Lesson 4 of 6The Accounting Cycle

Unit 1 · Lesson 4 of 6

Adjusting Entries and the Matching Principle

Adjusting entries, made at the end of each period, move revenue and expenses into the period they belong to; each one pairs a balance-sheet account with an income-statement account and applies the matching or revenue recognition principle.

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Key things to remember

1Every adjusting entry pairs one income statement account with one balance sheet account, and never involves Cash.
2Prepaid: Dr Expense, Cr Prepaid asset. Unearned: Dr Unearned Revenue, Cr Revenue.
3Accrued revenue: Dr Receivable, Cr Revenue. Accrued expense: Dr Expense, Cr Payable.
4Interest $I = P \times r \times t$ , with $t$ in years (months divided by 12).
5Straight-line amortization = (cost - residual value) / useful life; declining-balance = rate x net book value. Credit Accumulated Amortization (ASPE term; IFRS says depreciation).

Some things happen without a transaction. Every day the insurance policy you prepaid gets a day older, the delivery van wears a little more, and employees earn wages they will not be paid until next week. No invoice or cheque marks those moments, so nothing gets recorded during the year. If the statements were prepared straight from the ledger, they would be wrong. Adjusting entries, recorded on the last day of the period, bring every account up to date so the income statement shows the revenue earned and expenses incurred in exactly that period.

Why adjustments exist: time periods and matching

Adjusting entries come directly from three GAAP ideas working together. The time-period assumption chops the business's life into fiscal periods. Revenue recognition says revenue belongs to the period in which it is earned. Matching says expenses belong to the period whose revenue they helped earn. Cash rarely moves on the same day as those events, so the books must be adjusted. Adjustments fall into two families plus one estimate.

Deferrals: cash moved first, the revenue or expense happens later. Prepaid expenses (an asset used up over time) and unearned revenue (a liability earned over time).
Accruals: the revenue or expense happened first, cash moves later. Accrued revenue (earned but not yet billed or received) and accrued expenses (incurred but not yet paid, such as wages and interest).
Amortization: allocating the cost of a capital asset over its useful life, an estimate rather than a single event.

Fig 1Deferrals: cash comes first, recognition later. Accruals: recognition comes first, cash later.

The anatomy of every adjusting entry

Each adjusting entry has one income statement account (a revenue or an expense) and one balance sheet account (an asset or a liability). Cash is never part of an adjusting entry; if cash had moved, there would be a source document and the entry would have been made already.

Deferrals: prepaid expenses and unearned revenue

Lakeshore Design Studio (owner A. Okafor) closes its books on December 31, 2026. Its unadjusted trial balance shows: Prepaid Insurance $3,600 (a 12-month policy bought October 1), Supplies $1,450 (a count on December 31 finds $380 on hand) and Unearned Revenue $6,000 (received November 1 for 6 months of design services).

Date	Account	Debit	Credit
Dec 31	Insurance Expense	900
	Prepaid Insurance		900
	Insurance expired, Oct to Dec: 3/12 of $3,600.
Dec 31	Supplies Expense	1,070
	Supplies		1,070
	Supplies used: $1,450 - $380 on hand.
Dec 31	Unearned Revenue	2,000
	Service Revenue		2,000
	Earned 2 of 6 months: 2/6 of $6,000.

Deferral adjustments move part of a balance sheet amount onto the income statement.

Accruals: revenue earned and expenses incurred but not recorded

Lakeshore also finds: $1,800 of design work completed in late December but not yet billed; wages of $750 per working day earned on December 29, 30 and 31 that will be paid on the next payday, January 8, 2027; and a $24,000 bank loan at 6% per year taken out September 1, with interest paid when the loan is repaid. Interest uses the simple-interest formula with time in years.

I = P \times r \times t

$24, 000 \times 0.06 \times \frac{4}{12} = $480

Date	Account	Debit	Credit
Dec 31	Accounts Receivable	1,800
	Service Revenue		1,800
	Work completed in December, not yet billed.
Dec 31	Wages Expense	2,250
	Wages Payable		2,250
	Wages earned Dec 29 to 31: 3 days x $750.
Dec 31	Interest Expense	480
	Interest Payable		480
	Interest on bank loan, Sept 1 to Dec 31.

Accrual adjustments record revenue and expenses that have happened before any cash moves.

