At the end of a period a Trial Balance is updated by adjusting entries. Adjusting entries are the recorded changes to revenues and expenses that occured during that period. This update has an effect on the assets and liabilities accounts. There are two aspects that are measured by these adjustments, as follows:

1. A Net Income/Loss on the Income Statement
2. Balance Sheet Assets and Liabilities

Prepaid and Accrual accounts are the general categories that are updated with adjusting entries. For prepaid adjustments, cash is paid for the good/service before the expense is actually incurred or cash is received prior to revenue being earned. Sometimes prepaids are referred to as deferrals because the revenue or expense isn't recognized until after the cash is paid or received. Accruals are inverse of standard accounting, in that an expense is recorded before it occurs, and a revenue is recorded before it is received. There are four general types of adjusting entries:

 

Prepaid Expenses


These are payments that are made before the expense actually occurs. These payments are assets until they have been depleted. As the pre-payment is depleted, the portion that is used becomes an expense through an adjusting entry. For example, say $12,000 was paid for prepaid rent ($1,000/month). Each month an adjusting entry would occur with Prepaid Rent receiving a Debit (DR) of $1,000 and a Credit (CR) of $1,000 would occur for Cash.

The adjusting journal entry would be recorded as follows (keep in mind there was an original entry made for the payment, example below):
Date Debit Credit
Sept 8 Rent Expense $1,000
      Prepaid Rent $1,000
      Adjust for rent

 

Unearned Revenues


When the company receives a payment for a good or service before they have actually provided the good/service, it is considered unearned revenue. Until the business provides the customer the good/service that is owed, it is considered a liability. For the receipt of cash that is unearned, a cash DR entry would be made and a CR would be entered for Unearned Revenue. As that good/service is sold to the customer, an entry will be made to recognize the transactions as they occur; Unearned Revenue will receive a debit, and Goods/Service Revenue will be credited.

 

Accrued Expenses


An accrued expense is the opposite of a prepaid expense. An expense is accrued when the business receives the expense, but has not yet paid. There are many expenses that are accrued, for example employee wages and utility expenses. Because wages continually increase by day (until they are paid at their scheduled interval), it would require a lot of effort to make daily entries, so companies typically only accrue these expenses at the end of the month to capture what hasn't been paid out, and will be in the next period. For an accrued expense, i.e. wages, when closing the month a wages expense will be debited and wages payable will be credited. Once the expense is paid (in the next month) the wages expense will be debited and cash will be credited.
An additional example of an accrued expense is accrued interest. In some cases a company may take out a loan, where the interest is due annually. To account for this interest, it will be accrued until it is paid out. If the total interest for the year is $2,400, then each month $200 would be accrued adjust/account for this expense, for example:

Date Debit Credit
Sept 30 Interest Expense $200
      Interest Payable $200
      Interest expense accrual

 

Accrued Revenues


Accrued revenues occur when payment hasn't been received for a service/good that has been provided to a customer. Because Accrual Basis accounting dictates that each transaction is recorded as it occurs, it must be recorded when a company provides a good or service, even if they haven't been paid for it yet. This is particularly important with adjusting entries and closing a period (ie. month end closing). If this entry isn't made, then the Financial Statements would be understated; Accounts Receivable and Service Revenue. For a good/service that has been provided, but cash hasn't been received, Cash would be debited and Accounts Receivable would be credited.

It is IMPORTANT to take these additional points into consideration:
Keeping in mind that a transaction is recorded when it occurs, if it has not been completed at the time of closing a period (the end of a reporting period i.e. Month End), an adjusting entry must be made.

 

Adjusting Entry Examples


The Original Transaction (when it occurs) will look like the following for a Prepaid transaction. This assumes an annual prepaid expense of $60,000 was paid for rent
Date Debit Credit
Sept Prepaid Rent $60,000
      Cash $60,000
      Rent paid in advance


An Adjusting Entry for this rent expense will be made like the following, keeping in mind, for this particular example periods are monthly (so $60,000/12 months = $5,000 a month):
Date Debit Credit
Sept 31 Rent Expense $5,000
      Prepaid Rent $5,000
      adjustment for rent


***There are two rules that exist for Accruals in adjusting entries:
1. The Cash account will never be part of an adjusting entry.
2. Either the Revenue Account will increase (credit) or the Expense Account will increase (debit).
Date Debit Credit
Sept 31 Wages Expense $10,000
      Wages Payable $10,000
      Accrual of upaid wages

**once this is paid in the next period, then the transaction will be recorded to account for the payment of the wages (wages payable will be debited), and the cash account will be credited for the amount paid-- in the example above it would be $10,000.

For additional information, also see accounting tools article on adjusting entries.