Have you ever wondered what are adjusting entries? Companies track their financial activities—such as sales, purchases, and expenses—using an accounting system. However, not all transactions neatly align with the accounting period in which they occur. That’s where adjusting entries come into play!
Adjusting entries ensure that a company’s financial statements reflect the true financial position by recording revenues and expenses in the correct accounting period. These crucial entries help maintain accuracy and compliance before finalizing financial reports. In this blog, we’ll break down what adjusting entries are, why they matter, and the different types—complete with real-world examples.
What Are Adjusting Entries?
Adjusting entries are essential accounting adjustments made at the end of an accounting period to ensure financial statements are accurate and complete. These entries align revenues and expenses with the period in which they were actually earned or incurred—regardless of when cash changes hands. This practice follows the matching principle, a key accounting rule that requires expenses to be recorded in the same period as the revenues they help generate. Without adjusting entries, financial reports could misrepresent a company’s true financial health.
Why Are Adjusting Entries Important?
Adjusting entries play a critical role in maintaining reliable financial records. Here’s why they matter:
✔ Ensure Accuracy – They correct errors and record overlooked transactions, keeping the books up to date.
✔ Comply with Accounting Standards – They help businesses adhere to GAAP (Generally Accepted Accounting Principles), ensuring legal and regulatory compliance.
✔ Match Revenues & Expenses – They align income and costs with the correct accounting period, upholding the matching principle.
✔ Produce Reliable Financial Reports – They ensure the income statement and balance sheet reflect the company’s true financial position.
✔ Prevent Misleading Statements – Without adjustments, revenues or expenses could be overstated or understated, distorting financial performance.
✔ Simplify Tax Reporting – They guarantee accurate income and expense reporting, reducing errors in tax calculations.
✔ Support Better Decision-Making – By providing a clear financial picture, they help businesses plan budgets, investments, and growth strategies effectively.
In short, adjusting entries are essential for transparency, compliance, and informed financial management.
Types of Adjusting Entries
Businesses use five primary types of adjusting entries to maintain accurate financial records:
- Accrued Revenues
Income earned but not yet received in cash. These occur when services are completed or goods delivered before payment.
Example: A marketing agency completes a campaign in December but receives payment in January. The revenue must be recorded in December.
Journal Entry:
Debit: Accounts Receivable
Credit: Service Revenue
- Accrued Expenses
Costs incurred but not yet paid. Common for wages, utilities, and interest expenses.
Example: Employees work the last week of December but are paid in January. The wage expense belongs to December.
Journal Entry:
Debit: Salaries Expense
Credit: Salaries Payable
- Deferred Revenues (Unearned Revenues)
Payments received in advance for future services. These are liabilities until the service is performed.
Example: A software company receives annual subscription fees upfront. Revenue is recognized monthly as service is provided.
Journal Entry:
Debit: Unearned Revenue
Credit: Service Revenue
- Prepaid Expenses
Payments made for future benefits. Initially recorded as assets, then expensed as used.
Example: Paying 12,000forannualinsurance.Eachmonth,12,000forannualinsurance.Eachmonth,1,000 becomes an expense.
Journal Entry:
Debit: Insurance Expense
Credit: Prepaid Insurance
- Depreciation Expenses
Allocating the cost of long-term assets over their useful lives.
Example: A 60,000machinewitha5−yearlifedepreciatesat60,000machinewitha5−yearlifedepreciatesat12,000 annually.
Journal Entry:
Debit: Depreciation Expense
Credit: Accumulated Depreciation
Each adjusting entry ensures financial statements accurately reflect the company’s financial position by properly matching revenues and expenses to the correct accounting period.
Example 1: Accrued Revenue
Imagine you own a tutoring business and complete a $500 tutoring session on December 30, but the customer pays on January 5. Since you earned the money in December, you should record it as accrued revenue.
Adjusting Entry:
- Debit: Accounts Receivable $500
- Credit: Service Revenue $500
Example 2: Accrued Expense
Your company uses electricity throughout December, but the bill arrives in January. The expense still belongs in December.
Adjusting Entry:
- Debit: Utility Expense $200
- Credit: Utilities Payable $200
Example 3: Prepaid Expense
Your business pays $3,600 for a year of rent in January. Each month, you record one month’s expense ($300).
Adjusting Entry:
- Debit: Rent Expense $300
- Credit: Prepaid Rent $300
Example 4: Deferred Revenue
A customer pays you $1,200 for six months of website hosting in advance. Each month, you earn $200 of that payment.
Adjusting Entry:
- Debit: Unearned Revenue $200
- Credit: Service Revenue $200
Example 5: Depreciation
A company buys office furniture for $5,000, expecting it to last 5 years. Each year, it records $1,000 in depreciation.
Adjusting Entry:
- Debit: Depreciation Expense $1,000
- Credit: Accumulated Depreciation $1,000
Example 6: Interest Accrual
A business takes out a loan of $10,000 at 5% annual interest. At the end of the month, interest accrues but is not yet paid.
Adjusting Entry:
- Debit: Interest Expense $42
- Credit: Interest Payable $42
How to Record Adjusting Entries
- Identify the Account Needing Adjustment – Find out if the company has unrecorded revenues or expenses.
- Determine the Correct Amount – Calculate how much should be recorded in the correct period.
- Make the Adjusting Entry – Use the right accounts to update the records.
- Prepare Financial Statements – After all adjustments, companies create reports showing their financial position.
- Review and Verify Entries – Double-check for accuracy to prevent errors in financial statements.
- Consult an Accountant – If you are unsure about adjustments, seek professional help.
Ensuring Financial Accuracy by Adjusting Entries
Adjusting entries is essential for ensuring that a company’s financial statements are accurate and reflect its true financial position. These entries align revenue and expenses with the correct periods, providing a clear and reliable picture of the business’s performance. Without proper adjustments, financial reports can become misleading, leading to poor decisions and errors in tax filings.
For businesses looking to streamline this process, outsourcing accounting tasks to experts like Global FPO is a smart solution. profiterallc professional team ensures that adjusting entries are made accurately, helping businesses stay compliant with accounting standards. This allows companies to focus on their core operations while maintaining financial accuracy and integrity, driving informed decision-making and long-term success.
