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Lesson 10 of 13The Accounting Cycle: Service Business
Unit 2 · Lesson 10 of 13

Adjusting Entries

Adjustments update account balances at the end of a period so revenue and expenses are recorded in the period they actually belong to, following the accrual basis of accounting.

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Key things to remember

  1. 1Adjustments are recorded at the end of a period so account balances are correct before statements are prepared.
  2. 2Accrual basis: revenue/expenses recorded when earned/incurred. Cash basis: recorded only when cash changes hands.
  3. 3GAAP requires the accrual basis, which is why adjusting entries are necessary.
  4. 4Common adjustments: supplies used, prepaid expenses expiring, unrecorded (late-arriving) expenses, and depreciation.
  5. 5An adjusting entry is a normal double-entry transaction — equal debits and credits, journalized and posted like any other.

Adjustments are accounting changes that are recorded to ensure that all account balances are correct before financial statements are prepared. They exist because some events don't announce themselves with a source document on the day they happen — supplies get quietly used up day by day, insurance coverage quietly expires, and some invoices simply haven't arrived by the time the books need to close.

Accrual Basis vs. Cash Basis

The accrual basis of accounting matches the revenue earned with the expenses incurred to produce that revenue during the accounting period — this is the method required under GAAP and the one used throughout this course. The cash basis of accounting recognizes revenue and expenses only when cash changes hands, ignoring when the value was actually earned or used. Adjusting entries exist specifically to convert cash-basis-style raw data (what was paid or received) into the accrual-basis picture GAAP requires.

AAccrual basis
  • Revenue recorded when earned
  • Expenses recorded when incurred (matched to revenue)
  • Requires adjusting entries
  • Required under GAAP
BCash basis
  • Revenue recorded when cash is received
  • Expenses recorded when cash is paid
  • No adjusting entries needed
  • Simple, but not GAAP-compliant for most businesses
AccountTrial BalanceAdjustmentsAdj. Trial Bal.Income Stmt.Balance SheetNet Incomecarried to the smaller side of Income Statement (as a debit) and Balance Sheet (as a credit)………………
Fig 1Adjustments are worked out before the work sheet's Income Statement and Balance Sheet columns are completed.

Common Adjustments for a Service Business

  • Supplies used — the Supplies account only shows what was purchased, not what's left. A physical count at period-end shows how much is actually on hand; the difference between the account balance and the count is the amount used up, recorded as Supplies Expense.
  • Prepaid expenses expiring — if insurance or rent was paid in advance for several months, only the portion covering the period already elapsed should be an expense; the rest stays an asset (Prepaid Insurance/Prepaid Rent) until later periods use it up.
  • Late-arriving invoices — some expenses (like a utility bill for the final days of the period) are incurred before the period ends but the invoice doesn't arrive until after — these still need to be estimated and recorded in the correct period under the matching principle.
  • Depreciation — a fixed asset's cost is allocated as an expense over its useful life (covered in detail in the next topic).
Adjustments always work in pairs
Like every other transaction, an adjusting entry is still a normal double-entry transaction: it always has equal debits and credits, and it's still journalized and posted exactly like any other entry — it just doesn't come from an everyday source document.
DateAccountDebitCredit
Dec 31Supplies Expense570
Supplies570
To record supplies used during the year ($750 purchased − $180 counted on hand).
Trillium Bike Repair's year-end supplies adjustment.

Worked examples

Reveal one step at a time and try to beat it to the next line.

Example 1
Trillium's Supplies account shows a $750 balance at year-end (before adjustment). A physical count shows $180 of supplies actually remain. Prepare the adjusting entry.
Example 2
A business pays $1,200 on September 1 for a 12-month insurance policy, recorded entirely as Prepaid Insurance. By December 31 (4 months later), how much should be adjusted to Insurance Expense?

Where marks get lost

  • Adjusting Supplies Expense to equal the amount purchased instead of the amount used — the adjustment is based on what's left after a physical count, not the original purchase amount.
  • Forgetting that a prepaid expense adjustment only expenses the portion of time that has already passed, leaving the rest as an asset for future periods.
  • Skipping an adjustment because "no source document arrived yet" — the matching principle still requires estimating and recording expenses incurred, even without a formal invoice in hand yet.
  • Treating cash basis and accrual basis as equally acceptable choices — GAAP requires accrual basis for financial reporting.

Flashcards 5

Adjustments
Accrual basis of accounting
Cash basis of accounting
Prepaid expense
+ 1 more

Practice

1
Which accounting basis does GAAP require?
2
Supplies account balance is $920 before adjustment; a physical count shows $310 remaining. What is Supplies Expense for the period?
$
3
A $2,400, 12-month insurance policy is purchased on July 1. By December 31 (6 months later), how much Insurance Expense should be recorded?
$
4
What is the key difference between the accrual basis and the cash basis of accounting?
5
Which of these requires an adjusting entry at period-end?
6
Why must a business still record an expense for a bill that hasn't arrived yet by period-end?

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