Adjusting Entries
Accruals, deferrals, and period-end updates
Why This Matters
Here's the core problem: Your business operates on a cash basis (money in, money out), but accounting requires a timing basis (when you earn it, when you owe it).
Scenario 1: A customer promises to pay you $5,000 next month. Did you earn it? Yes. Should it be in this month's revenue? Yes. But the cash hasn't arrived yet.
Scenario 2: An insurance company bills you today for coverage lasting 12 months. Did you use all the insurance today? No. Should you expense all of it today? No.
Adjusting entries fix the gap between when cash moves and when economic events actually happen. They're the reason your financial statements reflect economic reality, not just checkbook activity.
What Are Adjusting Entries?
Adjusting entries are journal entries made at the end of an accounting period to update accounts and ensure they reflect economic reality rather than just cash transactions.
They fall into five categories:
Accrued Revenue
Earned, not yet received
Accrued Expenses
Incurred, not yet paid
Deferred Revenue
Received, not yet earned
Deferred Expenses
Paid, not yet used
Estimates
Depreciation, bad debts
The Gap: Cash vs. Accrual Accounting
Before adjusting entries, let's understand the problem they solve.
Cash Basis Accounting
- •Dec 1: Customer promises to pay $1,000 in January
- •Dec 31: You haven't received cash yet
- •Cash basis: Don't record anything
Accrual Basis Accounting
- •Dec 1: Customer promises to pay $1,000 in January
- •Dec 31: You earned it, so record it
- •Accrual basis: Record revenue in December
Adjusting entries move your accounting from cash basis to accrual basis.
The Five Types of Adjusting Entries
Real-World Example: ABC Consulting
Let's follow ABC Consulting through December with several adjusting entries needed.
Initial Trial Balance (Before Adjustments)
TRIAL BALANCE
ABC Consulting - December 31, 2026 (Before Adjustments)
| Account | Debit | Credit |
|---|---|---|
| Cash | $20,000.00 | |
| Accounts Receivable | $15,000.00 | |
| Prepaid Insurance | $1,200.00 | |
| Equipment | $50,000.00 | |
| Accumulated Depreciation | $5,000.00 | |
| Accounts Payable | $8,000.00 | |
| Unearned Revenue | $12,000.00 | |
| Owner's Equity | $44,200.00 | |
| Service Revenue | $35,000.00 | |
| Salary Expense | $12,000.00 | |
| Rent Expense | $6,000.00 | |
| Totals | $104,200.00 | $104,200.00 |
Adjusting Entries Needed
#1 Accrued Revenue
Work completed Dec 28, client pays in January. Amount: $3,000
Accounts Receivable $3,000
Service Revenue $3,000
#2 Accrued Expense
Employees worked last week of Dec, paid in January. Amount: $2,000
Salary Expense $2,000
Salaries Payable $2,000
#3 Prepaid Insurance
1 month of $1,200 insurance expired. Amount: $100
Insurance Expense $100
Prepaid Insurance $100
#4 Depreciation
Equipment depreciates $5,000/year. December: $416.67
Depreciation Expense $416.67
Accum. Depreciation $416.67
#5 Deferred Revenue Earned
Of $12,000 unearned revenue, 1 month of service provided. Amount: $1,000
Unearned Revenue $1,000
Service Revenue $1,000
Adjusted Trial Balance (After Adjustments)
ADJUSTED TRIAL BALANCE
ABC Consulting - December 31, 2026 (After Adjustments)
| Account | Debit | Credit |
|---|---|---|
| Cash | $20,000.00 | |
| Accounts Receivable | $18,000.00 | |
| Prepaid Insurance | $1,100.00 | |
| Equipment | $50,000.00 | |
| Accumulated Depreciation | $5,416.67 | |
| Accounts Payable | $8,000.00 | |
| Unearned Revenue | $11,000.00 | |
| Salaries Payable | $2,000.00 | |
| Owner's Equity | $44,200.00 | |
| Service Revenue | $39,000.00 | |
| Salary Expense | $14,000.00 | |
| Rent Expense | $6,000.00 | |
| Insurance Expense | $100.00 | |
| Depreciation Expense | $416.67 | |
| Totals | $109,616.67 | $109,616.67 |
Notice the changes:
- • Service Revenue increased from $35,000 to $39,000 (accrued + deferred)
- • New expenses appeared: Insurance Expense, Depreciation Expense
- • New liability: Salaries Payable $2,000
- • Unearned Revenue decreased from $12,000 to $11,000
- • Trial balance still balances!
