Adjusting entries are the journal entries a business records at the end of an accounting period to bring its books in line with what actually happened economically, even when no cash changed hands. Under accrual accounting, revenue counts when earned and expenses count when incurred, so daily bookkeeping almost always leaves gaps that need to be closed before financial statements are prepared. Most companies run through these adjustments monthly, quarterly, or at fiscal year-end.
Two accounting principles drive the whole exercise. Revenue recognition, framed by ASC 606 as a five-step process, says you record income when you satisfy a performance obligation for a customer, in the amount you expect to be paid.1FASB. Revenue from Contracts with Customers (Topic 606) The matching principle says costs tied to generating revenue belong in the same period as that revenue.2FASB. Statement of Financial Accounting Concepts No. 5 The IRS applies the same logic for tax purposes: under accrual accounting, income is reported in the year earned and expenses are deducted in the year incurred.3Internal Revenue Service. Publication 538 – Accounting Periods and Methods Interest accrues silently on a loan. Employees earn wages between the last payday and month-end. Prepaid insurance delivers value slowly across twelve months. None of these events trigger a receipt or invoice on the day the books close, so someone has to record what the normal transaction cycle missed.
The Five Types of Adjusting Entries
Every adjusting entry falls into one of a handful of categories, each closing a specific gap between cash movement and economic activity.
Accrued Expenses
An accrued expense is a cost the business has already incurred but hasn’t paid. Wages are the standard example. If a pay period ends on the 5th of next month and you’re closing books on the 31st, employees have earned several days of unpaid wages. The entry debits wage expense and credits wages payable, placing the cost on the income statement and creating a liability on the balance sheet. Interest on outstanding loans works the same way: the lender charges interest daily, but payments come monthly or quarterly, so accumulated interest gets recognized at period-end.
Accrued Revenues
Accrued revenues are the mirror image. You’ve delivered a product or performed work, but no invoice has gone out and no payment has arrived by the close of the period. A consulting firm that finishes a project on December 28 and bills on January 10 still earned that revenue in December. The entry debits accounts receivable and credits service revenue.
Deferred Expenses
When you pay for something in advance, the initial entry records an asset, because you’ve bought a future benefit. As you consume it, an adjusting entry moves a portion from the asset account to an expense account. Pay $12,000 for a one-year insurance policy and the monthly entry debits insurance expense $1,000 and credits prepaid insurance $1,000. Prepaid rent works identically.
Deferred Revenues
Deferred revenue arises when a customer pays before you deliver. A software company that collects an annual subscription up front owes twelve months of service. The cash receipt is recorded as a liability, not revenue. Each month, an entry debits the unearned revenue liability and credits revenue for the portion of service delivered.
Non-Cash Estimates: Depreciation and Bad Debt
Two non-cash adjustments show up on nearly every set of books.
Depreciation spreads the cost of a physical asset across its useful life. The straight-line method divides cost minus expected salvage value by the number of months or years of useful life.4Board of Governors of the Federal Reserve System. Chapter 3 – Property and Equipment A delivery truck bought for $50,000 with a $5,000 salvage value and a five-year useful life generates a monthly entry of $750: debit depreciation expense, credit accumulated depreciation. Book value drops without cash moving.
Bad debt adjustments recognize that some customers will never pay. GAAP requires the allowance method rather than writing off accounts only when they go delinquent, because a later write-off would charge the current period for a sale made months earlier.5DoD NAF Accounting. Position Paper 02 – Allowance for Doubtful Accounts Under the current expected credit losses (CECL) model in ASC 326, businesses holding financial assets at amortized cost estimate lifetime expected losses when the receivable is first recorded, not just when collection looks doubtful.6FDIC. Current Expected Credit Losses (CECL) The entry debits bad debt expense and credits the allowance for doubtful accounts.
Documents to Pull Before You Draft
Adjusting entries should be built on actual data, not rough estimates. Before drafting, gather the paperwork.
Bank statements reveal earned interest that hasn’t been recorded and service charges the bank deducted without an invoice. Vendor invoices that arrived after period-end (or haven’t arrived yet) need to be tracked down so costs for goods and services already received can be accrued. Insurance policies drive prepaid expense calculations: divide the total premium by the number of months in the coverage term.
Fixed asset schedules list each asset’s purchase price, acquisition date, salvage value, and useful life, feeding the depreciation calculation. Payroll records let you accrue wages between the last payday and the reporting date by multiplying unpaid working days by daily payroll cost. Loan agreements give you the interest rate and payment schedule, so you can calculate accrued interest for days between the last payment and period-end.
Every number should trace to one of these documents. Auditors will ask.
How to Record and Post an Adjusting Entry
Adjusting entries follow the same double-entry mechanics as any other journal entry: every debit must have an equal credit. What sets an adjusting entry apart is that it always touches at least one balance sheet account and one income statement account. An accrued wage entry increases wage expense on the income statement and increases wages payable on the balance sheet by the same amount. The accounting equation stays balanced while the timing gap closes.
