Understanding Adjusting Entries and Why They Matter

Learn how adjusting entries capture revenues and expenses in the correct period. Covers accrued income, prepaid expenses, and common mistakes.

12 min read Intermediate February 2026

Detailed accounting worksheet showing adjusting entries with journal entries and account codes visible on desk

Why Adjusting Entries Exist

Most businesses operate on an accrual accounting system. That’s not just accounting jargon—it’s the difference between knowing what actually happened financially and guessing. Without adjusting entries, your financial statements would be incomplete and misleading.

Here’s the reality: transactions don’t always line up neatly with calendar periods. You might earn revenue in January but not invoice until February. Or you’ll pay for insurance in December that covers the next three months. Adjusting entries fix these timing problems so your books reflect economic reality, not just when money changed hands.

Accountant reviewing financial records with calculator and organized ledger sheets on modern desk

The Four Types of Adjusting Entries

You’ll encounter adjusting entries in four main situations. Each one serves a purpose—capturing revenue you’ve earned but haven’t invoiced, recording expenses you’ve incurred but haven’t paid, or shifting prepaid amounts into the current period.

Accrued Revenue

You’ve provided services or delivered goods, but you haven’t sent an invoice yet. The revenue’s earned—you’ve done the work. So you record it now, not when payment arrives. For a consultant billing monthly, this means recording January work in January even if invoicing happens in early February.

Accrued Expenses

Opposite situation. You’ve incurred costs but haven’t paid yet. Utility bills are the classic example—you’ve used electricity in December, but the invoice arrives in January. Record the December expense in December. This is why December often looks expensive on accrual statements.

Deferred Revenue (Unearned)

A client pays you upfront for services you’ll deliver later. You’ve got the cash, but you haven’t earned the revenue yet. As you deliver the service over time, you shift amounts from the liability into revenue. SaaS subscriptions work this way—annual payment received, revenue recognized monthly.

Prepaid Expenses

You’ve paid for something upfront that you’ll use over multiple periods. Insurance, rent, or office supplies. You don’t expense the whole amount immediately. Instead, you allocate it across the months you’ll actually benefit from it.

Accounting journal entries displayed with debit and credit columns showing typical adjusting entry amounts and account classifications

How to Create an Adjusting Entry

The mechanics are straightforward once you understand the principle. You’re essentially asking one question: “What economic event occurred this period that our transaction record hasn’t captured yet?”

Identify the Mismatch

Look for timing differences between when you recorded a transaction and when the economic event actually occurred. Check unpaid invoices, unused prepaid amounts, and expenses you’ve incurred but not yet paid.

Determine the Amount

Calculate exactly how much revenue or expense belongs in this period. For accrued items, estimate if needed but document your basis. For prepaid amounts, divide the total by the number of periods covered.

Record the Journal Entry

Debit an asset or expense account, credit a liability or revenue account. Always maintain the fundamental equation: assets equal liabilities plus equity. Most adjusting entries involve balance sheet accounts paired with income statement accounts.

Document Your Basis

Write down why you made this entry. What calculation did you use? What’s your supporting evidence? Auditors will ask. Future you will forget. Clear documentation saves time during year-end reviews.

Common Mistakes to Avoid

We see the same errors repeatedly. Most happen because people rush through adjusting entries or don’t fully understand the principle behind them.

Forgetting to reverse them: Many adjusting entries get reversed in the following period. If you don’t reverse them, you’ll double-count the transaction. Use reversing entries or monitor accruals carefully.
Using the wrong account: Prepaid expenses aren’t expenses yet—they’re assets. Recording them as expenses immediately defeats the purpose of accrual accounting. Always think about what the account represents.
Making estimates without documentation: You’ll often estimate accrued amounts. That’s fine. But write down your estimate and your reasoning. Don’t guess and move on.
Adjusting for cash you haven’t received: This trips up many people. You don’t adjust for revenue until you’ve done the work. Promises of future sales don’t count.
Missing recurring adjustments: Some adjusting entries happen every month—depreciation, amortization, bad debt provisions. Create a checklist so you don’t forget them.

Spreadsheet showing common adjusting entry errors highlighted with corrections marked in red pen on accounting worksheet

Adjusting Entries and Your Audit

Auditors spend significant time on adjusting entries. They’re looking for completeness and accuracy. Missing adjusting entries are a major audit finding.

What Auditors Review

They’ll examine your adjusting entry documentation, test the mathematical accuracy of calculations, verify that accounts are classified correctly, and confirm that reversing entries were handled properly. They’ll also look for unusual entries or patterns that don’t match your business.

Prepare a summary of all adjusting entries before the audit. Show the account, amount, and explanation for each one. This speeds up the process considerably.

Auditor conducting financial review with spreadsheets and documentation organized in clear folders on desk

Key Takeaways

Adjusting entries aren’t optional. They’re what separates accrual accounting from cash accounting. They ensure your financial statements reflect economic reality—not just when money moves. You’ll use them constantly, especially during year-end closing.

The four types—accrued revenue, accrued expenses, deferred revenue, and prepaid expenses—cover nearly every situation you’ll encounter. Understand the principle behind each one, and the mechanics become obvious. Document everything, reverse appropriately, and you’ll avoid the common pitfalls that catch most people.

Your auditor will thank you for having clean, well-documented adjusting entries. More importantly, you’ll actually know what your financial position is at any given moment. That’s the real value here.

Ready to Master Year-End Closing?

Adjusting entries are just one piece of the year-end puzzle. Get our complete guide to the closing process and ensure you’re not missing any critical steps.

View Closing Checklist

Disclaimer

This article is provided for educational purposes to help you understand accounting concepts related to adjusting entries and year-end procedures. It’s not professional accounting advice, tax guidance, or audit preparation services. Accounting rules and tax treatment vary by jurisdiction and business structure. We strongly recommend consulting with a qualified accountant or auditor before making accounting decisions or preparing for an audit. The examples and scenarios described are for illustrative purposes and may not apply directly to your specific situation. Your circumstances are unique, and professional guidance is essential.