Adjusting entries affect two accounts at once, and always across two different financial statements: one side lands on the balance sheet as an asset or liability, and the other lands on the income statement as revenue or expense. They never touch cash. That single pairing is what makes them powerful, and it is why a missed adjustment distorts your profit and your financial position at the same time.
Under accrual accounting, revenue is recorded when earned and expenses when incurred, regardless of when money moves. Adjusting entries are the mechanism that enforces that rule at the end of each period, catching everything the regular transaction entries missed.
The Two-Sided Effect on Your Statements
Every adjusting entry is a paired debit and credit that crosses the boundary between the balance sheet and the income statement. One side hits an asset or liability. The other hits a revenue or expense. That crossing is deliberate, and it is why the ripple runs so far.
Consider an unrecorded expense. Liabilities are too low on the balance sheet, expenses are too low on the income statement, net income looks higher than it should, and retained earnings and owner’s equity both come out overstated. One missed entry throws off at least four line items across two statements.
Cash is the tell. Adjusting entries involve no deposit, no check, and no wire, so they have no direct effect on the operating activities section of the cash flow statement. If cash moved, it is not an adjusting entry.
What Each Type of Adjusting Entry Affects
Five categories cover almost every adjustment a business will make. Each one moves a specific pair of accounts in a specific direction.
Accrued Revenue
When you have performed work or delivered goods but not yet invoiced, the adjustment debits an asset (usually accounts receivable or interest receivable) and credits a revenue account. Total assets go up. Reported earnings go up.
Interest income is the textbook case. A $200,000 note at 10% annual interest earns roughly $55.56 per day, and at quarter-end you may have accumulated thousands in interest that will not arrive as cash for weeks. The adjustment captures what has been earned. Under the accrual method, the IRS treats income as earned when your right to receive it is fixed and the amount can be determined with reasonable accuracy, known as the all-events test.1eCFR. 26 CFR 1.451-1 – General Rule for Taxable Year of Inclusion Finish a consulting project on December 28, invoice on January 5, and the revenue still belongs in December.
Accrued Expense
The mirror image. You have incurred a cost but have not paid it. The entry debits an expense and credits a liability such as wages payable or interest payable. Expenses rise. Liabilities rise.
Wages are the common example. If your pay period ends on the 5th but the month closes on the 31st, employees worked roughly four weeks that will not appear on a paycheck until January. Loan interest works the same way: 15 days of accrued interest at month-end is a cost of the current period, even if the payment is not due yet. Skipping these entries makes the business look more profitable and less indebted than it is. The IRS applies the same all-events test to deductions, adding that economic performance must have taken place before an expense is deductible.2Office of the Law Revision Counsel. 26 U.S. Code 461 – General Rule for Taxable Year of Deduction
Deferred Expense (Prepaid Items)
When you pay upfront for something you will use over time, the payment starts as an asset. As the benefit is consumed, an adjustment moves the used portion into expense. Expenses rise. The asset shrinks.
Pay $12,000 for a 12-month insurance policy on day one and the full amount sits in prepaid insurance. Each month, $1,000 moves into insurance expense. Prepaid rent follows the same pattern: $120,000 for a year’s lease becomes $10,000 of rent expense per month as the space is occupied. Office supplies work slightly differently because usage is not calendar-driven; you count what is left at period-end, calculate what was consumed, and move that amount from the supplies asset into supplies expense. In all three cases, the balance sheet shrinks by exactly the amount the income statement absorbs.
Deferred Revenue
When a customer pays before you deliver, that cash is not income. It is a liability, often called unearned revenue, because you owe the customer either the promised product or their money back. As you fulfill the obligation, the entry debits the unearned revenue liability and credits revenue. The liability shrinks. Reported revenue rises.
A software company that collects $24,000 for a two-year subscription starts with the full amount parked as a liability. Each month, $1,000 shifts into earned revenue. After 24 months, the liability hits zero. If the company never delivers, the liability stays on the books, and the customer may have legal grounds for a refund or breach-of-contract claim.
Depreciation and Amortization
Long-lived assets like equipment, vehicles, and buildings lose value through wear and obsolescence. The adjustment debits depreciation expense, which reduces net income, and credits accumulated depreciation, a contra-asset account that reduces the asset’s book value on the balance sheet.
Accumulated depreciation is worth understanding on its own terms. Instead of standing alone, it offsets the original cost of the asset. A $50,000 delivery truck with $20,000 of accumulated depreciation shows a net book value of $30,000, and both figures remain visible so anyone reading the financials can see how much of the useful life has been consumed. Amortization works identically for intangible assets like patents or purchased software licenses. From an adjusting-entry perspective, it is the same animal with a different name.
These are the most predictable entries on the books. Once you set the method and the useful life, the periodic amount stays consistent, which is why depreciation is often the first entry a business automates, and also easy to overlook when new assets are acquired mid-year and a partial-period calculation is needed.
Consequences When Adjusting Entries Are Wrong or Missing
The immediate consequence is misstated financial statements. Missed accrued expenses make net income look higher than reality. Missed accrued revenues make it look lower. Missed depreciation overstates asset values. Each error flows through to retained earnings, equity, and any financial ratio a lender or investor might calculate. A single overlooked adjustment at year-end can make a company appear to meet a loan covenant it is actually violating.
The tax consequences are concrete. When accounting errors lead to a substantial understatement of income tax, the IRS imposes a penalty equal to 20% of the underpayment. An understatement is considered substantial when it exceeds the greater of 10% of the tax that should have been reported or $5,000, with different thresholds for corporations.3Office of the Law Revision Counsel. 26 U.S. Code 6662 – Imposition of Accuracy-Related Penalty on Underpayments That 20% sits on top of the tax already owed, plus interest.
For public companies the stakes are higher. Inaccurate adjusting entries that distort reported earnings can trigger SEC investigations, civil penalties, and officer-and-director bars. In fiscal year 2024, the SEC obtained $8.2 billion in total financial remedies, with material misstatements among the priority areas.4U.S. Securities and Exchange Commission. SEC Announces Enforcement Results for Fiscal Year 2024
When You Actually Have to Make These Entries
Adjusting entries are a feature of accrual accounting. Not every business is required to use the accrual method, and readers on the cash method can largely set the question aside.
For tax years beginning in 2026, a corporation or partnership must switch to accrual accounting if its average annual gross receipts over the prior three years exceed $32 million.5Internal Revenue Service. Revenue Procedure 2025-32 Below that threshold, most small businesses have a choice. Sole proprietors and partnerships that clear the size test can stay on the cash method and avoid the bulk of adjusting entries.
Whichever method you use, the IRS requires that it clearly reflect income. If your chosen method does not accurately capture what you earned and spent, the IRS can force a change.6Office of the Law Revision Counsel. 26 U.S.C. 446 – General Rule for Methods of Accounting Businesses with complex revenue streams, long-term contracts, or significant inventory often find accrual is the only method that passes this test, even when gross receipts fall below the threshold. Once you are on accrual, adjusting entries stop being optional and start being the last checkpoint before your statements go out the door.