What Are Adjusting Entries?
Adjusting entries are special journal entries made at the end of an accounting period to ensure that income and expenses are recorded in the correct period. These entries help keep financial records accurate and in line with the accrual basis of accounting.
In simple terms, adjusting entries update the accounting books to reflect any revenues that have been earned or expenses that have been incurred, even if no money has changed hands yet.
Without these adjustments, financial statements may present an incorrect picture of a business’s financial health.
Why Are Adjusting Entries Important?
Adjusting entries are necessary because businesses use the accrual method of accounting. This method records income when it is earned and expenses when they are incurred, regardless of when cash is received or paid.
Here are a few reasons why adjusting entries matter:
- They make sure revenues are matched with the expenses that helped generate them.
- They keep financial statements accurate and trustworthy.
- They comply with accounting standards like Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).
- They provide a realistic view of the company’s financial condition.
When Are Adjusting Entries Made?
Adjusting entries are usually made at the end of each accounting period—monthly, quarterly, or annually. They are part of the closing process, which prepares the books for the next period.
These entries are essential before preparing the trial balance and final financial statements. They ensure that every account reflects the correct amount for that period.
Types of Adjusting Entries
There are five common types of adjusting entries. Each has a specific purpose in making the books accurate.
1. Accrued Revenues
These are revenues that have been earned but not yet recorded or received. For example, if a company provided services at the end of December but won’t bill the client until January, it should record the revenue in December.
2. Accrued Expenses
These are expenses that have been incurred but not yet paid or recorded. For instance, if a company owes salaries to employees at the end of the month but pays them in the next month, the expense still needs to be recorded in the current period.
3. Deferred Revenues
Also known as unearned revenues, these are payments received before services are provided. A good example is a magazine subscription where the customer pays in advance. Revenue should be recognized only as each issue is delivered.
4. Deferred Expenses
Also known as prepaid expenses, these are costs paid in advance for services to be used in future periods. For example, if rent is paid for the next six months, only one month’s rent should be recognized as an expense in the current period.
5. Depreciation
This is the allocation of the cost of a fixed asset over its useful life. Depreciation spreads out the expense so that each accounting period reflects part of the asset’s cost.
Examples of Adjusting Entries
Let’s walk through a few basic examples to understand how adjusting entries work.
Example 1: Accrued Revenue
A company completes a project on December 30 for $2,000 but will invoice the client on January 5. Even though the cash will be received later, the revenue should be recorded in December:
- Debit Accounts Receivable $2,000
- Credit Service Revenue $2,000
Example 2: Prepaid Expense
A business pays $1,200 for a 12-month insurance policy in advance. At the end of the first month, only one month of insurance has been used:
- Debit Insurance Expense $100
- Credit Prepaid Insurance $100
How Adjusting Entries Affect Financial Statements
Adjusting entries help update the income statement and the balance sheet. They ensure:
- Revenues are not overstated or understated
- Expenses are correctly matched with the revenues they helped generate
- Assets and liabilities reflect the actual situation
These updates are essential for stakeholders, including management, investors, and auditors, who rely on accurate financial information.
Common Mistakes to Avoid
While adjusting entries are straightforward in concept, they can be easy to overlook. Here are a few common mistakes to watch out for:
- Forgetting to record revenue earned but not yet invoiced
- Missing unpaid expenses like utilities or wages
- Not adjusting prepaid items like insurance or rent
- Skipping depreciation entries for fixed assets
Careful end-of-period review and the use of checklists can help avoid these errors.
Role of Adjusting Entries in the Accounting Cycle
Adjusting entries are a vital step in the accounting cycle, which includes:
- Recording transactions in journals
- Posting to the ledger
- Preparing a trial balance
- Making adjusting entries
- Preparing adjusted trial balance
- Preparing financial statements
- Closing the books
Adjusting entries come in at step four and must be completed before the financial reports are finalized.
Are Adjusting Entries Manual or Automatic?
In small businesses, adjusting entries is often done manually. In larger companies, accounting software may automate some adjustments like depreciation or prepaid expenses.
Even with automation, it is essential to review all entries for accuracy, especially those involving human judgment like estimated expenses or partially completed work.
Final Thoughts
Adjusting entries play a silent but critical role in the accounting process. They are the behind-the-scenes actions that bring accuracy and completeness to financial reporting.
Without these entries, a company’s books could reflect outdated or incomplete information. Revenue might appear too high or too low. Expenses might not reflect what the business has truly used or incurred.
For any business that uses accrual accounting, adjusting entries are not just optional—they are essential. They are what transform raw records into meaningful financial reports that can guide better decisions.
