Adjusting entries in accounting: A beginner's guide
Adjusting entries are journal entries made at the end of an accounting period to update various accounts before creating financial statements. Think of them as your accounting time machine — they help match up your income and expenses to when they actually happened, not just when money changed hands. Let's break down what adjusting entries in accounting are, why they matter, and how to handle them in your business.
What is an adjusting entry in accounting?
Adjusting entries are the bridge between when business activities occur and when money changes hands. For example, if you pay your office rent on January 1st for the entire year, you'll need adjusting entries each month to show that you're using up that prepaid rent over time.
These entries are a key part of accrual accounting, where we record transactions when they happen rather than when money moves. If you're using cash accounting — recording income and expenses only when cash actually changes hands — you won't need adjusting entries. However, most growing businesses eventually switch to accrual accounting since it gives a more accurate picture of their financial health.
Why make adjusting entries?
Adjusting entries serve several crucial purposes in maintaining accurate financial records:
They ensure your financial statements reflect reality. When you use adjusting journal entries, your income statements will show all revenue earned and expenses incurred in the right time periods, while your balance sheet will accurately represent what you own and owe.
They help you track depreciation of major assets. Without adjusting entries, you'd show the full cost of equipment or vehicles in the month you bought them, rather than spreading that cost over the asset's useful life.
They prevent tax complications. Incorrect timing of income and expense recognition can lead to filing incorrect tax returns. This might mean underpaying taxes (which can lead to penalties) or overpaying (which ties up cash you could use in your business).
Types of adjusting entries
Accrued revenue
What it is: Accrued revenue represents income you've earned but haven't received payment for yet. This commonly happens when you perform services or deliver goods in one month but don't get paid until the following month.
Example: Imagine you run a landscaping business. In March, you completed a major spring cleanup project for a client, billing them $3,500. Your payment terms give them 30 days to pay, so you won't receive the money until April. Even though no cash has changed hands yet, you've earned that income in March, so you need an adjusting entry to record the revenue in the correct month.
Deferred revenue
What it is: Also called unearned revenue, this happens when customers pay you before you deliver goods or services. You can't recognize the revenue until you've actually provided what was promised.
Example: You own a gym that sells yearly memberships. In January, a customer pays $600 for a full year upfront. You can't count all $600 as January revenue because you haven't provided the full year of service yet. Instead, you'll need to make adjusting entries each month to recognize $50 of that revenue as you provide access to your gym facilities.
Accrued expenses
What it is: These are expenses you've incurred but haven't paid for yet. Common examples include utilities used but not billed, employee wages earned but not paid, and interest accumulated but not yet due.
Example: You own a retail shop and pay your utility bill a month after service. By December 31, you've used electricity all month, but won't get or pay the bill until January. If you typically pay $400 for utilities, you'll need an adjusting entry in December to show this expense, even though you haven't received the bill yet.
Deferred expenses
What it is: Also called prepaid expenses, these are costs you've paid in advance that need to be allocated over future periods. Common examples include insurance premiums, rent, and software subscriptions paid annually.
Example: You run a small marketing agency and in October, you prepay $1,800 for an annual subscription to a specialized design software. While you paid the full amount upfront, you'll use this software over 12 months. You'll need to make adjusting entries each month to show that you're using $150 worth of that prepaid expense.
Depreciation expenses
What it is: Depreciation represents the gradual "using up" of long-term assets like equipment or vehicles. Instead of expensing the entire cost when purchased, you spread it over the asset's expected useful life.
Example: Your coffee shop bought a new commercial espresso machine for $15,000. You expect it to last five years. Instead of showing a $15,000 expense when you bought it, you'll make monthly adjusting entries to record $250 in depreciation expense. This better reflects how you're using up the value of the machine over time.
When to get help with adjusting entries
While some adjusting entries are straightforward, others can get complex quickly. It might be time to bring in professional help if:
You're spending hours each month trying to figure out the right adjustments. Your time is better spent running your business.
Your business is growing and transactions are getting more complicated. Maybe you're dealing with multiple subscriptions, prepaid expenses, or complex depreciation schedules.
You're worried about compliance. Incorrect adjusting entries can lead to inaccurate financial statements and tax returns.
You're planning to seek funding or sell your business. Potential investors or buyers will want to see impeccable books.
Good adjusting entries foundational for accurate financial statements. Whether you handle these entries yourself or work with a professional, understanding their purpose and importance will help you make better business decisions and keep your finances on track. Regular, accurate adjusting entries now can save hours of cleanup and corrections later, giving you more confidence in your numbers when you need them most.
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