An adjusting entry is a journal entry made at the end of an accounting period.
Unlike most accounting entries, which correspond to immediate external transactions, adjusting entries are made to modify past transactions.
The primary purpose of adjusting entries is to record unrecognized revenues and expenses and to adjust the carrying value of certain balance sheet items.
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Unrecognized Revenue
Companies often provide goods or services before an invoice is sent to the customer. When this occurs, the company recognizes the revenue earned during the accounting period by making an entry at the end of the period.
Companies may also receive payment from customers before they provide goods or services. As the revenue is earned (i.e., as the goods or services are provided), the company makes an entry to recognize the amount of revenue that has been earned in the period.
For example, suppose a company sells a one-year online subscription and collects payment for the entire year upfront. At the end of each month, the company recognizes revenue equal to 1/12th of the initial payment.
Unrecognized Expense
Companies may pay for expenses before those expenses are consumed. When this occurs, the company makes an entry at the end of the accounting period to record the expenses that have been consumed during the period.
For example, suppose that a company prepays six months of rent. At the time the company makes the payment, the company recognizes the transaction in a current asset account called prepaid expenses. At the end of each month, the company makes an adjusting entry to recognize the amount of rent that has been “used up” in the period.
Balance Sheet Adjustments
The carrying value of certain assets must be adjusted at the end of an accounting period. For example, long-term tangible assets like buildings or equipment are carried on the balance sheet net of accumulated depreciation. Similarly, accounts receivable is carried on the balance sheet net of an allowance for doubtful accounts. For these and other balance sheet items, an entry must be made at the end of an accounting period to recognize the adjustment.
Adjusted Trial Balance
After the adjusting entries are made, the company runs a report called the adjusted trial balance.
Example of an Adjusting Entry
Consider a company that sells a one-year online subscription and collects payment for the entire year upfront.
Because the company has not yet provided the full year of service, the payment cannot be recognized as revenue immediately. Instead, the company initially records the payment as a liability called unearned revenue.
At the end of each month, the company makes an adjusting entry to recognize the portion of revenue that has been earned during that month.
For example, if the company collects $1,200 for the annual subscription, it would recognize $100 of revenue each month. The adjusting entry records the earned revenue and reduces the unearned revenue balance.
Through this process, revenue is recognized in the accounting period in which it is earned.
Key Takeaways
- Adjusting entries are journal entries made at the end of an accounting period.
- They are used to record unrecognized revenues and expenses.
- Adjusting entries may also modify the carrying value of certain balance sheet accounts.
- After adjusting entries are recorded, the adjusted trial balance is prepared.