Adjusting the Books of Accounts and Adjusted Trial Balance Preparation

(4th Step of the Accounting Process)

What are Adjusting Journal Entries (AJE)?

Adjusting entries, also called adjusting journal entries, are journal entries made at the end of a
period to correct accounts before the financial statements are prepared. This is the fourth step in
the accounting cycle. Adjusting entries are most commonly used in accordance with the matching
principle to match revenue and expenses in the period in which they occur.
Types of Adjusting Entries
There are three different types of adjusting journal entries as follows:
1. Prepayments
2. Accruals
3. Non-cash expenses
Each one of these entries adjusts income or expenses to match the current period usage. This
concept is based on the time period principle which states that accounting records and activities
can be divided into separate time periods.
In other words, we are dividing income and expenses into the amounts that were used in the
current period and deferring the amounts that are going to be used in future periods.
Why are Adjusting Entries Necessary?
When you make an adjusting entry, you’re making sure the activities of your business are
recorded accurately in time. If you don’t make adjusting entries, your books will show you paying
for expenses before they’re actually incurred, or collecting unearned revenue before you can
actually use the money.
So, your income and expenses won’t match up, and you won’t be able to accurately track revenue.
Your financial statements will be inaccurate—which is bad news, since you need financial
statements to make informed business decisions and accurately file taxes.
What Does an Adjusting Journal Entry Record?
Here are the main financial transactions that adjusting journal entries are used to record at the
end of a period.
Prepaid expenses or unearned revenues – Prepaid expenses are goods or services that have
been paid for by a company but have not been consumed yet. Insurance is a good example of a
prepaid expense. Insurance is usually prepaid at least six months. This means the company pays
for the insurance but doesn’t actually get the full benefit of the insurance contract until the end of
the six-month period. This transaction is recorded as a prepayment until the expenses are
incurred. The same is true at the end of an accounting period. Only expenses that are incurred
are recorded, the rest are booked as prepaid expenses.
Unearned revenues are also recorded because these consist of income received from customers,
but no goods or services have been provided to them. In this sense, the company owes the
customers a good or service and must record the liability in the current period until the goods or
services are provided.
Accrued expenses and accrued revenues – Many times companies will incur expenses but
won’t have to pay for them until the next month. Utility bills are a good example. December’s
electric bill is always due in January. Since the expense was incurred in December, it must be
recorded in December regardless of whether it was paid or not. In this sense, the expense is
accrued or shown as a liability in December until it is paid.
Non-cash expenses – Adjusting journal entries are also used to record paper expenses like
depreciation, amortization, and depletion. These expenses are often recorded at the end of period
because they are usually calculated on a period basis. For example, depreciation is usually
calculated on an annual basis. Thus, it is recorded at the end of the year. This also relates to the
matching principle where the assets are used during the year and written off after they are used.
How to Record Adjusting Entries?
Recording AJEs is quite simple. Here are the three main steps to record an adjusting journal
entry:
1. Determine current account balance
2. Determine what current balance should be
3. Record adjusting entry
These adjustments are then made in journals and carried over to the account ledgers and
accounting worksheet in the next accounting cycle step.

Example: Following our year-end example of Paul’s Shop, Inc.

➢ Paul paid 2 years advance rent on January 1, 2020 in the amount of 48,000.

Journal Entry
Date Account Name Debit Credit
January 1 Prepaid Rent 48,000.00
Cash 48,000.00
To record prepayment of rent.

On December 31 we recognize the amount of rent already consumed.

Computation: 48,000 ÷ 24 months = 2,000 per month
January to December is 12 months
So, 2,000 x 12 months = 24,000

Adjusting Journal Entry

Date Account Name Debit Credit
December 31 Rent Expense 24,000.00
Prepaid Rent 24,000.00
To record prepaid rent already
consumed.
➢ Paul’s December electric bill was 2,000 and is due January 15th.

Adjusting Journal Entry

Date Account Name Debit Credit
December 31 Utilities Expense 2,000.00
Accrued Expenses 2,000.00
To record accrued expenses.

➢ Paul’s building finished construction on May 1, 2020 and it costs 1,000,000, it has a useful
life of 10 years.

On December 31 we recognize the amount of depreciation for the year.

Computation: 1,000,000 ÷ 10 years = 100,000 depreciation per year.
April 1 to December 31 is 9 months
So, 100,000 ÷ 12 months = 8,333.33 x 9 months = 75,000

Adjusting Journal Entry

Date Account Name Debit Credit
December 31 Depreciation Expense 75,000.00
Accumulated Depreciation 75,000.00
To record depreciation expense for
the year.

➢ On October 1, a customer prepays Paul for guitar lessons for the next 6 months.
Journal Entry
Date Account Name Debit Credit
October 1 Cash 6,000.00
Unearned Income 6,000.00
To record unearned income from
student.

On December 31 we recognize the amount of income already earned.

Computation: 6,000 ÷ 6 months = 1,000 per month.
October to December is 3 months
So, 1,000 x 3 months = 3,000

Adjusting Journal Entry

Date Account Name Debit Credit
December 31 Unearned Income 3,000.00
Guitar Lessons Income 3,000.00
To record income already earned.

Now that all of Paul’s AJEs are made in his accounting system, he can record them on
the accounting worksheet and prepare an adjusted trial balance.
Adjusted Trial Balance Preparation

What is an adjusted trial balance?

The adjusted trial balance is what you get when you take all of the adjusting entries from the
previous step and apply them to the unadjusted trial balance. It should look exactly like your
unadjusted trial balance, save for any deferrals, accruals, missing transaction or tax adjustments
you made.
Just like in an unadjusted trial balance, the total debits and credits in an adjusted trial balance
must equal. If they don’t, you’ve made a mistake somewhere.
How does an adjusted trial balance get turned into financial statements?
At this point you might be wondering what the big deal is with trial balances. Did we really go
through all that trouble just to make sure that all of the debits and credits in your books balance?
Not quite. You’re now set up to make financial statements, which is a big deal.
Once you have a completed, adjusted trial balance in front of you, creating the three major
financial statements—the balance sheet, the cash flow statement and the income statement—is
fairly straightforward.
1. Using information from the revenue and expense account sections of the trial balance,
you can create an income statement.
2. Using information from the asset, liability and equity accounts in the trial balance, you can
prepare a balance sheet.
3. Finally, you can prepare a statement of cash flows using information found in any of the
accounts that interacts with the cash accounts in the trial balance.
If you’re doing your accounting by hand, the trial balance is the keystone of your accounting
operation. All of your raw financial information flows into it, and useful financial information flows
out of it.

Format

An adjusted trial balance is formatted exactly like an unadjusted trial balance. Three columns are
used to display the account names, debits, and credits with the debit balances listed in the left
column and the credit balances are listed on the right.

Like the unadjusted trial balance, the adjusted trial balance accounts are usually listed in order of
their account number or in balance sheet order starting with the assets, liabilities, and equity
accounts and ending with income and expense accounts.

Both the debit and credit columns are calculated at the bottom of a trial balance. As with the
accounting equation, these debit and credit totals must always be equal. If they aren’t equal, the
trial balance was prepared incorrectly or the journal entries weren’t transferred to the ledger
accounts accurately.

As with all financial reports, trial balances are always prepared with a heading. Typically, the
heading consists of three lines containing the company name, name of the trial balance, and date
of the reporting period.
Example: