Identifying Accounts That Need Adjustments at End of Period

At the end of an accounting period, some accounts in a company’s books might not show the right amounts. The amounts in these accounts must be changed to match what happened during that time. Accountants call these changes “adjustments.”

Adjustments are made because of two important ideas in accounting:

1. The matching principle – match money earned to money spent in the same period
2. The revenue recognition principle – record money earned when work is done, not when cash is received

A few main accounts often need adjustments at the end of a period. Let’s go over each one.

Prepaid Expenses

What Are Prepaid Expenses?

Prepaid expenses are things the company pays for ahead of time that get used up over many accounting periods. Some common prepaid expenses are rent, insurance, or supplies.

Why Do Prepaid Expenses Need Adjustments?

When a company first pays for a prepaid expense, it records the whole cost in an asset account called Prepaid Expense. However, as time passes and the company uses up the prepaid item, it must move some costs from the Prepaid Expense asset to an expense account. This follows the matching principle of matching the expense to the period when it was used.

Example of a Prepaid Expense Adjustment

Let’s say a company pays $12,000 in January for a year of rent. At first, they record the whole $12,000 as a Prepaid Rent asset. Each month, they must move $1,000 out of Prepaid Rent and into Rent Expense ($12,000 ÷ 12 months = $1,000 per month). By the end of the year, the entire Prepaid Rent asset will be used up, and $12,000 will show as Rent Expense, matching the expense to the periods when the space was used.

Unearned Revenue

What Is Unearned Revenue?

Unearned revenue is money a company gets paid by customers before doing the work. This follows the revenue recognition principle that says you record revenue only after you’ve done the job, even if you got paid earlier.

Why Does Unearned Revenue Need Adjustments?

When a company first gets the cash, it puts the whole amount in a liability account called Unearned Revenue. This is a liability because the company owes the customer work or products in the future. As the company does the work over time, it moves some of the money from the Unearned Revenue liability account to a revenue account. This matches the revenue (money earned) to the period when the work was done.

Example of an Unearned Revenue Adjustment

Let’s say a landscaping company gets paid $2,400 in March for a one-year lawn care contract. At first, they record the entire $2,400 as Unearned Revenue, a liability. As they do 1/12 of the work each month, they move $200 out of Unearned Revenue into a Service Revenue account ($2,400 ÷ 12 months = $200 earned per month). By the end of the one-year contract, the entire $2,400 will be recorded as revenue, matching money earned to work done in each period.

Depreciation

What Is Depreciation?

Depreciation is how a company spreads the cost of tangible items it buys for more than one year to use in the business. The items could be buildings, machines, vehicles, or computers. Instead of putting the whole cost into one period, depreciation allocates it across the years the asset will be used. This follows the matching principle because it matches the asset’s price to the revenue it helps generate over its useful life.

Why Does Depreciation Need Adjustments?

At the end of each accounting period, a company needs to record depreciation expenses and update the value of its assets. Without this adjustment, the company’s net income would be too high, and its assets would be overstated.

Example of a Depreciation Adjustment

Suppose a delivery company buys a truck for $50,000 and expects it to last 5 years. Each year, it records $10,000 of depreciation expense ($50,000 ÷ 5 years = $10,000 per year). It does this with an adjusting entry that increases (debits) Depreciation Expense and decreases (credits) Accumulated Depreciation, a contra-asset account. This accumulated account keeps track of the total depreciation over the asset’s life. The truck’s book value (cost minus accumulated depreciation) goes down by $10,000 each year until the end of year 5, when it’s fully depreciated.

Inventory

What Is Inventory?

Inventory includes the goods a company has on hand to sell to customers. This could be products the company makes or buys. When a company sells inventory, it records the cost of the goods sold as an expense, following the matching principle of matching the expense of the goods to the revenue from their sale in the same period.

Why Does Inventory Need Adjustments?

At the end of an accounting period, a company needs to ensure the inventory asset amount matches its actual inventory and record the cost of the inventory sold. To do this, it counts the inventory on hand (a physical count) and compares it to the inventory records. The difference needs to be adjusted with a journal entry.

Example of an Inventory Adjustment

Let’s say a bike shop’s records show $100,000 of inventory at the end of the year. They do a physical count and find only $96,000 on the shelves. The $4,000 difference is the cost of inventory sold that hasn’t been recorded yet. The adjustment would increase (debit) the Cost of Goods Sold Expense by $4,000 and decrease (credit) Inventory by $4,000. This matches the cost of the bikes sold with the revenue from their sales in the same period.

Accrued Revenues and Expenses

What Are Accrued Revenues and Expenses?

Accrued revenues are revenues that have been earned but not yet recorded. This can happen if a company does work in one accounting period but hasn’t billed the customer by the end yet.

Accrued expenses are expenses that have occurred but haven’t been paid or recorded by the end of the period. Common accrued expenses are wages, interest, or taxes.

Why Do Accrued Revenues and Expenses Need Adjustments?

Adjustments for accruals are needed to follow the revenue recognition and matching principles. Without these adjustments, revenues and expenses would not be recorded in the period when they happened.

Examples of Accrued Revenue and Expense Adjustments

Let’s say a consultant does $5,000 of work for a client in December but doesn’t send the invoice until January. In December, they would record an adjustment to increase (debit) Accounts Receivable and increase (credit) Consulting Revenue by $5,000. This records the revenue in the period when it was earned.

For accrued expenses, let’s say employees earned $8,000 in wages in the last few days of March that won’t be paid until April. In March, the company would record an adjustment to increase (debit) Wages Expense and increase (credit) Wages Payable by $8,000. This records the expense in the period when it occurred.

The Importance of Adjusting Entries

If a company didn’t make adjusting entries, its financial statements would not fairly show its financial position and performance. Revenues and expenses would be recorded in the wrong periods, and assets and liabilities would be too high or too low. This could lead to bad business decisions based on incorrect information.

Adjusting entries makes sure that the numbers in a company’s books follow the matching and revenue recognition principles of accounting. This helps users of financial statements, like owners, banks, and investors, get a true picture of the company’s finances. It’s a key part of the accounting cycle and a critical task for accountants at the end of each period.