An accrued expense is an expense (and a There are five basic types of adjusting entries:

liability) which was incurred by a borrower but  Accrued revenues (also called

the interest has not been recorded. Deferred accrued assets) are revenues already
insurance expense is the result of paying the earned but not yet paid or recorded.
insurance premiums at the start of an insurance  Unearned revenues (or deferred
coverage period.  Deferred revenues indicate revenues) are revenues received in cash
that a company has received money from a and recorded as liabilities prior to being
earned.
customer before it has been earned
 Accrued expenses (also called
When interest expense has been incurred by a company accrued liabilities) are expenses already
but no payment has been made and no related paperwork incurred but not yet paid or recorded.
has been processed, the company will need to accrue the  Prepaid expenses (or deferred
interest with a debit to Interest Expense and a credit to expenses) are expenses paid in cash and
Interest Payable. recorded as assets prior to being used.
As the debit balance in the asset account Prepaid Insurance  Other adjusting entries
expires, there will need to be an adjusting entry to 1) debit include depreciation of fixed
Insurance Expense, and 2) credit Prepaid Insurance. assets, allowancesfor bad debts, and
inventory adjustments.
As the deferred or unearned revenues become earned, the
credit balance in the liability account such as Deferred
Revenues needs to be reduced. Hence, the adjusting entry
to record these earned revenues will include 1) a debit to
Deferred Revenues, and 2) a credit to Fees Earned.

When customers pay a company in advance, the company

credits Unearned Revenues. Then as the company earns
some of the revenues, the account Unearned Revenues will
be debited and an income statement account such as
Service Revenues or Fees Earned will be credited. Thus,
the remaining credit balance in Unearned Revenues is the
amount received but not yet earned.

Nearly all adjusting entries involve a minimum of one

balance sheet account and a minimum of one income
statement account.

If the company fails to make the December 31 adjusting

entry there will be four consequences: 

1) Interest Expense will be understated (too little expense

being reported) by $1,000. 
2) Net Income will be overstated (too much net income
being reported) by $1,000. 
3) Owner's equity will be overstated by $1,000. 
4) Interest Payable will be understated by $1,000.

The accounting equation and balance sheet will show

liabilities (Interest Payable) understated by $1,000 and
owner's equity overstated by $1,000.

Types of Adjusting Entries

Stage I
Short-run production Stage I arises due to
increasing average product. As more of
the variable input is added to the fixed
input, the marginal product of the variable
input increases. Most importantly,
marginal product is greater than average
product, which causes average product to
increase. This is directly illustrated by
the slope of the average product curve.
Consider these observations about the
shapes and slopes of the three product
curves in Stage I.
 The total product curve has a
positive slope.
 Marginal product is greater than
average product. Marginal product
initially increases, the decreases
until it is equal to average product
at the end of Stage I.
 Average product is positive and the
average product curve has a
positive slope.
Stage II
In Stage II, short-run production is
characterized by decreasing, but positive
marginal returns. As more of the variable
input is added to the fixed input, the
marginal product of the variable input
decreases. Most important of all, Stage II
is driven by the law of diminishing
marginal returns.
The three product curves reveal the
following patterns in Stage II.
 The total product curve has a
decreasing positive slope. In other
words, the slope becomes flatter
with each additional unit of
variable input.
 Marginal product is positive and
the marginal product curve has a
negative slope. The marginal
product curve intersects the
horizontal quantity axis at the end
of Stage II.
 Average product is positive and the
average product curve has a
negative slope. The average
product curve is at its a peak at
the onset of Stage II. At this peak,
average product is equal to
marginal product.
Stage III
The onset of Stage III results due to
negative marginal returns. In this stage of
short-run production, the law of
diminishing marginal returns causes
marginal product to decrease so much
that it becomes negative.
Stage III production is most obvious for
the marginal product curve, but is also
indicated by the total product curve.
 The total product curve has a
negative slope. It has passed its
peak and is heading down.
 Marginal product is negative and
the marginal product curve has a
negative slope. The marginal
product curve has intersected the
horizontal axis and is moving
down.
  Average product remains positive
but the average product curve has
a negative slope.

Economic Production
These three distinct stages of short-run
production are not equally important.
Stage I, and with largely increasing
marginal returns, is a great place to visit,
but most firms move through it quickly.
Because each variable input is increasingly
more productive, firms employ as many
as they can, as quickly as they can. Stage
III, with negative marginal returns, is not
particularly attractive to firms. Production
is less than it would be in Stage II, but
the cost of production is greater due to
the employment of the variable input. Not
a lot of benefits are to be had with Stage
III.

Stage II, with decreasing but positive

marginal returns, provides a range of
production that is suitable to most every
firm. Although marginal product declines,
additional employment of the variable
input does add to total production. Even
though production cost rises with
additional employment, there are benefits
to be gained from extra production. The
trick is to balance the extra cost with the
extra production.

As a matter of fact, because Stage II

tends to be the choice of firms for short-
run production, it is often referred to as
the "economic region." Firms quickly move
from Stage I to Stage II, and do all they
can to avoid moving into Stage III. Firms
can comfortably, and profitably, produce
forever and ever in Stage II.