
- How to link the 3 statements