VideoAn overview of the main kinds of adjusting entries (prepaids, unearned revenue, accruals and amortization) and why every one of them touches both a balance sheet and an income statement account.Watch on YouTube

Amortization of capital assets

Lakeshore's equipment cost $42,000, has an estimated residual value of $6,000 and a useful life of 6 years. Under ASPE the yearly cost allocation is called amortization; under IFRS it is called depreciation. Either way the credit goes to a contra-asset, Accumulated Amortization, rather than to Equipment, so the balance sheet still shows the original cost (cost principle) alongside how much of it has been used (matching). Cost minus accumulated amortization is the net book value.

Straight-line = \frac{Cost - Residual value}{Useful life} = \frac{$42 , 000 - $6 , 000}{6} = $6, 000

Date	Account	Debit	Credit
Dec 31	Amortization Expense, Equipment	6,000
	Accumulated Amortization, Equipment		6,000
	Annual straight-line amortization.

Amortization never credits the asset account directly.

Adjustment	Principle	If omitted: net income	If omitted: balance sheet
Prepaid expense used	Matching	Overstated	Assets overstated
Unearned revenue earned	Revenue recognition	Understated	Liabilities overstated
Accrued revenue	Revenue recognition	Understated	Assets understated
Accrued expense (wages, interest)	Matching	Overstated	Liabilities understated
Amortization	Matching (and cost)	Overstated	Assets overstated

Owner's equity always moves the same direction as net income.

Fig 2Adjusting entries bring accounts up to date at period end; some can be reversed on the first day of the next period.

Quick checkTry it before you read on

Lakeshore forgets to record the $480 of accrued interest. What is the effect on the 2026 statements?

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Enter an adjusting entry and watch which side of the equation and which statement each half affects.

Worked examples

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

Example 1

On November 1, 2026 Northshore Outfitters prepaid $9,000 for six months' rent and debited Prepaid Rent. Record the December 31 adjusting entry and state the year-end balance of Prepaid Rent.

Example 2

A $15,000, 8% note payable is issued on October 1, 2026; principal and interest are due on March 31, 2027. Record the December 31 adjusting entry.

Example 3

Lakeshore's equipment cost $42,000. Calculate the first year's amortization (a) straight-line, with a $6,000 residual value over 6 years, and (b) declining-balance at 30%. Explain why the choice matters.

Example 4

Lakeshore's unadjusted net income is $35,450. Using all seven adjustments in this lesson (insurance $900, supplies $1,070, unearned revenue earned $2,000, accrued revenue $1,800, wages $2,250, interest $480, amortization $6,000), find adjusted net income.

Where marks get lost

Putting Cash in an adjusting entry. If cash moved, it is a regular transaction, not an adjustment.
Recording the amount remaining instead of the amount used, e.g. debiting Supplies Expense $380 (on hand) instead of $1,070 (used).
Crediting Equipment instead of Accumulated Amortization, which erases the asset's original cost from the records.
Using the annual interest rate without multiplying by the fraction of the year ( $t$ = months / 12).
Forgetting that wages earned after the last payday must be accrued even though nobody has been paid yet.

Flashcards 8

Deferral

Accrual

Adjusting entry for unearned revenue earned

Adjusting entry for accrued wages

+ 4 more

Practice

A 12-month insurance policy costing $7,200 is bought September 1 and debited to Prepaid Insurance. What is the December 31 adjusting entry amount? Answer to the nearest dollar.

A $15,000 loan at 8% per year was taken on October 1. How much interest should be accrued on December 31? Answer to the nearest dollar.

A business that received cash in advance has now performed part of the work. The adjusting entry is:

Accrued wages of $2,250 are not recorded at year end. The effect is:

Equipment cost $28,000, residual value $4,000, useful life 8 years. What is the annual straight-line amortization? Answer to the nearest dollar.

A truck cost $40,000 and has accumulated amortization of $10,000 after year 1. Using declining-balance at 25%, what is year 2 amortization? Answer to the nearest dollar.

Match each adjustment to the principle that requires it.

Accrued wages

Unearned revenue now earned

Recording equipment at original cost with a separate accumulated amortization account

Dividing the business's life into fiscal years

Name the contra-asset account credited when equipment is amortized under ASPE.

Which account will never appear in an adjusting entry?

The Supplies account shows $1,900. A count finds $650 of supplies on hand. What is the amount of the adjusting entry? Answer to the nearest dollar.

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