What it means
During a period, bookkeeping records what happens: invoices go out, bills come in, cash moves. But at the period end several things are true that no document yet shows.
Staff have earned wages not yet paid. Insurance paid last quarter has partly expired.
A customer who paid a year in advance has now received two months of service. Equipment has aged.
Adjusting entries capture each of these so the income statement shows the right revenue and expenses and the balance sheet shows the right assets and liabilities. There are five common types.
Accrued expenses record costs incurred but unbilled (debit expense, credit accrued liability). Accrued revenue records income earned but unbilled (debit receivable, credit revenue).
Prepaid expense adjustments move the used portion of a prepayment from the balance sheet to the income statement (debit expense, credit prepayment). Deferred revenue adjustments move earned amounts from the liability to revenue (debit deferred revenue, credit revenue).
Depreciation and amortization spread asset costs (debit expense, credit accumulated depreciation). Estimates such as bad debt provisions and inventory write-downs are also adjusting entries.
Every adjusting entry affects one income statement account and one balance sheet account, and none of them involves cash. That is the test: if an entry moves cash, it is a normal transaction, not an adjustment.
Many adjusting entries are reversed on the first day of the next period so that the eventual invoice or receipt can be recorded normally without double counting. Adjusting entries are where accounting judgement lives and where errors and manipulation hide.
An accrual that is too small overstates profit; a prepayment released too slowly does the same. Well-run finance teams keep a standard month-end checklist of adjustments, document the basis for each estimate and review the entries independently before closing the period.
In practice
Real-world examples.
Example
A gym that sells annual memberships adjusts deferred revenue each month, moving one twelfth of each membership into revenue as the service is delivered.
Example
A manufacturer records an adjusting entry at year end to write inventory down to net realisable value after finding that a product line has become obsolete.
Example
A landlord accrues rent receivable for a tenant whose quarterly payment falls after the period end.
Think of it
“Adjusting entries are like updating your GPS before a trip-they make sure everything is current and accurate before you proceed.
Formula
Calculation
Adjusted Balance = Unadjusted Balance plus or minus Adjusting Entry
Worked example. A consultancy's unadjusted trial balance at 31 December shows revenue of $900,000 and expenses of $650,000, a profit of $250,000. The accountant identifies these adjustments:
1. Work performed in December but not yet invoiced: $40,000. Debit accrued revenue $40,000, credit revenue $40,000.
2. A client paid $60,000 in November for a six-month project; two months are now complete. The whole $60,000 was recorded as revenue. Debit revenue $40,000, credit deferred revenue $40,000.
3. Annual insurance of $18,000 paid on 1 October was recorded entirely as expense. Nine months remain. Debit prepayments $13,500, credit insurance expense $13,500.
4. December salaries of $30,000 will be paid on 5 January. Debit salaries expense $30,000, credit accrued expenses $30,000.
5. Depreciation on equipment for the year: $22,000. Debit depreciation expense $22,000, credit accumulated depreciation $22,000.
6. A customer owing $8,000 has gone into liquidation. Debit bad debt expense $8,000, credit accounts receivable $8,000.
Adjusted revenue = $900,000 + $40,000 minus $40,000 = $900,000
Adjusted expenses = $650,000 minus $13,500 + $30,000 + $22,000 + $8,000 = $696,500
Adjusted profit = $900,000 minus $696,500 = $203,500
The adjustments reduced reported profit by $46,500. The balance sheet now also shows accrued revenue, deferred revenue, prepayments, accrued expenses and a higher accumulated depreciation that the unadjusted books had missed entirely.Case study
Seen in the real world.
A software reseller's bookkeeper prepared monthly accounts straight from the bank and sales ledgers with no adjusting entries. The company sold annual support contracts and recorded each one as revenue in full when invoiced, and paid its own annual software licences in a single month each year. Results were meaningless: the month in which most contracts renewed showed a huge profit, the month in which licences were paid showed a huge loss, and the owner made hiring decisions on the strength of the good months.
When a prospective investor's accountant restated the accounts with proper adjustments, deferring contract revenue over twelve months and spreading licence costs, the business turned out to be marginally profitable rather than strongly so, and two of the recent hires could not be justified. The company introduced a month-end close with a standard set of adjusting entries; the investment went ahead a year later on the basis of accounts both sides could trust.
Watch out
Common mistakes.
- Recording an adjusting entry that involves cash. Adjustments never touch cash; if cash moved, it is an ordinary transaction.
- Forgetting to reverse accruals, leading to double-counted expenses when the invoice arrives.
- Making adjustments only at year end. Monthly adjustments give reliable management accounts and a painless year-end close.
Questions
People also ask.
What is the difference between adjusting entries and closing entries?
Adjusting entries update balances before the statements are prepared. Closing entries transfer revenue and expense balances to retained earnings after the statements are prepared, resetting them for the next period.
Do adjusting entries affect cash flow?
No. They affect profit and balance sheet items but not cash, which is why the cash flow statement adds them back.
Who reviews adjusting entries?
In a well-controlled business, someone other than the person who prepared them. Auditors also test the largest and most judgemental ones.
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