An adjusting entry is an accounting transaction that is required to comply with the accrual basis method of accounting. Generally Accepted Accounting Principles (GAAP) includes the accrual basis of accounting, so that the financial statements are clearly stated. Once the adjusting entries are posted, an updated trial balance is generated, and the adjusted trial balance is used to produce the financial statements.
Accrual basis vs. cash basis method of accounting
The accrual basis method of accounting requires a business to post revenue when it is earned, and expenses when they are incurred. This method applies the matching principle, which matches revenue with the expenses that relate to producing the revenue. The accrual basis presents a more accurate picture of net income, and this method ignores cash inflows and outflows.
On the other hand, the cash basis of accounting posts revenue when cash is received and expenses when cash is paid. The cash method does not attempt to match revenue with the related expenses, and this method presents a distorted picture of company net income.
Assume, for example, that a shoe manufacturer purchases $5,000 in leather material on February 1st with cash. The leather is used in the production of shoes in March, and the completed shoes are sold to customers on April 10th. The manufacturer sells 1,000 pairs of shoes on April 10th at a total cost of $80,000. The sale price of the shoes totals $100,000.
The cash basis method posts this entry for the $5,000 leather material purchase paid for in cash:
Debit material expense $5,000
Credit cash $5,000
(To record leather purchased for cash)
An expense is posted when cash is paid, and the revenue from the April 10th shoe sales is not recorded until cash is received from customers.
Note the accrual basis entry for the $5,000 in leather material purchase in cash:
Debit inventory-material $5,000
Credit cash $5,000
(To record leather purchased using cash)
Using accrual basis accounting, the leather material is posted to inventory, an asset account. When the shoes are completed in March, the leather material cost is moved into inventory- finished goods. Here are the journal entries when the shoes are sold on credit on April 10th:
Debit cost of goods sold $80,000
Credit inventory- finished goods $80,000
Debit accounts receivable $100,000
Credit sales- shoes $100,000
(To record shoes sales on credit on April 10th:)
The $80,000 cost of the material, labor, and overhead is moved to cost of goods sold, an expense account. At the same time, the shoe manufacturer records revenue (sales) and posts the amount the firm is owed to accounts receivable.
Revenue and expenses are both posted on April 10th, so the matching principle applies.
Each adjusting entry affects an income statement account and a balance sheet account. Here are two common adjusting entries:
A prepaid expense is an asset account, because the company does not have to pay for an expense in the future. Assume that on June 1st, the shoe manufacturer pays $60,000 for insurance coverage on a factory for the next six months. Here is the initial journal entry:
Debit prepaid insurance $60,000
Credit cash $60,000
(To record prepaid insurance on June 1st)
Since the payment is for insurance coverage in future periods, the company does not record an expense on June 1st. On June 30th, the firm posts an adjusting entry to expense one month (1/6th) of the insurance cost:
Debit insurance expense $10,000
Credit prepaid insurance $10,000
(To record one month of insurance expense on June 30th)
This adjusting entry ensures that the expense is posted to the proper accounting period. The entry affects an income statement account (insurance expense), and an asset account (prepaid insurance).
In many cases, employees are owed wages at month end, because payroll is not processed on the last day of each month. Companies post an accrued payroll entry to record payroll expense in the correct accounting period.
Assume that on October 31st, the shoe manufacturer owes $20,000 in wages, and that the payroll will be processed on November 5th. Here is the October 31st journal entry:
Debit wage expense $20,000
Credit accrued payroll $20,000
(To record payroll expense and a payroll liability on October 31st)
This entry posts the wage expense in the period when the wages are earned (October). The accrued payroll balance is a liability account, so the adjusting entry affects an income statement account (expense) and a balance sheet account (liability).
On November 5th, the company posts this entry:
Debit accrued payroll $20,000
Credit cash $20,000
(To reduce the accrued liability and pay payroll in cash on November 5th)
When payroll is paid on November 5th, the journal entry does not affect an expense account.
Adjusted trial balance
Once all of the accrual entries are posted to the accounting records, the business generates an adjusted trial balance, and the updated trial balance is used to produce the financial statements.