Adjusting entries practice: what they are and how to record them

Adjusting entries are the journal entries you make at the end of a period so that each month shows the revenue it earned and the expenses it used up. This page explains the four main kinds, then walks through a prepaid expense from the day it is paid to the month-end adjustment.

What is an adjusting entry?

During the month, a bookkeeper records transactions as they happen: a sale, a bill paid, cash received from a customer. Most of those entries are triggered by a document or by cash moving. But some things change without any document arriving. Insurance coverage gets used up a little every day. Employees earn wages on Monday through Thursday that won't be paid until Friday. A machine wears out. A customer's advance payment slowly turns into work you have actually done.

None of these produce a document on the last day of the month, so the ledger falls behind reality. An adjusting entry brings it back in line. You make it at the end of the period, before you prepare the financial statements, and it always touches one balance sheet account (an asset or a liability) and one income statement account (a revenue or an expense).

That last point is the most useful rule on this page. If an adjusting entry you have written moves money between two balance sheet accounts, or between two income statement accounts, something is wrong. And in almost every adjusting entry, Cash is not one of the accounts. The cash either moved in an earlier period or will move in a later one. The adjustment is about timing, not payment.

Why adjusting entries matter

Accrual accounting asks two things of every period. Revenue goes in the period it is earned, whether or not the customer has paid. Expenses go in the period they help produce that revenue, whether or not the bill has been paid. This idea of putting expenses next to the revenue they support is often called matching.

Without adjustments, the income statement would follow the cash instead. A business that pays a full year of insurance in January would show a huge expense in January and nothing for eleven months. The balance sheet would also be wrong: no asset for unused coverage, no liability for wages owed.

Adjusting entries fix both statements at once. They are also the step between the unadjusted trial balance and the adjusted trial balance, so you will meet them again in trial balance practice and before closing entries.

The four kinds of adjusting entries

Most adjustments fall into two families. A deferral is when cash moved first and the revenue or expense comes later. An accrual is when the revenue or expense happened first and the cash comes later. Depreciation is usually treated as its own kind, though it works like a long deferral.

1. Prepaid expenses (a deferral)

The business pays in advance for something it will use over time: insurance, rent, a software subscription. The payment is first recorded as an asset, such as Prepaid Insurance or Prepaid Rent. At each month end, the part used up moves to an expense.

Adjusting entry: debit the expense, credit the prepaid asset. This is the worked example below.

2. Unearned revenue (a deferral)

A customer pays before the work is done. The business owes the customer that work, so the payment is a liability, Unearned Revenue. As the work is delivered, part of the liability becomes revenue. For example, Juniper Landscaping is paid $16,800.00 in advance for a 12-month service contract. After 2 months of service it has earned $2,800.00 ($1,400.00 a month).

Adjusting entry: debit Unearned Revenue, credit a revenue account. See the unearned revenue adjusting entry for the full walkthrough.

3. Accrued expenses (an accrual)

An expense has been incurred but not yet paid or even recorded: wages earned since the last payday, interest building up on a loan, a utility bill that will be paid next month. For example, Pine Street Dental's staff earn $820.00 per working day, and the month ends with 4 days unpaid, so $3,280.00 of wages belongs to this month.

Adjusting entry: debit the expense, credit a payable such as Wages Payable or Interest Payable. See the accrued expenses adjusting entry.

4. Depreciation

Equipment, vehicles and buildings help the business earn revenue for years, so their cost is spread over their useful life. Harbor Bakery's mower cost $31,750.00, has a salvage value of $2,850.00 and a 5-year life, so straight-line depreciation is $5,780.00 a year.

Adjusting entry: debit Depreciation Expense, credit Accumulated Depreciation. The equipment account itself is left at cost. See the depreciation journal entry.

A fifth kind: accrued revenue

The mirror image of an accrued expense. The business has done work it hasn't billed yet, such as a few days of service at month end. The adjustment debits Accounts Receivable and credits a revenue account.

