Adjusting Entries – Chapter 3

Adjusting entries are needed so that the accounts reflect reality at the end of an accounting period.

The 3 Adjustment Steps:

What is the current account balance?
👉 Example: Prepaid Insurance is $2,400 (for 24 months).
What should the balance be?
👉 One month has passed → Only 23 months are left prepaid → $2,300.
Make the adjusting entry
👉 Record the $100 used this month as Insurance Expense.

Dr. Insurance Expense $100
Cr. Prepaid Insurance $100

📦 Analogy: Think of a gym membership you paid for upfront. You slowly "use up" that membership every month. You need to update your books to reflect what’s used vs. what’s left.

🏢 Section 2: Prepaid Expenses

Prepaid = paid before the benefit is received
Originally recorded as Assets (future benefits)
Over time, convert to Expenses as benefits are used

🧠 Mnemonic: "Prepaid becomes paid."

📈 Examples: Prepaid Rent, Prepaid Insurance, Supplies

🏗️ Section 3: Depreciation

Plant assets (like equipment) lose value over time, like how a new car depreciates the moment you drive it off the lot.

We don’t expense the full cost all at once — we spread it over time using depreciation.

📉 Straight-Line Depreciation Formula:

Annual Depreciation = (Asset Cost − Salvage Value) / Useful Life

Example: $2,400 asset, 0 salvage value, 2 years = $100/month

📦 Like eating a cake slice by slice over a month instead of stuffing it all on day one.

🧾 Section 4: Unearned Revenue

Cash is received before services are performed
Initially recorded as a Liability (you owe the service)
Becomes Revenue as you fulfill the service

📦 A customer pays for a magazine subscription upfront. Each month you deliver a magazine, you "earn" part of that cash.

🧾 Section 5: Accrued Expense

You incur an expense now but haven’t paid it yet.

Example: Wages owed to employees at month-end

Dr. Expense
Cr. Liability

📦 It’s like running up a tab at a restaurant—you’ve already eaten, but haven’t paid.

💵 Section 6: Accrued Revenue

You earned revenue, but the customer hasn’t paid yet

Dr. Asset (like Accounts Receivable)
Cr. Revenue

📦 You fixed a client’s car, but they haven’t paid yet—you still count it as income.

🔄 Summary Table

Type	Description	Adjusting Entry	Fixes This Mistake
Deferral (Expense)	Paid cash before using it	Dr. Expense, Cr. Asset	Expense was understated
Deferral (Revenue)	Received cash before earning it	Dr. Liability, Cr. Revenue	Revenue was understated
Accrual (Expense)	Used but not yet paid	Dr. Expense, Cr. Liability	Expense was understated
Accrual (Revenue)	Earned but not yet received	Dr. Asset, Cr. Revenue	Revenue was understated

🛠️ Section 1: The 3 Steps to Make Adjustments