What it means
In business, money does not always move at the same time work gets done. You might pay for a full year of insurance upfront, or complete a big project in March but only get paid in April.
To give a true and fair view of financial health, accounting rules require us to match revenues and expenses to the exact period they relate to, regardless of when cash is paid or received. This is known as accrual accounting.
Adjusting entries are the final tweaks made before closing the books for the month or year to fix these timing gaps. There are two main types of adjusting entries: deferrals and accruals.
Deferrals happen when cash moves before the work is done. For instance, paying rent in advance means you start with an asset, and each month you make an adjusting entry to shift a portion of that asset into an expense as you use the space.
Accruals happen when work is done before cash moves. A classic example is employee salaries.
If payday falls on the fifth of next month, you must record the wages earned in the current month using an adjusting entry so profits are not overstated. For non-finance managers, understanding adjusting entries is vital because they directly impact your reported profit and loss.
Without them, your monthly financial reports will bounce wildly based on when bills happen to be paid rather than when business actually took place. They ensure your reports are accurate, reliable, and compliant with standard accounting practices, helping you make better commercial decisions.
In practice
Real-world examples.
Example
Your software startup pays six thousand pounds upfront for a twelve-month cloud hosting contract. Each month, you record a five hundred pound adjusting entry to move that cost from prepaid expenses to operational expenses.
Example
Your manufacturing firm finishes a large bulk order for a client on the twenty-fifth of June, but issues the invoice on the second of July. You record an adjusting entry in June to log the revenue when the work was actually completed.
Example
Your boutique hotel uses temporary agency staff during December. The agency invoice for two thousand pounds arrives in January, so you record an adjusting entry in December to ensure the winter wage costs are matched to the correct month.
Think of it
“Imagine baking a cake for a party on Saturday, but you buy the ingredients on Tuesday and clean the kitchen on Sunday. An adjusting entry is like taking photos of the finished cake and placing them firmly in Saturday's diary, even though the prep and cleanup happened on different days.
Formula
Calculation
Adjusted Balance = Unadjusted Balance + Accrual (or - Deferral). Example: Unpaid utility bill at month-end = £300. Unadjusted electricity expense: £1,200. Adjusting Entry: Add £300 to expense and add £300 to liabilities (accounts payable). Adjusted electricity expense: £1,500.Case study
Seen in the real world.
Oakwood Design, a small graphic design agency, always paid its office rent quarterly in advance. In the past, the founder, Sarah, recorded the full three thousand pounds as an expense on the exact day she paid it in January. This meant January looked like a terrible loss-making month, while February and March showed massive, unrealistic profits.
After hiring a part-time finance manager, Oakwood implemented monthly adjusting entries. When the three thousand pound rent was paid in January, it was initially logged as an asset called prepaid rent. At the end of January, February, and March, an adjusting entry was processed to move one thousand pounds each month from prepaid rent into rent expense.
This simple shift transformed Oakwood's financial tracking. Sarah could finally see her true monthly operational costs, allowing her to spot cash flow trends, price her design projects accurately, and present reliable profit reports when applying for a business expansion loan.
Watch out
Common mistakes.
- Forgetting to reverse or update prepayments regularly, leading to assets being permanently overstated on the balance sheet.
- Making adjusting entries that involve exchanging physical cash, when these entries should exclusively deal with non-cash timing adjustments.
- Applying adjusting entries inconsistently each month, which distorts performance trends and ruins meaningful financial comparison.
Questions
People also ask.
Do adjusting entries involve physical bank transactions?
No. Adjusting entries deal purely with accounting adjustments for revenues and expenses. No cash moves during an adjusting entry.
When should adjusting entries be made?
They are typically prepared at the very end of an accounting period, such as monthly, quarterly, or annually, before financial statements are finalized.
Are adjusting entries required for small businesses?
Yes, if you use accrual accounting rather than cash-basis accounting. They are essential for accurate tax reporting and financial management.
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