What an adjusting entry does
During the year you record what happens as it happens: cash paid, cash received, bills sent. At the end of the period some items are still sitting in the wrong place. A prepaid insurance policy has partly been used up. Some supplies are gone. Employees have worked days that have not been paid yet. Adjusting entries fix these items.
Every adjusting entry touches one income statement account (a revenue or an expense) and one balance sheet account (an asset or a liability). Cash is almost never part of an adjusting entry, because the cash side was already recorded or will be recorded later.
The four types are: prepaid items that get used up, unearned amounts that get earned, accrued expenses you owe but have not paid, and accrued revenue you have earned but not billed. These six problems cover the first three types plus depreciation.
The business and the six problems
Brightside Web Studio is an invented one-owner company that builds and maintains websites. Its books are adjusted on December 31, the end of the year. For each problem, work out the amount first, then write the adjusting entry.
Problem 1. On October 1 the studio paid 2,400 for a 12 month insurance policy and debited Prepaid Insurance. How much insurance has expired by December 31?
Problem 2. The Supplies account shows 1,350, made up of the opening balance plus purchases during the year. A count on December 31 shows 400 of supplies on hand.
Problem 3. Equipment costing 18,000 was bought on January 1 of this year. It has an estimated salvage value of 3,000 and a useful life of 5 years. Use straight-line depreciation and record the depreciation for the full year.
Problem 4. Employees earn 400 per workday in total and are paid every Friday. December 31 falls on a Wednesday, so Monday, Tuesday and Wednesday are unpaid.
Problem 5. On November 1 a client paid 4,800 in advance for 6 months of website care. The studio credited Unearned Revenue. Two months of service have been provided by December 31.
Problem 6. On December 1 the studio borrowed 10,000 on a note payable at 6 percent annual interest. No interest has been paid yet. Record the interest for December, which is one month.
A short method
Ask three things. What is currently in the books? What should be in the books? What entry gets from one to the other? For problem 2 the books say 1,350 and the count says 400, so the Supplies account must go down by the difference.
For anything spread over time, find the amount per month first, then multiply by the number of months. For straight-line depreciation, subtract salvage value from cost, then divide by the useful life in years.
Answers
Problem 1: Insurance of 2,400 over 12 months is 200 per month. October, November and December are 3 months, so 200 times 3 is 600. Debit Insurance Expense 600 / Credit Prepaid Insurance 600. Prepaid Insurance now has 1,800 left, which is 2,400 less 600.
Problem 2: Supplies used is 1,350 less 400, which is 950. Debit Supplies Expense 950 / Credit Supplies 950. The Supplies account now shows the 400 on hand.
Problem 3: Depreciable cost is 18,000 less 3,000, which is 15,000. Divided by 5 years, the yearly depreciation is 3,000. Debit Depreciation Expense 3,000 / Credit Accumulated Depreciation 3,000. Book value is 18,000 less 3,000, which is 15,000.
Problem 4: Three unpaid days at 400 per day is 1,200. Debit Wages Expense 1,200 / Credit Wages Payable 1,200. The expense belongs to this year because the work was done this year.
Problem 5: 4,800 over 6 months is 800 per month. Two months earned is 1,600. Debit Unearned Revenue 1,600 / Credit Service Revenue 1,600. Unearned Revenue still has 3,200, which is 4,800 less 1,600, and that is a liability until the remaining four months are provided.
Problem 6: Yearly interest is 10,000 times 0.06, which is 600. One month is 600 divided by 12, which is 50. Debit Interest Expense 50 / Credit Interest Payable 50.
Summary of all six entries
Add up the debits: 600 plus 950 plus 3,000 plus 1,200 plus 1,600 plus 50 equals 7,400. Add up the credits: 600 plus 950 plus 3,000 plus 1,200 plus 1,600 plus 50 equals 7,400. Debits equal credits.
Effect on profit: the five new expenses are 600 plus 950 plus 3,000 plus 1,200 plus 50, which is 5,800. The added revenue is 1,600. Net income before these adjustments would therefore have been overstated by 5,800 less 1,600, which is 4,200.
How to check your work
Check that each entry has one income statement account and one balance sheet account. If you debited an expense and credited another expense, or touched Cash, look again.
Check that the amount is the used or earned part, not the whole balance. In problem 1 the entry is 600, not 2,400. In problem 5 it is 1,600, not 4,800.
Check the time count. Problem 1 uses 3 months from October 1, problem 5 uses 2 months from November 1, and problem 6 uses 1 month from December 1. Count the months on a calendar if you are unsure.
Check the remaining balances. Prepaid Insurance should be 1,800, Supplies 400, equipment book value 15,000 and Unearned Revenue 3,200. A balance that looks too big or too small usually means the wrong amount was used.
Check the totals. Your six entries should add to 7,400 on each side.
Common mistakes
Forgetting the salvage value in straight-line depreciation. If you divided 18,000 by 5 you got 3,600, which is too high.
Reversing the entry for unearned revenue. The cash was already received and recorded as a liability, so earning it means debiting the liability and crediting revenue.
Recording interest for the whole year. The note existed for one month, so only one twelfth of the yearly interest belongs to this period.
Debiting Cash for accruals. Nothing was paid in problems 4 and 6, so they use Payable accounts.
Keep practicing
Change the dates and amounts and work each problem again. For a spreadsheet that shows how adjusting entries flow into the statements, the Accounting Student Study Workbook toolkit on this site includes an adjusting entries guide and depreciation schedules.
Common questions
Why does an adjusting entry rarely use Cash?
Adjusting entries match revenue and expenses to the right period. The cash was usually recorded when it moved, so the adjustment only corrects the account that is out of date.
What is the difference between Accumulated Depreciation and Depreciation Expense?
Depreciation Expense is the cost for the period and goes on the income statement. Accumulated Depreciation is the running total of that expense on an asset and is subtracted from the asset's cost on the balance sheet.
Does my course use the same method?
Many courses do, but some record prepaid items as expenses first or round depreciation by month. Follow your textbook and instructor if they differ.
This guide is general information, not tax, legal or accounting advice. Rules, fees and due dates change; check with the IRS, the NJ Division of Taxation or a licensed professional for your situation.