What is an adjusting journal entry (AJE)?
– An adjusting journal entry is a record made at the end of an accounting period to recognize income or expenses that have occurred but are not yet reflected correctly under the accrual basis of accounting. Its purpose is to move transactions from cash timing to the period in which they were earned or incurred so the financial statements present a true picture of operations.
Key concepts (short definitions)
– Accrual accounting: a system that records revenues when earned and expenses when incurred, regardless of cash receipts or payments.
– Cash accounting: records revenues and expenses only when cash actually changes hands.
– Matching principle: the accounting rule that expenses should be recognized in the same period as the related revenues they help produce.
– Accruals: revenues earned or expenses incurred that have not yet been recorded (e.g., services performed on credit; expenses incurred but unpaid).
– Deferrals: cash received or paid in advance that has been recorded but not yet earned or used (e.g., prepaid insurance; unearned revenue).
– Estimates: non-cash periodic adjustments based on judgement, such as depreciation expense or allowance for doubtful accounts.
Why AJEs matter
– Ensure revenue and expense recognition follow the matching and revenue-recognition principles.
– Correct timing differences so the income statement and balance sheet are aligned.
– Prevent material misstatements when transactions cross accounting periods.
Common accounts affected
– Balance sheet: prepaid expenses, accrued receivables, accounts payable, accrued liabilities (interest payable, wages payable), deferred/unearned revenue, accumulated depreciation, allowance for doubtful accounts.
– Income statement: depreciation expense, interest expense, insurance expense, revenue, bad‑debt expense.
Types of adjusting entries
1. Accruals (record revenue earned or expenses incurred but not yet billed/paid).
2. Deferrals (recognize earned revenue or incurred expense from amounts initially recorded as prepaid or unearned).
3. Estimates (periodic allocation or allowance based on judgment, e.g., depreciation, doubtful accounts).
When an entry is not an AJE
– A routine recorded transaction that happens on the last day of the period (for example, purchasing equipment on the last day) is typically not an adjusting entry. AJEs deal with timing differences that require recognition or allocation across periods.
Step‑by‑step checklist to prepare AJEs
1. Identify the cutoff date (period end).
2. Scan for transactions that span periods (prepaid items, invoices not yet issued, services performed but not billed).
3. Determine whether the item is an accrual, deferral, or estimate.
4. Measure the amount to recognize for the period (use contract terms, time-proportion, or a reasonable estimate).
5. Prepare the journal entry: debit the income statement account (expense or revenue) and credit the related balance sheet account (asset or liability), or vice versa as appropriate.
6. Document the rationale and calculation, attach supporting schedules.
7. Post the entry to the general ledger and review trial balance for reasonableness.
8. Reverse the entry in the next period if it was meant to be temporary (optional, depends on bookkeeping practice).
Worked numeric example (accrued interest)
Assumptions:
– Loan principal: $100,000
– Annual interest rate: 6% (0.06)
– Loan taken on Dec 1; fiscal year ends Dec 31
– Interest payments are quarterly, next payment Mar 1 (no cash paid by Dec 31)
Step 1 — compute interest for period Dec 1–Dec 31 (31 days):
Interest expense = Principal × Rate × (Days/365)
Interest expense = $100,000 × 0.06 × (31/365) ≈ $509.59
Step 2 — prepare the adjusting entry (to record interest incurred but unpaid at year end):
– Debit Interest Expense $509.59
– Credit Interest Payable (liability) $509.59
Effect:
– Income statement: recognizes $509.59 of interest expense in December.
– Balance sheet: shows $509.59 liability for interest payable as of Dec 31.
– When the cash payment is made on March 1, you will reduce Interest Payable (and record additional interest for Jan–Feb at that time, or have previously accrued).
Practical tips
– Use consistent day-count convention (actual/365 or actual/360) and document which you used.
– Keep a schedule for recurring AJEs (e.g., monthly accruals, monthly depreciation).
– Review estimates periodically and adjust if circumstances change.
– Consider reversing temporary accruals in the next period to simplify posting.
Quick checklist (one‑page)
– Have I reviewed cutoffs for revenue and expenses?
– Are there invoices not yet received or issued?
– Do I have prepaid items to amortize?
– Are there predictable recurring accruals (payroll, interest, utilities)?
– Have I documented calculations and supporting evidence?
– Should the entry be reversed next period?
Selected references
– Investopedia — Adjusting Journal Entry: https://www.investopedia.com/terms/a/adjusting-journal-entry.asp
– Financial Accounting Standards Board (FASB) — The Conceptual Framework (overview): https://www.fasb.org
– IFRS Foundation — About the IFRS Standards: https://www.ifrs.org
– AccountingCoach — Adjusting Entries (practical examples): https://www.accountingcoach.com/adjusting-entries/explanation
Educational disclaimer
This explainer is for educational purposes and does not constitute accounting, tax, or legal advice. For transactions with material impact or where judgement is required, consult a licensed accountant or relevant standards (GAAP/IFRS) before finalizing financial statements.