Adjusting Entries

Adjusting entries are journal entries, usually dated the last day of an accounting period, made to bring the balance sheet and income statement up to date under the accrual basis of accounting. They correct a simple problem: routine transactions recorded during the period rarely capture every revenue genuinely earned or every expense genuinely incurred by the exact closing date.

Adjusting entries fall into four categories: recognizing revenues that have been earned but not yet entered into the records, recognizing expenses that have been incurred but not yet recorded, recognizing that revenue already recorded actually pertains partly to a future period, and recognizing that an expense already recorded actually pertains partly to a future period. The first two are known as accrual-type adjusting entries; the latter two are known as deferral-type adjusting entries.

Typical accrual-type entries include recording accrued payroll for wages employees have earned but not yet been paid, and recording interest earned on an investment that has not yet been received in cash. Typical deferral-type entries include recognizing a portion of prepaid insurance as expense once that portion of coverage has actually been used, or recognizing previously collected unearned revenue as earned once the related goods or services have actually been delivered.

Without adjusting entries, financial statements would reflect only whichever transactions happened to generate a cash receipt, cash payment, invoice or bill during the period, rather than the true economic activity of the business as of the reporting date. This would understate or overstate both revenue and expenses in ways that have nothing to do with how the business actually performed, which is exactly the distortion accrual accounting, and the adjusting entries that implement it, exist to prevent.

Adjusting entries are posted after an unadjusted trial balance confirms debits equal credits, producing an adjusted trial balance that becomes the direct source for drafting the income statement and balance sheet. Many accrual-type adjusting entries are then undone at the start of the next period through a reversing entry, simplifying the bookkeeping once the related cash transaction eventually occurs and preventing it from being counted twice.

Adjusting entries should not be confused with correcting entries, which fix an outright mistake, such as a transaction posted to the wrong account or recorded at the wrong amount. Adjusting entries instead address genuine timing issues in an otherwise correctly recorded set of books — the underlying transactions were recorded accurately, they simply had not yet been brought fully up to date with everything that had economically occurred by the close of the period. Confusing the two can lead a bookkeeper to treat a genuine error as if it were merely a timing issue, or vice versa, which is why most accounting training deliberately drills the distinction early on. A correcting entry can be made at any time an error is discovered, while adjusting entries are, by convention, concentrated specifically at the close of each period.