People are often confused about why we adjust journal entries before creating our income statement. To understand what adjusted journal entries are and why we check them, visit our blog post on this topic.
When we go to make adjustments, there are four types of adjustments we typically do: Deferred Revenue, Deferred Expense, Accrued Revenue, and Accrued Expenses. If we don’t make these adjustments, we risk either overstating or understating figures on our balance sheet or income statement.
Deferred Revenue occurs when we promise customers a service or goods in exchange for cash, like gift cards. Deferred Expense happens when a company pre-pays or buys something, like a building, which incurs expenses over time. This erodes the asset’s value, documenting the expense as time progresses from one accounting period to another. Wondering what accounting periods are? Check out our blog post titled "Accounting Periods Explained." Accrued Revenue is when we have already delivered a service but are waiting for payment, usually in the next quarter, such as in consulting services. Accrued Expenses are expenses that have been incurred but not paid by the company until the next quarter, like wages payable or interest payable from loans.
We’ve broken this down into simple explanations below, along with a table to help remember the effects that occur when we fail to make these adjustments.
Deferred Reveune
When customers buy a gift card for $100 in cash. The company is promising goods or services in exchange for that gift card later on equivlanet to $100. This is written down as defferred reveune or (Unearned reveune) specifically.
This unearned revenue is a liability because its a promise to perform or derliver goods in the future. Unearned revenue cannot appear as sales reveune for the period until the service is delivered.
So let’s say Company XYZ has $50 in gift cards and derlivered $25 in gift cards. we have to adjust the entry. if we don’t adjusted the entry we overstating our liability i.e. unearned reveune is overstated and the revenue is understated because we derlivered the service. So our stockholders equity is understand also because of the understated revenue on net income.
So we Debit Unearned revenve and credit sales revenue. So liability goes down. Reveune goes up and so does Stockholders equity goes up.
Examples:
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Subscription Revenue Deferred: A company sells annual subscriptions for its services. During December, they receive $6,000 from customers for subscriptions that will be fulfilled evenly over the next 12 months. At December 31, there’s a deferred revenue liability of $6,000.
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Advance Customer Payments: A software company receives an upfront payment of $4,000 for a custom software project that will be completed over the next three months. At December 31, there’s a deferred revenue liability of $4,000.
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Gift Card Sales: A retail store sells gift cards worth $1,500 during the holiday season. These gift cards can be redeemed by customers at any time in the future. At December 31, there’s a deferred revenue liability of $1,500.
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Magazine Subscription Revenue Deferred: A magazine publisher sells annual subscriptions to its magazine. During December, they receive $800 from customers for subscriptions that will start in January and continue throughout the year. At December 31, there’s a deferred revenue liability of $800.
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Conference Registration Fees: An organization hosts an annual conference and collects $10,000 in registration fees for an event scheduled for the following March. At December 31, there’s a deferred revenue liability of $10,000.
Deferred Expenses
Deferred Expenses are recording the expense of a asset that is deferred to the future. In simple terms as we use a asset over time it generates expense that expense is defered for the future. For example
Deferred Expense: if we don’t adjust the entry we are overstating our asset and our expense is understanded
- Supplies
- Buildings
- prepaid expenses
- prepaid insurance
- advertising
- rent
- equipment
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Office Supplies Expense Deferred: At the beginning of the year, the company had $450 worth of office supplies on hand from the previous year. As office supplies are used, their cost becomes an expense. So, the company has $450 of office supplies expense deferred at the start of the year.
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Prepaid Insurance: A company pays an annual insurance premium of $2,400 on January 1. At the end of the year, $2,000 of insurance coverage remains unused. This means there is $2,000 of prepaid insurance expense at year-end.
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Prepaid Rent: A business pays $12,000 in advance for a one-year lease on office space on January 1. At the end of the year, there are still 4 months left on the lease, which is equivalent to $4,000 in prepaid rent.
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Prepaid Advertising: A company pre-pays $6,000 for a 6-month advertising campaign that starts in June. At the end of the year (December), $3,000 of advertising expenses are deferred because they relate to the upcoming months.
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Prepaid Subscriptions: A magazine publisher receives $1,200 from subscribers for a one-year subscription on December 1. At the end of the year, only one month of the subscription has been fulfilled, so there’s $1,100 of prepaid subscription revenue that’s deferred.
Accrued Reveunes
Accrued Reveunes are when a company performs services or provides goods before being paid. For example
- Consulting Services
- Legal Services
- Advertising Agencies
- Subscription-based businesses (e.g., streaming services)
- Software as a Service (SaaS) companies
- Healthcare providers
- Construction companies
- Property management companies
- Event planning and management services
- Accounting and auditing firms
So for example if we made investments on short-term investments and we earn $100 as interest reveune before we will not reveive the cash until next quarter. We need to make a adjusted entry.
We debit 100 on account interest receivable, and credit 100 on interest reveune.
So if didn’t adjust the entry we would we would be overstating 100 on asset and revenue.
So for Accrued reveune if you already provided the service and have not been paid yet this is know as Accrued revenues.
Accrued Expense
Accrued expense adjustments are necessary when the company has incurred an expense but the cash will paid in the next period.
So its really basically if I read the electrictiy a utilities expense and I get the bill this period but pay it off next quarter we are getting accrued expense. if we don’t adjust understating our liabilites and expenses.
- Wages and Salaries
- Rent Expense
- Interest Expense
- Utilities
- Taxes
- Employee Benefits
- Professional Services
- Maintenance and Repairs
- Accrued Bonuses
- Supplier Invoices
Examples:
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Wages Accrual: Employees earned $3,500 in wages during December, unpaid and unrecorded at December 31.
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Rent Accrual: Monthly rent for office space is $2,000, and it’s due on the 1st of the following month, so at December 31, there’s an accrued rent expense of $2,000.
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Interest Accrual: A company has a loan with an annual interest rate of 5%. At December 31, the interest expense accrued on the outstanding loan balance of $50,000 is $2,500 for the month.
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Utilities Accrual: The company’s monthly utility bill for electricity and water is $500, and the bill comes at the end of the month. At December 31, there’s an accrued utilities expense of $500.
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Income Tax Accrual: A business expects to owe $10,000 in income taxes for the current tax year. However, the tax payment is not due until the following year. At December 31, there’s an accrued income tax liability of $10,000.
Failling to Make Adjustment Effects
| Adjustment Type | Effect of Failing to Adjust Entry |
|---|---|
| Deferred Reveune | if we don’t adjust the entry we are overstating our liability and the revenue is understated. |
| Deferred Expense | if we don’t adjust the entry we are overstating our asset and our expense is understanded |
| Accrued Reveunes | if we don’t adjust the entry we are understating our assets and reveune |
| Accrued Expneses | if we don’t adjust the entry we are understating our liability and expenses. |