How to Prepare Adjusting Entries

Quick Answer

Adjusting entries are journal entries made at the end of an accounting period to update account balances so that financial statements reflect the accrual basis of accounting. The five main categories are accrued revenues, accrued expenses, deferred revenues, deferred expenses (prepayments), and estimates (such as depreciation and allowances). To prepare adjusting entries, review the unadjusted trial balance, identify accounts that need updating, determine the correct amounts, and record the entries before closing the books.

What Are Adjusting Entries?

Adjusting entries are the bridge between cash-basis bookkeeping and accrual-basis financial reporting. Throughout an accounting period, routine transactions — sales, purchases, payroll — are recorded as they occur. But some economic events span multiple periods, and the cash exchange does not align with the period in which the revenue is earned or the expense is incurred. Adjusting entries correct these timing differences so that the income statement and balance sheet are accurate as of the period-end date.

Without adjusting entries, financial statements would be misleading. Revenue might be understated (if earned but not yet billed), expenses might be understated (if incurred but not yet paid), and asset or liability balances would be wrong. Adjusting entries are a fundamental requirement under both US GAAP and IFRS.

The starting point for preparing adjustments is the unadjusted trial balance, which lists all account balances before period-end adjustments.

The Five Categories of Adjusting Entries

1. Accrued Revenues

Accrued revenues are earned but not yet recorded because the invoice has not been sent or cash has not been received. For example, if a consulting firm has completed $12,000 of work by month-end but will not bill the client until next month, an adjusting entry is needed:

This entry recognizes the revenue in the period it was earned, following the revenue recognition principle. For more examples, see our guide to accounts receivable journal entries.

2. Accrued Expenses

Accrued expenses are incurred but not yet recorded because the bill has not been received or the payment has not been made. Common examples include accrued wages, accrued interest, and accrued utilities. For instance, if employees have earned $4,500 in wages by period-end but payday is next month:

This entry matches the expense to the period in which the employees worked. Detailed examples are available in our accrued expenses journal entries guide.

3. Deferred Revenues (Unearned Revenues)

Deferred revenues occur when cash is received before the revenue is earned. The initial entry records the receipt as a liability (Unearned Revenue), and the adjusting entry recognizes the portion that has been earned by period-end. If a company received $6,000 for a 6-month contract and one month has passed:

Each month, $1,000 of the deferred amount is recognized as revenue. See our detailed guide to deferred revenue journal entries for more scenarios.

4. Deferred Expenses (Prepaid Expenses)

Deferred expenses are paid in advance and initially recorded as assets. The adjusting entry allocates the portion that has been consumed during the period. For example, if $3,600 of prepaid insurance covers 12 months and one month has expired:

Similar entries apply to prepaid expenses such as prepaid rent, prepaid advertising, and prepaid maintenance contracts.

5. Estimates and Allocations

Some adjusting entries rely on estimates rather than precise calculations. The most common are depreciation and allowance for doubtful accounts. If a machine costing $24,000 has a 10-year useful life and no salvage value, the monthly straight-line depreciation is $200:

For full coverage of depreciation methods and entries, refer to our depreciation journal entries guide. The allowance for doubtful accounts is another common estimate that adjusts the net realizable value of receivables.

Step-by-Step Process for Preparing Adjusting Entries

Step 1: Review the Unadjusted Trial Balance

Start with the unadjusted trial balance, which lists every account and its balance after routine transactions have been posted. Look for accounts that may need adjustment — particularly asset accounts that might have expired portions (prepaid expenses, supplies) and liability accounts that might have earned portions (unearned revenue).

Step 2: Identify Accounts Requiring Adjustment

Systematically review each balance sheet account and ask: has any portion of this asset been consumed? Has any portion of this liability been satisfied? Are there any unrecorded revenues or expenses? Common red flags include:

• Prepaid asset accounts with balances that have not been reduced all period
• Unearned revenue balances that have not decreased as services are delivered
• Fixed asset accounts with no corresponding depreciation recorded
• Interest-bearing debt with no interest accrual since the last payment

Step 3: Determine Adjustment Amounts

For each account requiring adjustment, calculate the correct period-end amount. This may involve:

• Counting the months expired on a prepaid contract
• Computing accrued interest using the formula: principal × rate × time
• Estimating uncollectible receivables based on aging or historical percentages
• Calculating depreciation using the appropriate method (straight-line, double-declining, units-of-production)

Step 4: Record the Adjusting Entries

Post each adjusting entry to the general journal with a clear description (e.g., "To record one month of prepaid insurance expired"). Date the entries as of the last day of the period. Each adjusting entry always affects both an income statement account and a balance sheet account — never two income statement accounts or two balance sheet accounts alone.

Step 5: Prepare the Adjusted Trial Balance

After posting all adjusting entries, prepare an adjusted trial balance to verify that total debits equal total credits. This becomes the foundation for the financial statements. Compare it to the unadjusted trial balance to confirm that every adjustment has been properly reflected.

Step 6: Verify with the Bank Reconciliation

As a final check, compare your cash account balance to the bank reconciliation. Any outstanding deposits, checks, or bank charges that have not yet been recorded may require additional adjusting entries before you close the books.

Common Mistakes When Preparing Adjusting Entries

• Omitting adjustments entirely — This is the most serious error. Without adjusting entries, financial statements do not comply with GAAP or IFRS.
• Duplicating adjustments — Recording the same accrual twice overstates both the expense and the liability. Always verify that the adjustment has not already been posted.
• Using incorrect time periods — Counting 2 months of depreciation when 3 months have passed understates expense and overstates assets.
• Forgetting to reverse accruals — If you accrue expenses at period-end and do not reverse them in the next period, you risk double-counting the expense when the actual payment is recorded.
• Mixing adjusting entries with closing entries — Adjusting entries update account balances; closing entries zero out temporary accounts. They serve different purposes and must be recorded in the correct sequence.

Adjusting Entries vs. Correcting Entries

Adjusting entries are routine period-end entries made to align accounts with the accrual basis. Correcting entries, on the other hand, fix errors discovered after the original transaction was posted. While adjusting entries are a normal part of every accounting cycle, correcting entries are exceptional and should be documented with an explanation of the original error and the correction.

Key Takeaways

• Adjusting entries ensure financial statements follow the accrual basis of accounting
• There are five categories: accrued revenues, accrued expenses, deferred revenues, deferred expenses, and estimates
• Every adjusting entry affects one income statement account and one balance sheet account
• Start with the unadjusted trial balance and systematically identify accounts needing adjustment
• Always prepare an adjusted trial balance after posting adjustments
• Common pitfalls include omitting adjustments, duplicating entries, and forgetting to reverse accruals