Welcome to a complete guide of adjusting entries in accounting!
If you are on your way of converting this stack of binders full of documents to this
compact set of financial statements, you’ll probably be recording your adjusting entries
right about here.
I will walk you through each of the five types of adjusting entries in lots of detail.
If you are adjusting, you need something to adjust from and something to adjust to.
You are adjusting from a cash accounting based trial balance
to an accrual accounting based trial balance.
Let’s get some of these bank transactions onto a trial balance, and then start adjusting.
We are going to record a few sample cash transactions for a training and consulting company that
also runs a YouTube channel, and then produce a “cash accounting” based trial balance.
As you pay and get paid for things, you debit and credit accounts.
The company receives payments from customers.
For the moment, all of these get recorded as revenues.
Debit cash for $50,000, credit revenue for $50,000.
Cash is a balance sheet account, revenue is an income statement account.
During the year, the company’s owner bought a new laptop for $1500.
What’s the journal entry for this?
A laptop is something the company owns, that is going to be used for multiple years.
Debit fixed assets, credit cash, for $1,500 each.
Both of these accounts are on the balance sheet.
The company also paid for a new newspaper subscription.
For the moment, this gets recorded as an expense.
Debit subscription expense for $500, credit cash for $500.
What’s the common element in these journal entries?
Cash is either the debit or the credit to each of the entries.
You should already start to feel a bit uncomfortable with these journal entries, as not all purchases
are expenses, and not all receipts are revenue, but don’t worry, that’s what we are going
to correct with adjusting journal entries.
We can now put together an initial trial balance, by combining the current period opening balances
with the current period movements by account.
Let’s take the “cash” line as an example.
The opening balance is $20,000, we debited the account for $50,000 when we received cash,
and we credited the account for $2,000 for the two journal entries where we spent cash
on the laptop and the newspaper subscription.
So the amount that goes onto the trial balance is $20,000 plus $50,000 minus $2,000 is $68,000.
A trial balance is a listing of all ledger accounts along with their respective debit
or credit balances.
Not all of the balances are truly perfect in the trial balance,
they are created from transactions.
At various stages in the accounting process, you can run a trial balance whenever you’d
like to check on the work-in-progress balances, and decide what action is needed next.
You go through the balances, and refine them.
You look for more information about the transactions, to see the whole picture and validate whether
the balances are correct.
Once we have this trial balance, we can review whether we need any adjusting entries.
There are two categories of adjusting entries: adjusting entries that deal with SOMETHING,
and adjusting entries that deal with NOTHING.
If an adjusting entry deals with SOMETHING, then something has been entered in the general
ledger, but the amount needs to be moved or split between accounting periods.
The three types of adjusting journal entries in this category are: prepaid expenses, deferred
(or “unearned”) revenue, and depreciation.
If an adjusting entry deals with NOTHING, then we have a case where nothing has been
entered in the general ledger yet, but certain expenses or revenues did occur that need to
accounted for in the current period.
The two types of adjusting journal entries in this category are:
accrued expenses and accrued revenue.
In total, there are two categories and five types of adjusting entries.
The common theme is that we want to put revenues and expenses in the period they belong.
Revenues are recognized when earned and expenses are recognized when incurred.
Let’s go through the adjusting entries for the “something” category, starting with
prepaid expenses.
The cash based journal entry that we made earlier is at the top.
When reviewing the details on the invoice for the newspaper subscription, it turns out
that the subscription started in the middle of the year,
is paid in advance, and covers 12 months.
So half of the amount relates to the current year, and the other half to next year.
If we left the full amount in expenses for the current year,
we would be overstating expenses.
We need to move half of the amount to next year, split it between two accounting periods.
How do we do this?
We move half of the amount to the balance sheet, more specifically the prepaid expense
(asset) account, and then next year we will move the amount from that prepaid expense
account into expense.
Right now, to state the expenses correctly for the current year, we record an adjusting
entry: a debit to prepaid expense (which is a balance sheet account) of $250, and a credit
to subscription expense of $250.
Subscription expense in the income statement is the central account here, the net balance
in the account after the adjusting entry is $250 debit.
The other way to do this is to make prepaid expense on the balance sheet the central account
that the entries move through: book the full amount of $500 to prepaid expense when you
record the cash movement (debit prepaid expense credit cash), and then record an adjusting
entry of $250 that takes half of the amount into subscription expense
(debit subscription expense credit prepaid expense).
Different journal entries, same end result in terms of movement by account: prepaid expense
on the balance sheet gets a net debit of $250, subscription expense a net debit of $250,
and cash a net credit movement of $500.
Next we examine revenues.
Most of the $50,000 cash received from customers relates to training services that have been
delivered during the current year and is therefore correctly recorded as revenue, however a small
part of the total amount ($3,000 to be exact)
is a prepayment for development of course material.
We found this out from a signed agreement in the binder with documents.
