The purpose of adjusting entries in accounting is to bring a company’s books into line with the accrual basis at the end of a reporting period, so the financial statements show the revenue actually earned, the expenses actually incurred, and the assets and liabilities that actually exist on the closing date, regardless of when cash changed hands. Both U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) require accrual-basis reporting, which makes these end-of-period entries unavoidable.1IFRS Foundation. IAS 1 Presentation of Financial Statements
Daily bookkeeping captures transactions when cash moves or an invoice is issued. That’s rarely the same moment as the economic activity behind it. Wages are earned before payday. Insurance is paid before it’s used. Subscriptions are collected before service is delivered. Left alone, the trial balance at period-end reflects the cash and paperwork that happened to cross the desk, not the period’s true economic performance. Adjusting entries close that gap.
The Two Principles Every Adjustment Enforces
Two accounting principles explain why the entries are needed at all.
The first is revenue recognition. Under ASC 606, revenue is recognized when a company satisfies a performance obligation by transferring the promised good or service to the customer, in the amount it expects to be paid.2Financial Accounting Standards Board. Revenue from Contracts with Customers (Topic 606) Delivery is the trigger, not the check. If the work is finished in March, the revenue belongs to March even if the invoice goes out in April.
The second is matching. Expenses belong in the same period as the revenue they helped produce. If sales staff earn $100,000 in commissions on this quarter’s deals, that cost belongs on this quarter’s income statement even if the checks are cut next month. Without matching, a period looks profitable simply because the costs that generated its revenue haven’t been paid yet.
Every adjusting entry traces back to one or both of these ideas. The specific entries fall into two families based on whether cash arrived before or after the economic event: deferrals and accruals.
Deferrals: When Cash Arrives Before the Activity
A deferral applies when cash has already changed hands but the revenue or expense shouldn’t hit the income statement yet. The original transaction sits on the balance sheet as an asset or liability, and adjusting entries gradually move it to the income statement as the economic event unfolds.
Prepaid Expenses
Paying for something in advance creates an asset, because the benefit hasn’t been used. Pay $18,000 upfront for a 12-month insurance policy and the check produces an $18,000 Prepaid Insurance asset. No expense hits the income statement on day one.
At the end of each month, an adjusting entry debits Insurance Expense for $1,500 and credits Prepaid Insurance for $1,500, moving one month’s worth of coverage ($18,000 รท 12) from the asset to the expense. After twelve entries, the asset is zero and the full cost has been spread across the months that benefited from the coverage. Office supplies follow the same logic: the purchase goes to a Supplies asset, and a period-end count determines how much moves to Supplies Expense.
Unearned Revenue
The mirror image sits on the seller’s side. A customer who pays $1,200 upfront for a one-year subscription hasn’t received anything yet, so the payment can’t be booked as revenue. It goes into an Unearned Revenue liability, because the business owes twelve months of service.
Each month, an adjusting entry debits Unearned Revenue by $100 and credits Service Revenue by $100. The liability shrinks, earned revenue grows, and after a year both sides balance out. Skip these entries and the balance sheet keeps carrying an obligation that has already been fulfilled while the income statement never shows the revenue that was actually earned.
Accruals: When the Activity Happens Before the Cash
Accruals go the other direction. The economic event has already occurred, but no cash has moved yet and no invoice has posted, so nothing in the ledger reflects it. The adjusting entry creates a new asset or liability and records the corresponding revenue or expense.
Accrued Expenses
Wages accumulate every day people work, but payroll runs on a schedule. If the period ends on a Wednesday and payday isn’t until Friday, three days of earned wages sit off the books. The adjusting entry debits Salaries Expense and credits Salaries Payable for those three days, so the income statement carries the labor cost and the balance sheet carries the obligation.
Interest is the same story. Borrow in December with the first payment due in March, and December’s interest is quietly accumulating. An entry debiting Interest Expense and crediting Interest Payable puts that cost in the right period.
Payroll taxes are an easy accrual to miss. Whenever wages accrue, the employer’s share of FICA along with federal and state unemployment taxes accrues too, and those tax liabilities should be recorded alongside the wage accrual. Early in the year the amounts are larger, because most employees haven’t reached wage-base caps.
