Making the Period Honest
At period-end, some revenues have been earned but not yet invoiced, and some expenses have been incurred but not yet paid. Without adjusting entries, the income statement would mis-measure the period and the balance sheet would mis-state the firm's position.
Adjusting entries come in four flavours — two accruals and two deferrals:
Accrued revenue — revenue earned but not yet recorded (no invoice sent yet). Example: interest on a loan the firm made, accumulating daily but billed quarterly. Adjustment: Dr Accrued Revenue (asset), Cr Revenue.
Accrued expense — expense incurred but not yet paid. Example: wages for the last week of December, paid in January. Adjustment: Dr Expense, Cr Accrued Expense (liability). Without this entry, December's costs are understated and January's overstated.
Prepaid expense (deferred expense) — cash paid in advance for something not yet consumed. Example: annual insurance paid in January. Each month, 1/12 is consumed: Dr Insurance Expense, Cr Prepaid Insurance. The prepaid shrinks as the benefit is used up.
Unearned revenue (deferred revenue) — cash received in advance for service not yet delivered. Each period, the portion delivered is recognised: Dr Unearned Revenue (liability shrinks), Cr Revenue.
The principle behind all four: matching — revenues belong to the period they are earned in, expenses belong to the period they help generate revenue. Adjusting entries are the mechanism that enforces matching when cash and economic reality fall in different periods.
After adjustments, the trial balance becomes the adjusted trial balance — the launch pad for financial statements. Skip adjustments, and the statements are fiction that happens to balance.
The four adjustment flavours
| Flavour | Situation | Entry |
|---|---|---|
| Accrued revenue | Earned, not yet invoiced | Dr Asset / Cr Revenue |
| Accrued expense | Incurred, not yet paid | Dr Expense / Cr Liability |
| Deferred revenue | Cash received, not yet earned | Dr Liability / Cr Revenue (as earned) |
| Deferred expense | Cash paid, not yet consumed | Dr Expense / Cr Asset (as consumed) |
Tip: One diagnostic sorts all four: did the cash move before or after the economic event? Cash after → accrual. Cash before → deferral. Then the entry writes itself.