Adjusting journal entries (AJEs) are one of the most fundamental concepts in accounting, and they appear throughout the FAR section of the CPA Exam. Whether you are working through a revenue recognition problem, a balance sheet question, or a full set of financial statements, adjusting entries are almost always lurking in the background. Many candidates underestimate this topic because it feels basic, but the exam tests it in ways that require genuine understanding, not just memorization.
This guide covers the major categories of adjusting entries, explains the timing and recognition principles behind each one, and highlights the specific patterns the CPA Exam tests most frequently. If you can master adjusting entries, you will have a stronger foundation for virtually every other topic on FAR.
Why Adjusting Entries Exist
Adjusting entries exist because of accrual accounting. Under the cash basis, you record transactions when cash changes hands. Under the accrual basis (which GAAP requires), you record revenues when earned and expenses when incurred, regardless of when cash is received or paid. The gap between cash activity and economic activity creates the need for adjustments.
At the end of each accounting period, a company must review its accounts and make adjusting entries to ensure that revenues and expenses are recognized in the correct period. Without these adjustments, the financial statements would not accurately reflect the company's financial position or performance.
Adjusting entries share several characteristics:
- They are made at the end of an accounting period.
- They always involve at least one income statement account and at least one balance sheet account.
- They never involve cash. If cash is part of the entry, it is not an adjusting entry.
- They are required by accrual accounting to properly match revenues with expenses.
The Four Categories of Adjusting Entries
Adjusting entries can be organized into four categories. Understanding these categories makes it much easier to identify when an adjustment is needed and what the entry should be.
1. Accrued Revenues (Revenue Accruals)
Accrued revenues are revenues that have been earned but not yet received in cash and not yet recorded. The company has provided goods or services but has not yet billed or collected from the customer.
The adjusting entry:
Debit: Accounts Receivable (or Interest Receivable, etc.)
Credit: Revenue (or Interest Revenue, etc.)
Common examples tested on the CPA Exam:
- Accrued interest revenue - Interest earned on notes receivable or investments that has not yet been received.
- Accrued service revenue - Services performed but not yet billed at the end of the period.
- Accrued rent revenue - Rent earned but not yet received from tenants.
2. Accrued Expenses (Expense Accruals)
Accrued expenses are expenses that have been incurred but not yet paid in cash and not yet recorded. The company has received the benefit of a service or has an obligation, but the payment has not been made.
The adjusting entry:
Debit: Expense
Credit: Accrued Liability (or Wages Payable, Interest Payable, etc.)
Common examples tested on the CPA Exam:
- Accrued wages - Employees have worked but have not yet been paid as of the end of the period. The exam often gives a payroll cycle that straddles the period end.
- Accrued interest expense - Interest incurred on notes payable or bonds that has not yet been paid.
- Accrued utilities - Utility services received but not yet billed or paid.
- Accrued income taxes - Taxes owed but not yet paid.
3. Deferred Revenues (Unearned Revenue)
Deferred revenues arise when a company receives cash before earning the revenue. The cash has been collected, but the performance obligation has not yet been satisfied. Until the revenue is earned, it is recorded as a liability (unearned revenue).
The initial entry when cash is received:
Debit: Cash
Credit: Unearned Revenue (liability)
The adjusting entry at period-end to recognize the earned portion:
Debit: Unearned Revenue
Credit: Revenue
Common examples tested on the CPA Exam:
- Magazine subscriptions - Cash received upfront for a 12-month subscription. Revenue is earned monthly as magazines are delivered.
- Advance rent collections - Tenant pays several months of rent in advance.
- Gift cards - Cash received when the card is purchased; revenue recognized when the card is redeemed.
- Retainers - Professional service firms receiving payment before services are rendered.
4. Deferred Expenses (Prepaid Expenses)
Deferred expenses arise when a company pays cash before incurring the expense. The cash has been paid, but the benefit has not yet been consumed. Until the benefit is used, the prepayment is recorded as an asset.
The initial entry when cash is paid:
Debit: Prepaid Expense (asset)
Credit: Cash
The adjusting entry at period-end to recognize the consumed portion:
Debit: Expense
Credit: Prepaid Expense
Common examples tested on the CPA Exam:
- Prepaid insurance - A 12-month policy paid in advance. Each month, one-twelfth is expensed.
- Prepaid rent - Rent paid in advance for future months.
- Supplies - Supplies purchased in bulk. The consumed portion is expensed; the unused portion remains as an asset.
Depreciation as an Adjusting Entry
Depreciation is a special type of adjusting entry that deserves its own discussion because of how frequently it is tested. Depreciation allocates the cost of a tangible long-lived asset over its useful life.