Worked example: a prepaid expense from start to finish

Here is the transaction from the lesson's free exercise:

Step 1: Record the payment as an asset

On January 1, none of the coverage has been used. Juniper has bought twelve months of protection it will receive in the future. Something you own that gives future benefit is an asset, so the payment goes to Prepaid Insurance, not to Insurance Expense.

Prepaid Insurance increases, and assets increase with a debit. Cash decreases, and assets decrease with a credit.

This first entry is the ordinary entry for the payment, not an adjustment. Getting it right is what makes the adjustment possible, which is why the free exercise starts here.

Step 2: Work out how much was used this period

The policy costs $5,760.00 for 12 months, so each month of coverage costs $5,760.00 / 12 = $480.00. By January 31, one month has passed. One month of coverage, $480.00, has been used up.

Step 3: Record the adjusting entry on January 31

The used part moves out of the asset and into the expense. Insurance Expense increases with a debit. Prepaid Insurance decreases with a credit.

After posting, Prepaid Insurance shows $5,280.00: eleven months of coverage still to come. January's income statement shows $480.00 of insurance expense, which is exactly what January used. Cash is not touched, because the cash left on January 1.

Step 4: Repeat each month, or catch up if you adjust less often

If Juniper adjusts monthly, it makes the same $480.00 entry every month for twelve months, and Prepaid Insurance reaches zero when the policy ends. If it only adjusted at the end of March, it would expense all three months at once: 3 × $480.00 = $1,440.00, leaving $4,320.00 prepaid.

The premium exercises in this lesson practice exactly that. In one, Pine Street Dental paid $2,640.00 on August 1 for a 12-month policy and adjusts at the end of October. Three months have been used, so the entry is $220.00 × 3 = $660.00, debiting Insurance Expense and crediting Prepaid Insurance. In another, Northside Print Shop paid $8,400.00 for 3 months of rent in advance and 1 month has passed, so $2,800.00 moves from Prepaid Rent to Rent Expense.

Common mistakes with prepaid expenses

These are the mistakes the exercises in this lesson check for. Each one gets its own feedback when you press Check.

• Expensing the whole payment on day one. Debiting Insurance Expense for $5,760.00 when Juniper pays puts a full year of cost into January. The policy covers future months, so the payment belongs in Prepaid Insurance until each month is used.
• Putting every line on the wrong side. Crediting Prepaid Insurance and debiting Cash on the payment date would mean the asset went down and cash came in. Ask what increased and what decreased: the prepaid asset went up (debit) and cash went down (credit). In the adjustment, the expense goes up (debit) and the prepaid asset goes down (credit).
• Expensing the whole policy at the adjustment. For Pine Street Dental, expensing all $2,640.00 at the end of October would ignore the nine months still to come. Only the months used, $660.00, become an expense. The remaining $1,980.00 stays prepaid.
• Expensing only one month when several have passed. Entering $220.00 for Pine Street Dental would be right for a monthly adjustment, but this one covers August, September and October. Count every month since the policy started or since the last adjustment.
• Expensing the months still to come. For Northside Print Shop, 1 month of rent has passed and 2 are still prepaid. Expensing the 2 future months, $5,600.00, swaps the used and unused parts. The expense is the part that has passed, $2,800.00.

How to check any adjusting entry

Before you post an adjustment, ask four questions:

1. Is one account on the balance sheet and one on the income statement? Prepaid Insurance and Insurance Expense pass. Prepaid Insurance and Cash do not.
2. Is Cash absent? If you are about to credit Cash in a month-end adjustment, ask whether money actually moved today. Usually it didn't.
3. Does the amount match the time that passed? Divide the total by the number of months, then multiply by the months in this period.
4. Does the remaining balance make sense? After the adjustment, the prepaid asset should equal the months still to come times the monthly amount. For Juniper after January, 11 × $480.00 = $5,280.00.

The same checks work for unearned revenue, accrued expenses and depreciation, with the accounts swapped for the right pair.

Practice with new numbers

Adjusting entries become automatic after you have done many with different amounts and periods. The free exercise below gives you new numbers each time, and every line of your entry is checked.