Chapter 3 — Adjusting Entries

Why we adjust: accrual accounting

By the end of a period the books are almost right — but not quite. Some things were paid for in advance and have since been used up; some work has been done but not yet billed; some costs have piled up without an invoice. Adjusting entries are the clean-up step that gets every account to its true end-of-period figure before the financial statements are prepared.

The reason this step exists is accrual accounting. Under the accrual basis we record revenue when it is EARNED and expenses when they are INCURRED — regardless of when the cash moves. That is very different from the cash basis, where you would only record something when money changes hands.

Adjusting entries are how those two principles are enforced at period end. Every adjustment is one of just four patterns — which is the whole map of this chapter.

The one rule behind every adjustment

Before the four patterns, learn the rule they all obey, because it turns adjusting entries from memorization into logic. Every adjusting entry touches exactly one income-statement account (a revenue or an expense) and one balance-sheet account (an asset or a liability). And one account is never involved: Cash. Cash was already handled when the money moved; an adjustment only fixes what is left.

The four patterns split into two families. Deferrals are for cash that already moved — you deferred (delayed) recording the revenue or expense, and now part of it belongs to this period. Accruals are for cash that has NOT moved yet — the revenue or expense happened first, and the cash will follow later.

• Deferral — Prepaid expenses: an asset you paid for is being used up → move part of the asset to expense.
• Deferral — Unearned revenues: cash collected in advance is now being earned → move part of the liability to revenue.
• Accrual — Accrued revenues: revenue earned but not yet recorded or received → record an asset and revenue.
• Accrual — Accrued expenses: an expense incurred but not yet recorded or paid → record an expense and a liability.

Two patterns start from something already on the books (deferrals); two start from nothing yet recorded (accruals). Keep that split in mind and every adjustment tells you its own entry.

Pattern 1 — Prepaid expenses (asset becomes expense)

A prepaid expense is something you paid for ahead of time and recorded as an asset — supplies in the closet, an insurance policy, rent paid in advance. As the period passes you use part of it up, so the adjusting entry moves the used-up portion out of the asset and into an expense: debit the expense, credit the asset.

Skip this adjustment and two things go wrong at once: the asset is overstated and the expense is understated, so profit looks too high. That is exactly what the matching principle is there to prevent.

Depreciation: a prepaid expense for long-lived assets

Equipment, vehicles, and buildings are really just very long prepaid expenses: you pay once, then use them up over years. Spreading that cost across the years of use is called depreciation. Each period you record depreciation expense for the portion used up — but with one twist in how you credit it.

Instead of crediting the asset directly, you credit a contra-asset account called Accumulated Depreciation. That keeps the original cost visible while tracking how much has been used up.

Pattern 2 — Unearned revenues (liability becomes revenue)

Sometimes a customer pays before you do the work. The cash is real, but you haven't earned it yet, so it was recorded as a liability called Unearned Revenue. As you deliver the service, part of that liability turns into earned revenue. The adjusting entry: debit Unearned Revenue, credit the revenue account.

Notice it is the mirror image of a prepaid expense. There, an asset became an expense; here, a liability becomes revenue. Same idea, opposite side of the equation.

Pattern 3 — Accrued revenues (earned, not yet recorded)

An accrued revenue is work you have already done that hasn't been billed or recorded yet — the cash has not arrived and no entry has been made. Because it is earned, the revenue recognition principle says record it now. The adjusting entry creates the receivable and the revenue: debit Accounts Receivable, credit the revenue account.

Miss this one and both revenue and assets are understated — the business looks like it did less work than it actually did.

Pattern 4 — Accrued expenses (incurred, not yet recorded)

An accrued expense is a cost you have run up but not yet paid or recorded — wages your staff have earned since the last payday, interest building on a loan, utilities used but not yet billed. The adjusting entry records the expense and the matching liability: debit the expense, credit a payable.

The adjusted trial balance

Once every adjusting entry is journalized and posted, you prepare one more trial balance — the adjusted trial balance. It lists every account at its corrected end-of-period balance and proves, once again, that total debits equal total credits. This is the version the financial statements are built from.

That is the whole chapter: four patterns, one rule (one income-statement account, one balance-sheet account, never Cash), and a final adjusted trial balance that keeps the books honest.