The adjusting entry:
Debit: Depreciation Expense
Credit: Accumulated Depreciation
The exam tests various depreciation methods, including straight-line, double-declining balance, sum-of-the-years-digits, and units-of-production. For adjusting entry purposes, the critical concept is that depreciation must be recorded at the end of each period to ensure assets are not overstated and expenses are properly recognized.
Key points the exam tests:
- Partial-year depreciation when assets are acquired mid-year.
- Changes in depreciation estimates (remaining book value over remaining useful life).
- Depreciation of assets with a residual value (cost minus residual value is the depreciable base).
- Accumulated depreciation as a contra-asset that reduces the carrying amount of the asset.
Common Exam Patterns for Adjusting Entries
The CPA Exam tests adjusting entries in several predictable patterns:
Pattern 1: Calculate the Adjusting Entry Amount
The question gives you the original transaction and the period-end date, then asks for the adjusting entry amount. For example, a six-month insurance policy purchased on October 1 for a calendar-year company. At December 31, three months have been consumed, so three-sixths (or one-half) of the premium is expensed.
Pattern 2: Determine the Correct Account Balance
The question asks for the correct balance in Prepaid Insurance or Unearned Revenue at period-end after the adjusting entry. You need to calculate the original balance, subtract the portion that has been earned or consumed, and report the remaining balance.
Pattern 3: Error Correction
The question tells you an adjusting entry was not made or was made incorrectly, then asks how the omission affects net income, total assets, or total liabilities. These questions test your understanding of the dual effect of adjusting entries on the income statement and balance sheet simultaneously.
Pattern 4: Reversing Entries
Reversing entries are optional entries made at the beginning of the next period that reverse the previous period's accruals. They simplify the recording of subsequent cash transactions. The exam occasionally asks about the purpose or effect of reversing entries, particularly for accrued expenses and accrued revenues.
Effects of Omitting Adjusting Entries
The exam frequently tests the consequences of failing to record an adjusting entry. Here is a framework for analyzing these questions:
- Omitting an accrued revenue: Revenues understated, assets (receivables) understated, net income understated, retained earnings understated.
- Omitting an accrued expense: Expenses understated, liabilities understated, net income overstated, retained earnings overstated.
- Omitting a deferred revenue adjustment: Revenues understated, liabilities (unearned revenue) overstated, net income understated, retained earnings understated.
- Omitting a prepaid expense adjustment: Expenses understated, assets (prepaid) overstated, net income overstated, retained earnings overstated.
- Omitting depreciation: Expenses understated, assets overstated (accumulated depreciation too low), net income overstated, retained earnings overstated.
Exam strategy: For these questions, write out the journal entry that should have been made. Then determine how each account is affected. If the entry was not made, the debit account is understated and the credit account is understated. Trace those effects to the financial statements.
Tips for Mastering Adjusting Entries
- Always identify the category first. Is it an accrued revenue, accrued expense, deferred revenue, or deferred expense? Knowing the category tells you the structure of the entry.
- Remember: adjusting entries never involve cash. If you find yourself debiting or crediting cash, you are making a regular entry, not an adjusting entry.
- Draw a timeline. For problems involving partial periods, draw a timeline showing the start date, the period-end date, and the total time span. This prevents calculation errors.
- Practice the error-correction pattern. Write the correct entry, compare it to what was recorded (or not recorded), and trace the effects on the financial statements.
- Understand reversing entries conceptually. You do not need to memorize when they are used. Just know they reverse accruals to simplify subsequent entries.
Connecting Adjusting Entries to Other FAR Topics
Adjusting entries are not an isolated topic. They connect to virtually every other area of FAR:
- Revenue recognition (ASC 606) requires adjusting entries for deferred and accrued revenue.
- Depreciation adjustments connect to long-lived asset accounting.
- Accrued interest connects to bond and note payable accounting.
- Bad debt expense connects to receivable accounting.
- Prepaid and accrual adjustments affect the statement of cash flows under the indirect method.
By mastering adjusting entries, you build a stronger foundation for all of these related topics.
Final Thoughts
Adjusting journal entries may seem like a basic topic, but the CPA Exam tests them in ways that require genuine understanding. Candidates who treat adjusting entries as a review topic and move on too quickly often miss points they should have earned. Take the time to work through each category, practice the calculation patterns, and understand the effects of omissions.
Think CPA provides targeted practice on adjusting entries that tests your understanding from multiple angles, including calculation questions, account balance questions, and error-correction scenarios. Our detailed explanations show you not only the correct answer but the reasoning process, helping you build the kind of conceptual understanding that carries over to every other area of the exam.
Get the fundamentals right, and the rest of FAR becomes that much easier. Adjusting entries are the foundation. Make sure yours is solid.