What it means
Accrual accounting says revenue is recorded when it is earned and costs when they are incurred, not when the cash moves. Because day to day bookkeeping follows invoices and bank payments, the two rarely line up perfectly, and adjusting entries close the gap before the accounts are finalised.
There are four familiar families. Accrued expenses record costs incurred but not yet invoiced, accrued revenue records work done but not yet billed, prepayments spread a cost already paid across the periods it covers, and deferred revenue holds cash received in advance until the work is delivered.
Depreciation is usually treated as a fifth, recognising the use of an asset over time. Every adjusting entry touches at least one income statement account and one balance sheet account, and that is a useful check.
If your entry only moves two expense accounts around it is a reclassification, not an adjustment, because it does not change reported profit. The business consequence is credibility.
A month that shows a $40,000 profit only because December's rent, wages and utilities have not yet been posted is not a month anybody can plan from, and boards quickly lose trust in reporting that swings with invoice timing rather than trading. Most finance teams run a standing checklist so adjustments happen the same way every period: accrue known unbilled costs, release prepayments, recognise revenue earned on incomplete jobs, post depreciation and review any large cash receipts for deferral.
The checklist is what makes a close repeatable rather than heroic. One nuance often missed is the reversing entry.
Many accruals are reversed on the first day of the following period so that the real invoice, when it arrives, does not double count the cost, and forgetting to reverse is one of the more common causes of a mysteriously bad month.
In practice
Real-world examples.
Example
A marketing agency finishes a project on 28 March but does not invoice until 10 April. At month end it posts an accrual recognising $35,000 of revenue and a matching accrued income asset, so March shows the profit on work that March actually performed.
Example
A restaurant group receives its quarterly electricity bill six weeks after the quarter closes. Each month the controller accrues an estimated $9,000 based on meter readings, then reverses the accrual when the real bill arrives, so no single month absorbs a full quarter of energy cost.
Example
A training company takes $60,000 in January for a course running from March to May. The receipt is held as deferred revenue and released at $20,000 a month across the three delivery months, keeping January's profit from being flattered by cash the company has not yet earned.
Formula
Calculation
Period expense from a prepayment = total amount paid x (months of cover used / total months covered).
A consultancy pays $24,000 on 1 July for twelve months of professional indemnity insurance, and initially records the whole amount as a prepaid expense, which is an asset. At the 31 December year end, six months of cover has been used.
Expense for the period = $24,000 x (6 / 12) = $12,000, which is $2,000 per month.
The adjusting journal entry is: debit insurance expense $12,000, credit prepaid insurance $12,000.
After posting, the income statement carries $12,000 of insurance cost for the six months actually covered, and the balance sheet still shows $24,000 - $12,000 = $12,000 of prepaid insurance as an asset representing the cover running from January to June.Case study
Seen in the real world.
Halden Interiors is a fictional commercial fit-out firm presented here as an illustrative case. Its monthly management accounts bounced between a $70,000 profit and a $50,000 loss with no obvious change in activity, and the board began to distrust every number it saw.
The new financial controller found that subcontractor costs were only recorded when invoices arrived, often two months after the work, while customer invoices went out on completion. Months with heavy invoicing looked excellent and the following months looked disastrous. She introduced a monthly accrual for unbilled subcontractor work based on site progress reports, a prepayment schedule for insurance and software, and reversing entries on the first of each month.
Within a quarter the fictional swing in monthly profit narrowed to roughly $12,000, and the pattern finally matched what the site managers were reporting. Nothing about the business had changed; only the timing of recognition had been corrected.
Watch out
Common mistakes.
- Posting an adjustment that touches only balance sheet accounts or only income accounts. A genuine adjusting entry always affects both sides, and one that does not is a reclassification.
- Forgetting to reverse accruals in the following period. When the real invoice lands the cost is counted twice, which quietly destroys the next month's reported profit.
- Treating cash received in advance as revenue. Money for work not yet delivered belongs in deferred revenue, and recognising it early overstates both profit and the health of the pipeline.
Questions
People also ask.
Do small businesses on a cash basis need adjusting entries?
Far fewer, but even cash-basis businesses usually make some, particularly for depreciation and for prepayments spanning a year end.
When should adjusting entries be posted?
Before the books are closed for the period and before management accounts are issued, since their whole purpose is to make those accounts accurate.
Who should approve them?
Someone other than the person posting, because adjusting entries are judgement-based and are a common route for both honest error and deliberate manipulation.
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