Adjusting Journal Entry: Definition, Purpose, Types, and Example

Accounting is the backbone of financial management, ensuring that a business’s financial records accurately reflect its economic activities. At the heart of this process lies the concept of the adjusting journal entry—a critical tool used to align a company’s books with the accrual basis of accounting. This article explores the definition, purpose, types, and examples of adjusting journal entries, providing a comprehensive understanding of their role in financial reporting.

Definition of Adjusting Journal Entry

An adjusting journal entry (AJE) is a modification made to a company’s accounting records at the end of an accounting period—typically a month, quarter, or year. These entries ensure that revenues, expenses, assets, and liabilities are recorded in the period in which they are earned or incurred, rather than when cash changes hands. This aligns with the accrual basis of accounting, a fundamental principle under Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).

Unlike regular journal entries, which record day-to-day transactions such as sales or purchases, adjusting entries address items that have not yet been recorded or need correction. They are typically prepared by accountants before financial statements are generated, ensuring the accuracy and completeness of the balance sheet, income statement, and other reports.

Purpose of Adjusting Journal Entries

The primary purpose of adjusting journal entries is to adhere to the matching principle and the revenue recognition principle. The matching principle dictates that expenses should be recorded in the same period as the revenues they help generate, while the revenue recognition principle requires revenue to be recognized when it is earned, not necessarily when payment is received. Adjusting entries bridge the gap between cash-based transactions and the accrual-based reporting required for accurate financial statements.

Adjusting entries serve several specific purposes:

1. Accruals: To record revenues or expenses that have been earned or incurred but not yet recorded. For example, a company may have provided services in December but won’t bill the client until January. An adjusting entry ensures the revenue appears in December’s financials.
2. Deferrals: To allocate revenues or expenses that have been recorded but not yet earned or used. For instance, if a company pays a year’s rent in advance, an adjusting entry spreads that cost over the applicable months.
3. Estimates: To account for expenses or losses that are anticipated but not precisely known, such as depreciation of assets or bad debts.
4. Corrections: To fix errors or reclassify amounts that were incorrectly recorded in prior entries.

By fulfilling these purposes, adjusting entries ensure that financial statements reflect a true and fair view of a company’s financial position and performance, which is essential for stakeholders like investors, creditors, and management.

Types of Adjusting Journal Entries

Adjusting journal entries can be categorized into five main types, each addressing a specific accounting need. Below, we explore these types in detail.

1. Accrued Revenues

Accrued revenues represent income earned during an accounting period but not yet recorded or received in cash. These often arise when a company delivers goods or services before invoicing the customer. For example, a consulting firm may complete a project in late December but not bill the client until January. An adjusting entry records this revenue in December to match the period in which the work was performed.

Example Journal Entry:

• Debit: Accounts Receivable $5,000
• Credit: Service Revenue $5,000

This entry increases both an asset (Accounts Receivable) and revenue on the income statement.

2. Accrued Expenses

Accrued expenses are costs incurred during a period but not yet recorded or paid. Common examples include salaries owed to employees or interest on a loan that has accumulated but isn’t due until the next period. Recording these ensures expenses are matched with the revenues they help produce.

Example Journal Entry:

• Debit: Salaries Expense $3,000
• Credit: Salaries Payable $3,000

This increases an expense on the income statement and a liability on the balance sheet.

3. Deferred Revenues (Unearned Revenues)

Deferred revenues occur when a company receives payment in advance for goods or services it has not yet delivered. Initially recorded as a liability (Unearned Revenue), an adjusting entry recognizes the revenue as it is earned over time. For instance, a magazine subscription paid upfront requires monthly adjustments as issues are delivered.

Example Journal Entry:

• Debit: Unearned Revenue $1,200
• Credit: Subscription Revenue $1,200

This reduces the liability and increases revenue.

4. Prepaid Expenses (Deferred Expenses)

Prepaid expenses involve payments made in advance for goods or services to be used in future periods, such as insurance or rent. These are initially recorded as assets and then expensed over time through adjusting entries.

Example Journal Entry:

• Debit: Insurance Expense $500
• Credit: Prepaid Insurance $500

This reduces the asset and records the expense for the period.

