Adjusting Entries: A Detailed Approach

The Role of Adjusting Entries

Adjusting entries are an integral part of the accounting process, particularly under the accrual method of accounting. Accrual accounting is built on the principle that revenues and expenses are recognized when they are earned or incurred, regardless of when cash is exchanged. The objective is to provide a more accurate representation of a business’s financial position by matching revenues with their corresponding expenses in the same accounting period. This differs from cash-based accounting, where transactions are recorded only when cash changes hands.
At the core of accrual accounting is the notion that the passage of time or the consumption of a service (such as rent or electricity) creates an obligation or expense, even if no immediate cash payment is made. For students new to accounting, understanding the distinction between actual payments and the recognition of revenue or expenses is crucial. Adjusting entries serve as the bridge between these two concepts.
To demonstrate these principles, we’ll explore various examples from the balance sheet of a fictitious business, “Fictious Corp,” and examine the necessary adjusting entries.

Example: Fictious Corp's Balance Sheet (As at 31/12/2024)

Below is the unadjusted balance sheet of Fictious Corp as of December 31, 2024. We will work through various examples to adjust these balances to reflect the accrual method of accounting.

Unadjusted Balance Sheet of Fictious Corp (31/12/2024)

Current Assets	EUR	Current Liabilities	EUR
Bank	60,000 Dr	Accounts Payable	30,000 Cr
Accounts Receivable	40,000 Dr	Company Credit Card	3,000 Cr
Inventory	15,000 Dr	Accrued Expenses	2,500 Cr
Prepaid Expenses	3,500 Dr	Current Bank Loan Due	15,000 Cr
Non-Current Assets		Non-Current Liabilities
Equipment	150,000 Dr	Bank Loan (Non-current)	30,000 Cr
Accumulated Depreciation	30,000 Cr	Share Capital	150,000 Cr
		Retained Earnings	8,000 Cr

| Total Assets | 238,500 Dr | Total Liabilities & Equity | 238,500 Cr |

Adjusting Entries for Accrual Accounting

Bank Charges

At the end of each month, businesses typically incur bank charges for services such as wire transfers or check processing. These fees are often automatically deducted from the bank account, but they may not be immediately recorded in the company’s financial records.

In this example, Fictious Corp has incurred bank charges of EUR 50 for the three months ending December 31, 2024. These charges need to be reflected in the company’s records even though they have not been explicitly recorded

Journal Entry:

Account	Debit (EUR)	Credit (EUR)
Retained Profit	50 Dr
Bank		50 Cr

This adjusting entry ensures that the bank balance is accurately updated, and the expense is recognized, reducing the retained earnings by EUR 50. The adjusted bank balance will now reflect EUR 59,950.

Accounts Receivable

Accounts receivable represent amounts owed to the business by customers for goods or services provided on credit. If a business delivers goods before issuing an invoice, both the revenue and the accounts receivable will be understated.

In the case of Fictious Corp, goods worth EUR 5,000 were shipped on December 30, 2024, but the invoice was not recorded. This adjusting entry corrects both the accounts receivable and the revenue for the year.

Journal Entry:

Account	Debit (EUR)	Credit (EUR)
Accounts Receivable	5,000 Dr
Retained Profit		5,000 Cr

After this adjustment, the accounts receivable balance increases to EUR 45,000, which more accurately reflects the amount owed to the company.

Provision for Bad Debts

The provision for bad debts is a contra asset account, meaning it is subtracted from accounts receivable to give a more realistic picture of what the business expects to collect. This adjusting entry accounts for the possibility that not all outstanding receivables will be collected, either due to a customer’s financial difficulties or dishonesty.

In this example, Fictious Corp identifies EUR 3,100 of receivables that are unlikely to be collected.

Journal Entry:

Account	Debit (EUR)	Credit (EUR)
Retained Profit	3,100 Dr
Provision for Bad Debts		3,100 Cr

The provision for bad debts is deducted from accounts receivable on the balance sheet. After this adjustment, the accounts receivable is EUR 45,000, but the net amount after the deduction of the EUR 3,100 provision for bad debts is EUR 41,900.

