Adjusting Entry

An adjusting entry is a journal entry made in a company's general ledger at the end of an accounting period to record revenues and expenses that have not yet been recorded. Think of it as a financial “true-up.” The business world doesn't stop neatly on the last day of the month or year. Bills arrive later, customers pay early, and services are rendered over long periods. Adjusting entries are the accounting magic that ensures a company's financial statements accurately reflect what actually happened during that specific period, regardless of when cash changed hands. This practice is the cornerstone of the accrual basis of accounting, which is far more realistic than simply tracking cash in and out. By making these adjustments, companies adhere to two golden rules of accounting: the revenue recognition principle (book revenue when it's earned) and the matching principle (match expenses to the revenues they helped generate).

For a value investor, understanding adjusting entries is like having a secret decoder ring for financial statements. These entries are the difference between a blurry, distorted snapshot of a company and a crystal-clear, high-resolution photograph. Without them, a company that collected a huge upfront payment for a two-year project would look incredibly profitable in one quarter and then inexplicably unprofitable for the next seven, even while doing the same amount of work. Adjusting entries ensure that the income statement reflects the true profitability for the period and the balance sheet presents an accurate picture of the company's assets and liabilities. Digging into the nature and size of a company's adjustments can reveal the quality of its management and its earnings. Are the adjustments reasonable and consistent, or are they aggressive and designed to paint a deceptively rosy picture? Spotting these nuances is a key part of the financial detective work required to uncover a company's true intrinsic value and avoid potential red flags.

Adjusting entries generally fall into two major categories—accruals and deferrals—which are then split into revenues and expenses.

Accruals record revenues or expenses that have been earned or incurred but haven't yet been reflected in the cash accounts.

• Accrued Revenues: This is revenue that has been earned, but the cash hasn't been received yet. Imagine a marketing agency that completes a campaign for a client in December but, per the contract, won't send the invoice until January. The agency must make an adjusting entry to record that revenue in its December financial statements because that's when the work was done and the revenue was earned.
• Accrued Expenses: This is an expense that the company has incurred, but hasn't paid for yet. The classic example is employee wages. If a company's pay period ends a few days after the month does, it must make an adjusting entry to record the wages expense for the last few days of the month, even though the paychecks won't be cut until the next month. This ensures the expense is matched to the period in which the employees' work helped generate revenue.

Deferrals are the opposite of accruals. Here, the cash has already changed hands, but the revenue or expense is recognized over time.

• Deferred Revenues (or Unearned Revenues): This happens when a company receives cash from a customer for goods or services it has yet to provide. Think of a software company that sells a yearly subscription. When it receives the full payment on January 1st, it can't book all of it as revenue immediately. Instead, it records the cash and a liability called unearned revenues. Then, through an adjusting entry at the end of each month, it recognizes 1/12th of the subscription fee as revenue.
• Deferred Expenses (or Prepaid Expenses): This occurs when a company pays for something that it will use up over time. A common example is an insurance policy. A company might pay for a full year of insurance coverage upfront. This payment creates an asset on the balance sheet called a prepaid expense. Each month, an adjusting entry is made to “expense” one month's worth of the insurance premium, reducing the prepaid asset accordingly.

While routine, adjusting entries can also be a place where companies engage in earnings management. A savvy investor knows what to look for.

A company should handle its adjustments in a consistent manner year after year. If you suddenly see a massive change in the way it accrues for bad debt or recognizes revenue, it’s worth asking why. Is there a legitimate business reason, or is the company trying to manipulate its earnings to meet a quarterly target?

Be wary of a company that reports a large and sudden increase in accrued revenues, especially near the end of a quarter. This could be a sign that management is aggressively booking revenue for deals that are not yet finalized, a practice known as “channel stuffing” or pulling sales forward.

This is the ultimate litmus test for a value investor. A healthy company's net income and cash flow from operations should trend together over the long term. If a company consistently reports strong profits but weak operating cash flow, it may be due to aggressive accrual accounting. The “profits” are on the page, but the cash isn't in the bank. Always cross-reference the income statement with the statement of cash flows to make sure the earnings are backed by real cash.