The cash is received this year, the work will take place next year.
In more technical revenue recognition terms, the performance obligations in the contract
have not yet been met, as the course material is yet to be developed.
This revenue needs to be moved to next year,
as we don’t want to overstate current year revenue.
Just like with prepaid expenses, we park it on the balance sheet, and then next year move
it into revenue.
You could conceptually call this adjusting entry “prepaid revenue”, but the common
name for it is deferred revenue or unearned revenue.
Debit revenue in the income statement for $3,000,
credit deferred revenue on the balance sheet for $3,000.
Deferred revenue is a liability, because if you fail to provide the services agreed in
the contract in the future, you will have to pay the money back.
The third type of adjusting entry is depreciation.
This is a case where an amount needs to be split not just between two accounting periods,
but multiple periods.
Earlier on, we recorded the purchase of a laptop to fixed assets.
Depreciation allocates the amount paid for the fixed asset to current expense in those
periods expected to benefit from the use of the asset.
In the case of a laptop, the useful economic life is expected to be five years, and no
residual value is expected.
Using straight-line depreciation, $300 is allocated to the current year, and the remaining
$1200 will have to be depreciated over the remaining four years.
The journal entry is debit depreciation expense for $300,
credit accumulated depreciation for $300.
You don’t record the credit directly to fixed assets, but to the contra-account called
accumulated depreciation.
This way, you can identify from the general ledger gross book value of $1500, accumulated
depreciation of $300 so far, and net book value (which is the difference between the
two) of $1200.
Prepaid expenses, deferred revenue, and depreciation, are adjusting journal entries dealing with
SOMETHING: something has been entered in the general ledger, but the amount needs to be
moved or split between accounting periods.
We now move from something to nothing.
Let’s review the source documentation!
The two types of adjusting journal entries in this category are: accrued expenses and
accrued revenue.
We are looking for cases where nothing has been recorded yet, but certain expenses or
revenues did occur that need to accounted for in the current period.
Are there any expenses we incurred for which we have not paid yet, and for which we have
not received an invoice yet?
An example is accounting fees.
The activities of the external accountant performing the accounting tasks for the company
are taking place after the calendar year is finished,
but certainly relate to the current period.
We are certain to receive an invoice in the future, for expenses incurred related to the
current period, so we have to set some money aside for this.
We don’t want to understate current period expenses!
Debit accounting fees for $2,000, credit accrued expenses for $2,000.
A related review happens on the revenue side.
Has any revenue been earned, for which the company was not paid yet, and for which the
company has not sent an invoice yet?
The company we are looking at is a training and consulting company
that also runs a YouTube channel.
If you are part of the YouTube Partner Program, then YouTube pays you monthly for your share
of the advertising revenue from the channel within a few weeks after the end of the month.
This is a type of revenue for which you don’t have to send an invoice, YouTube prepares
the overviews for you on the YouTube Analytics dashboard, and transfer you the money.
In February, you receive payment for your January revenue.
In March, you receive payment for your February revenue.
And on and on and on through the year.
What’s important for our adjusting entries, is that in January of next year, you receive
payment for your channel revenue that you earned in December.
We want to capture that revenue in the current year, as we don’t want to understate revenue.
We record debit accrued revenue on the balance sheet for $1,700, and credit revenue in the
income statement for $1,700.
Let’s run another trial balance.
The old “cash accounting” based trial balance, plus the movements from the adjusting
entries, provide you a new trial balance on an accrual basis.
Let’s take the revenue line as an example.
When we recorded the cash journal entries, we booked $50,000 credit as revenue.
Then we made an adjusting entry for deferred revenue, where we debited revenue by $3,000,
and an adjusting entry for accrued revenue, where we credited revenue by $1,700.
In total, in the new “accrual accounting” based trial balance, the balance in revenue
is $48,700 credit.
If you want to check the other lines, then pause the video right here, as we are moving
right along!
The definition of adjusting entries.
Adjusting entries are accounting journal entries that convert a company's accounting records
to the accrual basis of accounting.
Adjusting entries almost always involve a balance sheet account
and an income statement account.
Here’s a summary table with the four possible combinations: revenues versus expenses, and
accrued versus deferred or prepaid.
Accrued revenue adjusting entries occur when revenue is earned before the invoice is sent
and/or the payment is received, the revenue needs to be captured in the current period
as this when you have earned it.
Deferred revenue adjusting entries occur when revenue is earned after the invoice is sent
and/or the payment is received, the recognition of the revenue needs to be postponed to a
future period as you have not earned it yet.
Accrued expense adjusting entries occur when expenses are incurred before the invoice is
received and/or payment is made, the expenses need to be captured in the current period
as this is when you have incurred them.
Prepaid expense and depreciation adjusting entries occur when expenses are incurred after
the invoice is received and/or payment is made, the expenses need to be moved or split
between accounting periods.