Common Adjusting Entry Scenarios
Year-End Accrued Interest
A business borrowed $100,000 at 6% annual interest on September 1. By December 31, 4 months have passed.
$100,000 × 6% × (4 ÷ 12) = $2,000
(To record four months of accrued interest)
Utility Bill Not Yet Received
You know your December electric bill will be $1,500, but it hasn't arrived yet.
(To record estimated December utilities)
Subscription Revenue (Monthly)
A SaaS company charges $500/month. Customers pay annually ($6,000) on January 1. By January 31, they've earned 1 month.
(To record one month of subscription service provided)
Office Supplies Used
Beginning: $500 supplies. Purchased: $3,000. End count: $400 remaining.
$500 + $3,000 - $400 = $3,100 used
(To adjust supplies inventory to actual count)
Key Principle: Matching
Adjusting entries exist because of the matching principle: Expenses should be matched to the period in which they were incurred.
Matching Principle in Action:
Without Adjusting Entry:
- • January: Pay $1,200 insurance → Expense $1,200
- • Problem: January's P&L is overstated by $1,100
With Adjusting Entry:
- • January: Pay $1,200 insurance → Record Prepaid Asset
- • Dec 31: Expense $100 → Matches one month of benefit
- • Solution: Each month gets $100 expense
Adjusting Entries Don't Involve Cash (Usually)
Important Principle:
Most adjusting entries don't involve the Cash account. Why? Because the cash transaction already happened (or will happen later). You're adjusting for the timing gap.
WRONG (usually):
Insurance Expense $100
Cash $100
RIGHT:
Insurance Expense $100
Prepaid Insurance $100
(Cash was spent when insurance was prepaid)
Timeline: When Adjusting Entries Happen
Accounting Period
Jan 1 → Dec 31
Transactions recorded throughout the period (journal entries, postings)
Period-End (Step 5)
- 1. Prepare trial balance
- 2. Identify needed adjustments
- 3. Record adjusting entries
- 4. Prepare adjusted trial balance
Financial Statements
Prepare statements AFTER adjustments ensure they reflect reality
How to Identify Needed Adjustments
At period-end, ask yourself these questions:
Have we earned all revenue we've been paid for?
→ Deferred Revenue
Have we incurred expenses we haven't paid yet?
→ Accrued Expenses
Have we earned revenue we haven't billed yet?
→ Accrued Revenue
Have we fully used all prepaid items?
→ Prepaid/Deferred Expenses
Do assets need adjusting?
→ Estimates (Depreciation, Bad Debts)
Key Takeaway
Adjusting entries are the bridge between cash-based and accrual-based accounting. They ensure that revenue is recorded when earned (not just when cash arrives) and expenses are recorded when incurred (not just when paid). Without them, financial statements would reflect only checkbook activity, not economic reality. With them, they're accurate and useful for decision-making.
Test Your Understanding
Which type of adjusting entry increases both assets and revenue?
You prepaid $2,400 for 12 months of rent on January 1. By January 31, how much should you adjust?
Why do most adjusting entries NOT involve cash?
A company receives $12,000 on January 1 for a 12-month service contract. What adjusting entry is needed on January 31?
True or False: If your trial balance doesn't balance, you should skip adjusting entries and go straight to preparing financial statements.
Ready to Practice?
You now understand why adjusting entries exist and how to make them. The Practice Lab is where you'll prepare trial balances, identify needed adjustments, record adjusting entries, and verify the adjusted trial balance.
Try the Practice Lab