5. Depreciation and Amortization

Fixed assets like machinery or intangible assets like patents lose value over time. Depreciation (for tangible assets) and amortization (for intangible assets) allocate this cost over the asset’s useful life. An adjusting entry records the periodic expense and reduces the asset’s book value.

Example Journal Entry:

• Debit: Depreciation Expense $1,000
• Credit: Accumulated Depreciation $1,000

This increases expenses and reduces the net value of the asset on the balance sheet.

Example of Adjusting Journal Entries in Practice

To illustrate how adjusting journal entries work, let’s consider a hypothetical small business, BrightFuture Consulting, preparing its financial statements for December 2025. The company’s trial balance before adjustments shows the following:

• Cash: $20,000
• Accounts Receivable: $10,000
• Prepaid Rent: $6,000 (paid for 6 months starting December 1)
• Equipment: $30,000
• Accounts Payable: $5,000
• Unearned Revenue: $3,600 (for a 12-month service contract starting December 1)
• Service Revenue: $25,000
• Salaries Expense: $15,000

BrightFuture identifies the following adjustments needed as of December 31, 2025:

1. Accrued Revenue: The company completed $2,000 of consulting work in December but hasn’t billed the client yet.
   • Debit: Accounts Receivable $2,000
   • Credit: Service Revenue $2,000
2. Accrued Expense: Employees earned $1,500 in salaries for the last week of December, payable in January.
   • Debit: Salaries Expense $1,500
   • Credit: Salaries Payable $1,500
3. Deferred Revenue: One month of the $3,600 service contract ($3,600 ÷ 12 = $300) was earned in December.
   • Debit: Unearned Revenue $300
   • Credit: Service Revenue $300
4. Prepaid Expense: One month of the $6,000 prepaid rent ($6,000 ÷ 6 = $1,000) was used in December.
   • Debit: Rent Expense $1,000
   • Credit: Prepaid Rent $1,000
5. Depreciation: The equipment, with a 5-year useful life and no salvage value, depreciates by $500 per month ($30,000 ÷ 60 months).
   • Debit: Depreciation Expense $500
   • Credit: Accumulated Depreciation $500

After posting these entries, BrightFuture’s adjusted trial balance reflects:

• Accounts Receivable: $12,000 ($10,000 + $2,000)
• Prepaid Rent: $5,000 ($6,000 – $1,000)
• Accumulated Depreciation: $500
• Salaries Payable: $1,500
• Unearned Revenue: $3,300 ($3,600 – $300)
• Service Revenue: $27,300 ($25,000 + $2,000 + $300)
• Salaries Expense: $16,500 ($15,000 + $1,500)
• Rent Expense: $1,000
• Depreciation Expense: $500

These adjustments ensure BrightFuture’s income statement accurately reports December’s revenue of $27,300 and expenses totaling $18,000 ($16,500 + $1,000 + $500), yielding a net income of $9,300. The balance sheet reflects updated asset and liability balances, providing a clear financial picture.

Importance of Adjusting Journal Entries

Adjusting journal entries are indispensable for several reasons:

• Accuracy: They ensure financial statements reflect the true financial position and performance of a business.
• Compliance: They align records with GAAP or IFRS, meeting regulatory and legal requirements.
• Decision-Making: Accurate financial data aids management, investors, and creditors in making informed decisions.
• Taxation: Properly adjusted books ensure correct taxable income calculations.

Without adjusting entries, financial statements could misrepresent a company’s profitability and financial health, potentially leading to poor business decisions or legal consequences.

Challenges and Considerations

While adjusting entries are essential, they come with challenges. Estimating amounts like bad debts or depreciation requires judgment, which can introduce subjectivity. Additionally, overlooking necessary adjustments or misclassifying entries can distort financial reports. To mitigate these risks, businesses often rely on experienced accountants and robust accounting software to automate and verify the process.

Conclusion

Adjusting journal entries are a cornerstone of accrual accounting, ensuring that financial records reflect the economic reality of a business. By addressing accruals, deferrals, estimates, and depreciation, these entries uphold the matching and revenue recognition principles, delivering accurate and reliable financial statements. Whether it’s recognizing earned revenue, expensing prepaid costs, or allocating asset depreciation, adjusting entries play a vital role in financial transparency. For businesses like BrightFuture Consulting, mastering this process is key to maintaining trust with stakeholders and driving long-term success.