Inventory

Inventory refers to the goods held by a business for resale. At year-end, businesses conduct a physical count of inventory to ensure the recorded amount matches the actual stock on hand. Any discrepancies must be adjusted to reflect the accurate inventory value.

In this case, the physical count shows that Fictious Corp has inventory valued at EUR 12,500, while the books reflect EUR 15,000. The discrepancy of EUR 2,500 is due to unrecorded sales that resulted in a reduction in inventory.

Journal Entry:

Account	Debit (EUR)	Credit (EUR)
Retained Profit	2,500 Dr
Inventory		2,500 Cr

The inventory value is adjusted to EUR 12,500, and this adjustment reduces profits, recognizing that goods were sold but not recorded.

Prepaid Expenses

Prepaid expenses refer to payments made in advance for services that will be received in the future, such as insurance or rent. In the balance sheet, prepaid expenses are treated as assets because they represent the right to receive a service in the future. As the service is consumed over time, the prepaid expense is reduced, and an expense is recorded in the income statement.

In this example, Fictious Corp paid EUR 3,500 for an annual insurance policy starting on December 1, 2024. By December 31, 2024, one month of the insurance coverage has elapsed, meaning 1/12 of the prepaid insurance should be recognized as an expense.

Key Concept Clarification:

Prepaid Expense: This is a personal account representing an entity (in this case, the insurance company) that has provided a service. Payment has already been made, but the service is “prepaid” for future coverage.
Insurance Expense: The consumption of the service (insurance coverage) is recorded in the nominal account, representing the actual expense incurred.

Journal Entry:

Account	Debit (EUR)	Credit (EUR)
Retained Profit	292 Dr
Prepaid Insurance		292 Cr

After this adjustment, the prepaid insurance balance is reduced to EUR 3,208, and the insurance expense is recognized for the period.

Depreciation of Equipment

Fictious Corp owns equipment (computers) valued at EUR 150,000, and it is estimated that they will become obsolete in five years. Depreciation for the year is calculated as:

Depreciation Expense=Cost of EquipmentUseful Life\text{Depreciation Expense} = \frac{\text{Cost of Equipment}}{\text{Useful Life}}Depreciation Expense=Useful LifeCost of Equipment

In this case, the depreciation is EUR 30,000 for one year (EUR 150,000 ÷ 5 years).

Journal Entry:

Account	Debit (EUR)	Credit (EUR)
Retained Profit	30,000 Dr
Accumulated Depreciation		30,000 Cr

The accumulated depreciation account will now show a balance of EUR 60,000. This contra-asset account is deducted from the equipment’s original value to show its book value.

Accounts Payable vs. Accrued Expenses

It’s essential to distinguish between accounts payable and accrued expenses:

Accounts Payable: These are liabilities related to goods purchased for resale or other goods necessary for business operations. For example, inventory received but not yet paid for would fall under accounts payable. In most cases, this is directly associated with goods for resale.
Accrued Expenses: These are liabilities for services already used by the business but not yet paid for. Examples include rent, utilities, or wages. These are not related to goods for resale but rather to other operational expenses.

In Fictious Corp’s case, the business received goods worth EUR 5,000 on December 31, 2024, but the invoice has not yet arrived. Therefore, an adjustment is needed to reflect both the inventory increase and the liability.

Journal Entry for Accounts Payable:

Account	Debit (EUR)	Credit (EUR)
Inventory	5,000 Dr
Accounts Payable		5,000 Cr

After this adjustment, the inventory and accounts payable are both increased by EUR 5,000, ensuring the company’s financial statements correctly reflect the goods received and the amount owed to the supplier.

Accrued Expenses: Rent Example

Accrued expenses represent costs that have been incurred but not yet paid. This adjustment ensures that expenses are recorded in the correct accounting period. In this case, we’ll use rent as an example, as it is one of the most common forms of accrued expenses.

Fictious Corp rents office space, and the rent for December 2024, amounting to EUR 1,500, has not yet been paid by the end of the year. An adjustment is needed to recognize this liability.

Key Concept Clarification:

Accrued Expense: This is a personal account representing an entity (the landlord) that has provided a service (the rental of space). The company owes money for this service but has not yet made payment.
Rent Expense: The consumption of the service (use of office space) is recorded in the nominal account as rent expense. This represents the actual cost incurred during the accounting period.