After the entries are drafted and reviewed, they’re posted to the general ledger, updating the balance in every affected account. The accountant then prepares an adjusted trial balance — a listing of all account balances after adjustments — to confirm total debits still equal total credits. A mismatch signals a data-entry error. If the trial balance checks out, the adjusted figures flow into the income statement, balance sheet, and other reports.
Accounting software automates posting and can schedule recurring adjustments like monthly depreciation or insurance amortization. Automation doesn’t eliminate review. Someone still has to verify that source documents support the amounts and that each debit and credit hits the right account.
Reversing Entries at the Start of the Next Period
Some adjusting entries create a headache in the following period. If you accrued $3,000 in wages on December 31, the full paycheck that goes out on January 5 partly overlaps with that accrual. Without a reversing entry, the bookkeeper processing that January paycheck has to remember to split it between the liability account (for the accrued portion) and wage expense (for the new-period portion). Special handling like that is easy to forget and a common source of double-counted expenses.
A reversing entry, recorded on the first day of the new period, flips the original: debit wages payable, credit wage expense for $3,000. The accrual zeroes out, and when the full paycheck posts normally on January 5, wage expense automatically holds only the January portion.
Reversing entries are optional and typically used only for accruals, not for deferrals or depreciation, where no overlapping transaction in the next period would cause confusion.
When a Small Adjustment Still Matters
Not every timing difference warrants a formal entry. Materiality gives accountants room to skip adjustments so small they wouldn’t influence any reasonable person’s decision-making. But materiality is not just a math exercise. The SEC has stated that exclusive reliance on any numerical threshold, including the common 5% rule of thumb, has no basis in the accounting literature or the law.7U.S. Securities and Exchange Commission. Staff Accounting Bulletin No. 99 – Materiality
A numerically small misstatement can still be material if it masks an earnings trend, converts a reported loss into income, affects compliance with a loan covenant, or increases management’s bonus.7U.S. Securities and Exchange Commission. Staff Accounting Bulletin No. 99 – Materiality Intentional misstatements get even less leeway; deliberately skipping small adjustments to manage earnings may violate federal securities law regardless of dollar amount. When in doubt, record the entry. The cost of an unnecessary one is near zero; the cost of a missing one can be substantial.
What Getting Them Wrong Costs
Skipping or botching adjusting entries produces inaccurate financial statements and expensive downstream consequences.
Tax Penalties
If misrecorded adjustments cause a business to understate taxable income, the IRS can impose a 20% accuracy-related penalty on the underpayment attributable to negligence or a substantial understatement of income tax. For individuals, a substantial understatement means the tax shown on the return falls short by the greater of 10% of the correct tax or $5,000. For C corporations (other than S corporations), the threshold is the lesser of 10% of the correct tax (or $10,000 if higher) and $10 million.8Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments The IRS also charges interest on the penalty, accruing from the original due date of the return. Relief is available for reasonable cause and good faith, but “we forgot to accrue the expense” is a tough argument to win.9Internal Revenue Service. Accuracy-Related Penalty
Loan Covenant Violations
Many business loans include financial covenants: minimum current ratios, maximum debt-to-equity ratios, or minimum net income thresholds. When adjusting entries are missing or wrong, reported ratios don’t reflect reality. A lender that discovers a covenant breach can demand immediate repayment. Even if the loan isn’t called, the debt may need to be reclassified from long-term to current, which makes the liquidity picture look significantly worse.
Restatement and Audit Costs
For public companies, material errors in adjusting entries can trigger restatements. Restatements damage investor confidence, often cause stock price declines, and nearly always drive up audit fees in later years. Auditing standards specifically require auditors to identify and test journal entries for signs of fraud or error, with particular attention to entries that affect cash or reclassify revenue and expenses.10PCAOB. AU 316.61 – Consideration of Fraud in a Financial Statement Audit The adjustment process is one of the first areas scrutinized, because estimates and manual judgment are exactly where errors and fraud are most likely.
Who Actually Has to Do This
Not every business is required to use accrual-basis accounting, so not every business faces the full adjusting entry workload. Federal tax law prohibits C corporations, partnerships that include a C corporation as a partner, and tax shelters from using the cash method.11Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting The main exception is the gross receipts test: if average annual gross receipts over the prior three tax years stay at or below $32 million (the inflation-adjusted threshold for tax years beginning in 2026), the entity can generally elect the cash method.12Internal Revenue Service. Revenue Procedure 2025-32 Publicly traded companies face a separate mandate: SEC regulations require financial statements filed under the Securities Act of 1933 and the Securities Exchange Act of 1934 to conform to U.S. GAAP, which means full accrual reporting.13eCFR. 17 CFR Part 210 – Form and Content of Financial Statements
The accounting method a business uses must clearly reflect income, and the IRS reserves the right to require a change if it doesn’t.14Office of the Law Revision Counsel. 26 USC 446 – General Rule for Methods of Accounting Once accrual applies, adjusting entries are the mechanism that makes it work.