Accrued Revenue
A consulting firm that finishes $5,000 of work in December but plans to invoice in January still earned that $5,000 in December. The adjusting entry debits Accounts Receivable and credits Service Revenue, placing the revenue in the correct period and recording the right to collect. Skip it and both the income statement and the balance sheet understate the business: profit looks lower than it was, and a legitimate receivable is hidden.
Non-Cash Adjustments
Some entries record economic reality that has no cash transaction attached at all. Their purpose is the same, though: to make the statements reflect what actually happened during the period.
Depreciation
Buying a $50,000 machine isn’t a $50,000 expense in the month of purchase, because the machine produces value for years. Depreciation spreads the cost across its useful life. Under straight-line depreciation, subtract expected salvage value from purchase price and divide by the years of expected use. A $50,000 machine with a $5,000 salvage value and a nine-year useful life generates $5,000 in annual depreciation.
The adjusting entry debits Depreciation Expense and credits Accumulated Depreciation, a contra-asset account that reduces the equipment’s carrying value on the balance sheet. No cash moves. The entry simply records that the asset has less remaining value than it did at the start of the period.
Bad Debt Expense
Selling on credit means some customers won’t pay. Rather than waiting to write off individual accounts, GAAP requires companies to estimate expected losses and record them in the same period as the related revenue. Under ASC 326’s current expected credit losses (CECL) model, the estimate draws on past experience, current conditions, and reasonable forecasts of future collectibility.3Office of the Comptroller of the Currency. Allowances for Credit Losses – Comptrollers Handbook
The entry debits Bad Debt Expense and credits Allowance for Doubtful Accounts, another contra-asset that reduces the net value of Accounts Receivable. Common approaches to sizing the estimate include applying a flat percentage to credit sales based on historical patterns, or aging receivables by how long invoices have been outstanding and applying higher loss rates to older buckets.
How the Adjustments Change the Financial Statements
The income statement absorbs the most visible impact. Every adjustment to revenue or expense changes net income. Without accrued expense entries, costs are understated and profits look artificially high. Without accrued revenue entries, earnings are understated and the business looks weaker than it is. Without depreciation, profit is overstated every period until the asset is fully consumed.
The balance sheet shifts in parallel. Adjusting entries reduce assets like Prepaid Insurance as the benefit is consumed. They reduce liabilities like Unearned Revenue as obligations are met. They create liabilities that didn’t previously appear: Salaries Payable, Interest Payable, accrued payroll taxes. They create assets like Accounts Receivable for work completed but unbilled. And contra-asset accounts, Accumulated Depreciation and Allowance for Doubtful Accounts, bring the carrying value of long-lived assets and receivables closer to what those items are realistically worth.
Once every adjustment is posted, the result is an adjusted trial balance, the final set of balances from which the income statement, balance sheet, and other reports are prepared. Lenders assessing creditworthiness and investors assessing profitability are reading numbers shaped by these entries. If the adjustments are wrong or missing, every ratio and every conclusion drawn from the statements inherits that error.
What Skipping Adjusting Entries Costs
The purpose of the entries becomes clearest when they’re skipped. Reported earnings drift away from real earnings. A company that never accrues wages looks more profitable than it is right up to the day it has to cut the checks. A company that never records depreciation shows profits that ignore the wearing out of the equipment producing them. A company that recognizes an entire year of prepaid subscriptions as revenue on day one shows a spike it hasn’t earned.
Lenders who discover that statements were prepared without proper adjustments lose confidence in the numbers and may tighten covenants or call loans. Investors conducting due diligence before an acquisition will reprice or walk away from deals where reported earnings relied on incomplete accruals. Overstated expenses can reduce taxable income enough to attract IRS attention on their own. For public companies, misstatements are an SEC enforcement priority.4Securities and Exchange Commission. SEC Announces Enforcement Results for Fiscal Year 2024
Adjusting entries aren’t bureaucratic formality. They’re the step that turns a running list of cash movements into a reliable picture of what a business earned, owed, and owned during a specific stretch of time. That’s the whole reason they exist.