Journal Entry:

Account	Debit (EUR)	Credit (EUR)
Rent Expense	1,500 Dr
Accrued Expenses		1,500 Cr

After this adjustment, the accrued expenses increase by EUR 1,500, representing the unpaid rent, while rent expense is recognized in the financial statements for the period.

Prepaid Expenses vs. Accrued Expenses: Clarifying Confusion

The terms “prepaid expenses” and “accrued expenses” often confuse students because both relate to expenses, yet they have distinct meanings and uses in accounting:

Prepaid Expenses: These are payments made in advance for services that will be used in the future. They represent assets until the service is consumed. Common examples include insurance and rent.

Personal Account Representation: Prepaid expenses reflect payments made to entities like insurance companies, landlords, or service providers. These are asset accounts because they represent the business’s right to receive future services. When the service is consumed, the prepaid expense is reduced, and an expense is recorded.

Accrued Expenses: These are expenses that have been incurred but not yet paid by the end of the accounting period. These liabilities represent obligations for services already received (such as utilities or rent) but not yet settled.

Personal Account Representation: Accrued expenses represent entities like landlords or utility companies that have provided a service but have not yet been paid. When the payment is made, the accrued liability is reduced, but the expense is already recognized when the service is used.

Customer Deposits/Unearned Revenue

Another important concept in accrual accounting is customer deposits or unearned revenue. This refers to payments received from customers in advance of delivering goods or services. These payments are not considered revenue until the business fulfills its obligation to provide the product or service. Therefore, they are recorded as liabilities until the service is performed.

For example, if Fictious Corp received a customer deposit of EUR 10,000 on December 28, 2024, for services to be rendered in January 2025, the company must record this as unearned revenue. This liability reflects the company’s obligation to deliver the service in the future.

Journal Entry

Account	Debit (EUR)	Credit (EUR)
Bank	10,000 Dr
Unearned Revenue		10,000 Cr

This entry shows that the company has received cash but has not yet earned the revenue. Once the service is delivered, the unearned revenue will be transferred to the revenue account.

Final Adjusted Balance Sheet

After making all the necessary adjustments, Fictious Corp’s balance sheet is updated to reflect the accrual accounting adjustments. This includes adjustments for accounts payable, accrued expenses, prepaid expenses, and unearned revenue, ensuring an accurate representation of the company’s financial position as of December 31, 2024.

Adjusted Balance Sheet of Fictious Corp (31/12/2024)

Current Assets	EUR	Current Liabilities	EUR
Bank	69950 Dr	Accounts Payable	35,000 Cr
Accounts Receivable	45,000 Dr	Unearned Revenue	10,000 Cr
Provision for Bad Debts	(3,100 Cr)	Company Credit Card	3,000 Cr
Net Accounts Receivable	41,900 Dr	Accrued Expenses	4,000 Cr
Inventory	17,500 Dr	Current Bank Loan Due	15,000 Cr
Prepaid Expenses	3,208 Dr	Non-Current Liabilities	15,000 Cr
Non-Current Assets		Bank Loan (Non-current)	30,000 Cr
Equipment	150,000 Dr	Share Capital	150,000 Cr
Accumulated Depreciation	(60,000 Cr)	Retained Profit	24.442 Dr

| Total Assets | 222,558 Dr | Total Liabilities & Equity | 222,558 Cr |

Conclusion

Adjusting entries are critical for ensuring that financial statements are accurate and complete. They allow businesses to match revenues with expenses in the correct accounting period, ensuring the accrual method of accounting is properly applied. Through careful adjustments for bank charges, accounts receivable, provisions for bad debts, inventory, prepaid and accrued expenses, and unearned revenue, businesses can present a true and fair view of their financial position.
Understanding the distinctions between terms like accrued and prepaid expenses, as well as recognizing the role of personal and nominal accounts, helps students and professionals alike grasp the nuances of accounting. With clear examples and explanations, accounting concepts become more accessible, allowing for accurate financial reporting.

Adjusting Entries: A Detailed Approach

The Role of Adjusting Entries

Example: Fictious Corp's Balance Sheet (As at 31/12/2024)