Learn It
Cash does not always move at the same time as the expense or revenue it relates to. Sometimes the business pays before it uses something. Sometimes it earns revenue before it receives the cash. Sometimes it owes money it has not yet paid.
As we saw in Cash Basis vs. Accrual Basis, earning money is not always the same as receiving cash. This lesson takes that idea further. The bookkeeper must ask two questions:
AND
"When was the income earned or the expense used?"
When the answers are different, an adjusting entry is needed at the end of the period to make the books match what actually happened.
Four Types of Timing Differences
1. Prepaid Expenses
The business pays for something before it uses it. Insurance, rent, and subscriptions paid in advance are common examples. The payment is recorded as an asset (like Prepaid Insurance). Each month, the portion that has been used moves to expense.
Timeline: Pay cash → record asset → use it over time → move to expense each month
2. Accrued Expenses
The business has used something but has not yet paid for it. Wages earned by employees but not yet paid are the most common example. The expense is recorded now, and a liability is created. When the payment is made later, the liability is reduced.
Timeline: Use the service → record expense + liability → pay cash later → reduce liability
3. Accrued Revenue
The business has earned revenue but has not yet billed or received payment. For example, a service business completes work but has not sent the invoice yet. The revenue is recorded now, and an asset (Accounts Receivable) is created.
Timeline: Complete the work → record revenue + receivable → invoice and collect later → reduce receivable
4. Deferred (Unearned) Revenue
The business receives cash before it has earned it. A customer deposit or advance payment is a common example. The cash is recorded as a liability (Unearned Revenue) because the business owes the customer the work. As the work is completed, the liability is reduced and revenue is recognized.
Timeline: Receive cash → record liability → complete the work → move to revenue
See It
Let's look at four examples and see the before-and-after accounting effect of each.
12 Months of Insurance Paid in Advance
On January 1, the business pays $12,000 for a full year of insurance.
| When | Cash | Prepaid Insurance | Insurance Expense |
|---|---|---|---|
| Jan 1 (payment) | ($12,000) | $12,000 | $0 |
| Jan 31 (adjustment) | $0 | $11,000 | $1,000 |
One month of insurance ($1,000) moves from the asset to the expense. $11,000 remains as a prepaid asset for the remaining 11 months.
Wages Earned But Not Yet Paid
By January 31, employees have earned $2,000 in wages. Payday is February 5.
| When | Wage Expense | Accrued Wages Payable | Cash |
|---|---|---|---|
| Jan 31 (adjustment) | $2,000 | $2,000 | $0 |
| Feb 5 (payday) | $0 | $0 | ($2,000) |
The expense is recorded in January when it was earned. The liability is cleared in February when cash is paid.
Work Completed But Not Yet Invoiced
By January 31, the business has completed $1,500 of work but has not sent the invoice yet.
| When | Accounts Receivable | Service Revenue |
|---|---|---|
| Jan 31 (adjustment) | $1,500 | $1,500 |
The revenue is earned, so it is recognized now. The receivable will be cleared when the customer pays.
Customer Deposit Received Before Work Is Done
A customer pays $3,000 in advance. By January 31, $1,000 of work has been completed.
| When | Cash | Unearned Revenue | Service Revenue |
|---|---|---|---|
| Deposit received | $3,000 | $3,000 | $0 |
| Jan 31 (adjustment) | $0 | $2,000 | $1,000 |
$1,000 of the deposit is now earned revenue. $2,000 remains as a liability — the business still owes that work.
Why Adjusting Entries Are Necessary
Without adjusting entries, the books would only reflect cash movement. A month where the business paid $12,000 for insurance would look like a terrible month — even though that insurance covers the entire year. A month where the business received a $3,000 deposit would look like a great month — even though no work has been done yet.
Adjusting entries fix this. They make sure each month's profit reflects what actually happened that month — not just when cash moved. This is what makes accrual-basis bookkeeping more accurate than cash-basis for understanding how a business is really doing.
Do It
Complete the month-end adjustment worksheet. For each situation, enter the amounts and construct the adjusting journal entry.
Do It — Month-End Adjustment Worksheet
Four situations need month-end adjusting entries. For each one:
- Enter the amount used or earned this month
- Enter the amount remaining (for prepaids and deferred revenue)
- Construct the adjusting journal entry — select the accounts and type the debit and credit
For accrued wages and accrued revenue, there is no original prepaid amount — the full amount is being recognized this month.
1Prepaid Insurance: $12,000 paid on Jan 1 for 12 months. It is now Jan 31. Record one month of insurance expense.
$12,000
| Account | Debit | Credit |
|---|---|---|
$ | — | |
| — | $ |
2Accrued Wages: Employees earned $2,000 in wages by Jan 31. Payday is Feb 5. Record the wages owed at month-end.
$0 (none yet)
| Account | Debit | Credit |
|---|---|---|
$ | — | |
| — | $ |
3Accrued Revenue: The business completed $1,500 of work by Jan 31 but has not yet invoiced the customer. Record the earned revenue.
$0 (none yet)
| Account | Debit | Credit |
|---|---|---|
$ | — | |
| — | $ |
4Deferred Revenue: A customer paid $3,000 in advance. By Jan 31, $1,000 of work has been completed. Record the revenue earned.
$3,000
| Account | Debit | Credit |
|---|---|---|
$ | — | |
| — | $ |
Prove It
Answer each question, then read the explanation. There's no score — this is just to help the ideas stick.
Question 1
A business pays $12,000 for 12 months of insurance on January 1. What is recorded on January 1?
Question 2
Employees have earned $2,000 in wages by the end of the month, but payday is the 5th of next month. What adjusting entry is needed at month-end?
Question 3
A customer pays $3,000 in advance for work that has not yet been completed. How should this be recorded?
Ready for more than a short exercise?
This exercise isolates four adjusting entries with the information clearly laid out. Real bookkeeping requires you to identify which accounts need adjustment, calculate the correct amounts from supporting documents, and make these decisions among dozens of accounts. QBO Dojo practice clients let you apply these skills across realistic business activity inside QuickBooks Online.
Explore QBO Dojo Practice ClientsKey Takeaways
- Prepaid expenses: pay first, record as asset, move to expense as used.
- Accrued expenses: use first, record expense and liability, pay later.
- Accrued revenue: earn first, record revenue and receivable, collect later.
- Deferred revenue: receive cash first, record liability, move to revenue as earned.
- Adjusting entries match expenses and revenue to the correct period.
- The question is not only when cash moved — but when the income was earned or the expense was used.