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.
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.
In practice
Real-world examples
Example 1
Your software startup pays $6,000 upfront for a twelve-month cloud hosting contract in January. Because the service is used evenly across the year, you record a $500 adjusting entry at the end of each month to move a portion of that cost from prepaid expenses on the balance sheet to hosting expense on the profit and loss statement. By December, the full $6,000 has been recognised in the months it relates to, so monthly margins reflect the true cost of running the product.
Example 2
Your manufacturing firm completes a $48,000 bulk order for a client on 25 June, but the invoice is not issued until 2 July. Because the goods were delivered and the obligation was met in June, you record an adjusting entry that increases accounts receivable and sales revenue by $48,000 in June. Without this entry, June would understate revenue and July would appear to include income that was actually earned the month before.
Example 3
Your boutique hotel uses temporary agency staff throughout December. The agency invoice for $2,000 arrives in January, but the work was performed in December, so you record an accrued expense for that amount in December. This matches the winter staffing cost to the same month as the holiday guests who generated the revenue, so December's profit is measured correctly.
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
This is a fictional, illustrative scenario. Oakwood Design, a small graphic design agency, always paid its office rent quarterly in advance. In the past, the founder, Sarah, recorded the full $3,000 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 unrealistic profits, until a part-time finance manager introduced monthly adjusting entries.
When the $3,000 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 moved $1,000 each month from prepaid rent into rent expense. This simple shift transformed Oakwood's financial tracking. Sarah could finally see her true monthly operating 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.
The change also altered how Sarah judged her pricing. Once January's profit was no longer distorted by one large payment, she could see that a typical design project contributed about $4,000 of margin after direct labour. Her lender reviewed three months of consistent monthly statements. The expansion loan was approved because the figures showed steady performance rather than unexplained spikes.
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 finalised.
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.