In order for financial statements to be completed on an accruals basis and comply with the matching principle, adjusting journal entries need to be made at the end of each accounting period.
There are numerous types of adjusting journals, but the four adjusting journal entries examples listed below are among the most common usually encountered.
- Interest expense
- Payroll accrual
- Unearned revenue
- Prepaid expenses
Interest Expense Adjusting Entries
If a business has debt finance, one of the adjusting journal entries will be for interest accrued but not paid at the and of an accounting period.
Suppose for example a business has a debt of 50,000 with interest at 8% paid on the 10th of each month. For our accounting period ending on June 30, interest will have been paid on June 10, but the next interest payment date will not be until after the month end on July 10. Adjusting journal entries are needed to accrue for the interest for the period from June 10 to June 30 (20 days)
Assuming simple interest, an estimate of the interest is given as follows:
Interest = Principal x Rate x Term Interest = 50,000 x 8% x 20/365 Interest = 219
The adjusting journal entries to record the interest accrual are as follows:
The interest expense for the month has been included in the interest expense account and the liability for unpaid interest is reflected in the balance sheet interest payable account.
Payroll Accrual Adjusting Entries
In most businesses the payroll period and the accounting period do not coincide. For example, if the payroll period is weekly and the accounting period is monthly, there will always be a period at the end of each month where the employee has worked hours which have not yet been accounted for.
Suppose a typical payroll week starts on the June 27 and ends the following month on July 3. At the end of the accounting period, June 30, the normal payroll journals for the week ending July 3 will not have been processed, and the payroll for that week will not have been reflected in the financial statements. To correct this adjusting journal entries are made to accrue for the payroll relating to June.
Looking at the week (7 days) from June 27 to July 3, we can see that 4 days (June 27 to June 30) relate to this accounting period, and 3 days (July 1 to July 3) relate to the next accounting period.
Suppose the average weekly payroll is 3,500, then the payroll relating to this accounting period is estimated at 3,500 x 4/7 = 2,000, and the adjusting journal entries are as follows:
The wage expense for the month has been included in the wage expense account and the liability for unpaid wages is reflected in the balance sheet wages payable account.
Adjusting Journal Entries – Unearned Revenue
If a business is paid in advance for the goods or services it provides then adjusting journal entries will be needed at the end of the accounting period to adjust the unearned revenue account.
For example, suppose a business charges annual subscriptions of 3,000 to customers, which are recorded in the unearned revenue account when received. At the end of an accounting period the amount which has been earned for the period needs to be transferred from the unearned revenue account (balance sheet), to the revenue account (income statement) using adjusting journal entries.
If the subscriptions are used evenly throughout the year, then the amount of revenue earned for a month is 3,000/12 = 250, and the adjusting journal entries are as follows:
The revenue earned during the month has been transferred from the unearned revenue account to the revenue account.
It should be noted that the term unearned revenue is often replaced by the term deferred revenue, both terms mean the same thing and refer to the fact that income has been received but not yet earned.
Adjusting journal entries – Prepaid Expenses
A business will often pay expenses which might relate to a number of accounting periods, the expenses are paid in advance and are known as prepaid expenses.
For example, the business might pay its rent quarterly in advance, when paid the amount will have been debited to a prepaid rent account in the balance sheet. At the end of each of the next three months adjusting journal entries are made to record the amount of rent utilised during the month.
Suppose the quarterly rent is 9,000, at the end of a month the amount of rent expense incurred is 9,000/3 = 3,000, and the adjusting journal entries will be as follows:
The rent for the month of 3,000 has been transferred from the prepaid rent account in the balance sheet, to the rent expense account in the income statement.
The term prepaid expense is sometimes replaced with the term deferred expense. In practice, a prepaid expense is usually one which has been paid less than 12 months in advance and is shown as a current asset on the balance sheet, whereas as deferred expense refers to an expense paid more than 12 months in advance, shown as a long term asset on the balance sheet.