Adjusting Entries

An adjusting entry is a journal entry recorded at the end of an accounting period to align the general ledger with the underlying economic transactions that have occurred but not yet been recorded. Because organisations operate on accrual accounting rather than pure cash basis, the raw transaction log will always lag economic reality—rent has been consumed but not yet invoiced, interest has accrued but not been received, depreciation has happened but no cash has left the bank. Adjusting entries close those gaps before financial statements go out the door.

Why accrual accounting creates the need

Under the accrual method, a company records revenue when it is earned and expenses when they are incurred, not when cash changes hands. This approach gives a truer picture of operating performance—a business that ships $100,000 of goods on credit in December has genuinely earned $100,000 of revenue that month, even if payment arrives in January. Equally, a company that has used three months of office rent should record three months of expense, even if rent is paid in a lump sum on the first of each quarter.

Raw transaction records—cheques written, invoices received, deposits made—naturally cluster around the moment cash moves. They do not automatically capture economic substance that occurs away from the moment of payment. Adjusting entries bridge that gap, converting cash-aligned records into an accrual-basis ledger that matches revenue and expenses to the periods that deserve them.

The five main categories of adjusting entries

Accrued revenue covers money earned but not yet billed or received. A law firm might complete 60 hours of client work in December but not send the invoice until January; an adjusting entry at December 31 records the revenue and an accounts receivable asset. The entry reverses in January when the invoice goes out.

Accrued expenses do the opposite: costs incurred but not yet paid. Employees earn wages for days worked at year-end before the next paycheque; interest accrues on loans; utilities are consumed but invoiced later. An adjusting entry on the final day of the year records both the expense and the accounts payable liability.

Depreciation and amortisation represent the systematic allocation of a fixed asset cost over its useful life. No cash leaves the bank when depreciation is recorded, but under accrual accounting, using up a piece of equipment or a patent must be reflected as an expense. Accumulated depreciation is the main example of an adjusting entry that runs the entire life of an asset.

Deferred (prepaid) expenses arise when a company pays for something in advance—a one-year insurance policy, rent paid upfront, or software subscriptions. The cash outflow happens immediately, but the economic benefit spreads across the period of use. Each month, an adjusting entry moves a portion from the prepaid asset account to expense, matching cost to benefit.

Deferred revenue (unearned revenue) is the mirror image: a customer pays in advance for a service or good to be delivered later. A subscription software company that receives $12,000 for a year of service must initially credit unearned revenue; each month, an adjusting entry shifts $1,000 into actual revenue, linking payment received to services rendered.

The mechanics: debit, credit, and reversal

An adjusting entry is a standard journal entry—a balanced debit and credit—but it is non-reversible in the sense that it does not correspond to an external transaction that will later cancel it out. Once recorded, it stays on the books until deliberately adjusted or removed. Some firms use a “reversing entry” convention: on the first day of the next period, they reverse the adjusting entry, which ensures that when the actual transaction (invoice, payment) arrives, the accounting is handled cleanly without manual intervention.

For example, suppose a company accrues $5,000 of salary expense on December 31 for three days of work in December that will be paid on January 5. The adjusting entry is:

Salary Expense     $5,000 (debit)
  Salaries Payable        $5,000 (credit)

On January 5, when the payroll cheque is processed (say, for $8,000 covering the three days plus the rest of the week), the accounting system records it normally. If a reversing entry was made on January 1, the reversal wipes out the December 31 accrual, and the full $8,000 cheque hits the expense account, avoiding double-counting. If no reversal was used, the accountant must manually credit only the remaining $3,000 against Salaries Payable and debit the new $5,000 to Expense—extra work but no error.

Avoiding the common pitfalls

The greatest risk of adjusting entries is incompleteness or error. If a company overlooks a deferred revenue item, it will overstate net income. If it fails to record estimated bad debts, accounts receivable will be artificially high. Worse, inconsistent or invented adjustments erode the credibility of the financial statements and invite auditor challenge.

Professional accountants typically work from a checklist of likely adjusting entries—depreciation schedules, lease registers, aging of receivables, vendor statements, debt agreements—and verify each against supporting documents. Supervisory review is standard; in public companies, external auditors will test adjustments for accuracy and appropriateness. The adjusting entry process is where opinion enters accounting; two firms with identical transactions might legitimately record different depreciation patterns or bad debt estimates if they use different methods or estimates.

The closing sequence

Adjusting entries are usually the first step in the period-closing routine. Once all adjustments are posted, the trial balance is updated, financial statements are prepared from the adjusted balances, and then closing entries zero out the temporary (revenue and expense) accounts for the next period. Some software suites compress these steps, but the logical sequence is always: record adjustments, verify the adjusted trial balance, print statements, close temporary accounts.

For external stakeholders—creditors, investors, regulators—the adjusted accounts are what matter. An un-adjusted balance sheet is almost never a valid financial statement. The discipline of adjusting entries is what allows accrual accounting to work at all.

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