Why are adjusting entries important and how do they contribute to accurate financial reporting?

What is an adjusting entry?

Adjusting entries are changes to journal entries you’ve already recorded. Specifically, they make sure that the numbers you have recorded match up to the correct accounting periods.

Journal entries track how money moves—how it enters your business, leaves it, and moves between different accounts.

Here’s an example of an adjusting entry: In August, you bill a customer $5,000 for services you performed. They pay you in September.

In August, you record that money in accounts receivable—as income you’re expecting to receive. Then, in September, you record the money as cash deposited in your bank account.

To make an adjusting entry, you don’t literally go back and change a journal entry—there’s no eraser or delete key involved. Instead, you make a new entry amending the old one.

For example, going back to the example above, say your customer called after getting the bill and asked for a 5% discount. If you granted the discount, you could post an adjusting journal entry to reduce accounts receivable and revenue by $250 (5% of $5,000).

Making adjusting entries is a way to stick to the matching principle—a principle in accounting that says expenses should be recorded in the same accounting period as revenue related to that expense.

In the accounting cycle, adjusting entries are made prior to preparing a trial balance and generating financial statements.

Why make adjusting entries?

When you make an adjusting entry, you’re making sure the activities of your business are recorded accurately in time. If you don’t make adjusting entries, your books will show you paying for expenses before they’re actually incurred, or collecting unearned revenue before you can actually use the money.

So, your income and expenses won’t match up, and you won’t be able to accurately track revenue. Your financial statements will be inaccurate—which is bad news, since you need financial statements to make informed business decisions and accurately file taxes.

One more thing: Adjusting journal entries are essential for depreciating assets. Which is important for reporting tax deductions and balancing your books.

Who needs to make adjusting entries?

If you do your own accounting, and you use the accrual system of accounting, you’ll need to make your own adjusting entries.

If you do your own accounting and you use the cash basis system, you likely won’t need to make adjusting entries.

No matter what type of accounting you use, if you have a bookkeeper, they’ll handle any and all adjusting entries for you.

Spreadsheets vs. accounting software vs. bookkeepers

Adjusting entries will play different roles in your life depending on which type of bookkeeping system you have in place.

If you do your own bookkeeping using spreadsheets, it’s up to you to handle all the adjusting entries for your books. Then, you’ll need to refer to those adjusting entries while generating your financial statements—or else keep extensive notes, so your accountant knows what’s going on when they generate statements for you.

If you use accounting software, you’ll also need to make your own adjusting entries. The software streamlines the process a bit, compared to using spreadsheets. And it will likely generate financial statements for you. But you’re still 100% on the line for making sure those adjusting entries are accurate and completed on time.

If you have a bookkeeper, you don’t need to worry about making your own adjusting entries, or referring to them while preparing financial statements. They’ll do both for you.

If you don’t have a bookkeeper yet, check out Bench—we’ll pair you with a dedicated bookkeeping team, and give you access to simple software to track your finances.

The five types of adjusting entries

If making adjusting entries is beginning to sound intimidating, don’t worry—there are only five types of adjusting entries, and the differences between them are clear cut. Here are descriptions of each type, plus example scenarios and how to make the entries.

1. Accrued revenues

When you generate revenue in one accounting period, but don’t recognize it until a later period, you need to make an accrued revenue adjustment.

Example scenario

Your business makes custom tote bags. In February, you make $1,200 worth for a client, then invoice them. The client pays the invoice on March 7.

You incurred expenses making the bags—cost of materials and labor, workshop rent, utilities—in February. To accurately reflect your income for the month, you need to show the revenue you generated. (Remember: Revenue minus expenses equals income.)

First, you make an adjusting entry, moving the revenue from a “holding account” (accrued receivables) to a revenue account (revenue.) Then, on March 7, when you get paid and deposit the money in the bank, you move the money from revenue to cash.

Example adjusting entry

In your general ledger, the adjustment looks like this. First, during February, when you produce the bags and invoice the client, you record the anticipated income.

For the sake of balancing the books, you record that money coming out of revenue.

Then, when you get paid in March, you move the money from accrued receivables to cash.

2. Accrued expenses

Once you’ve wrapped your head around accrued revenue, accrued expense adjustments are fairly straightforward. They account for expenses you generated in one period, but paid for later.

Example scenario

Suppose in February you hire a contract worker to help you out with your tote bags. You agree in advance to pay them $400 for a weekend’s work. However, they don’t invoice you until early March.

Example adjusting entry

In February, you record the money you’ll need to pay the contractor as an accrued expense, debiting your labor expenses account.

In March, when you pay the invoice, you move the money from accrued expenses to cash, as a withdrawal from your bank account.

3. Deferred revenues

If you’re paid in advance by a client, it’s deferred revenue. Even though you’re paid now, you need to make sure the revenue is recorded in the month you perform the service and actually incur the prepaid expenses.

Example scenario

Over the years, you’ve become well-respected in the tote bag community. You’re invited to speak at the annual Tote Symposium, in Lodi, California.

The conference showrunners will pay you $2,000 to deliver a talk on the changing face of the tote bag industry. They pay you in January, after you confirm you’ll be attending. You’ll speak at the conference in March.

Example adjusting entry

First, record the income on the books for January as deferred revenue. You’ll credit it to your deferred revenue account for now.

Then, in March, when you deliver your talk and actually earn the fee, move the money from deferred revenue to consulting revenue.

4. Prepaid expenses

Prepaid Expenses work a lot like deferred revenue. Except, in this case, you’re paying for something up front—then recording the expense for the period it applies to.

Example scenario

You rent a new space for your tote manufacturing business, and decide to pre-pay a year’s worth of rent in December.

In December, you record it as prepaid rent expense, debited from an expense account.

Then, come January, you want to record your rent expense for the month. You’ll move January’s portion of the prepaid rent from an asset to an expense.

5. Depreciation expenses

When you depreciate an asset, you make a single payment for it, but disperse the expense over multiple accounting periods. This is usually done with large purchases, like equipment, vehicles, or buildings.

At the end of an accounting period during which an asset is depreciated, the total accumulated depreciation amount changes on your balance sheet. And each time you pay depreciation, it shows up as an expense on your income statement.

The way you record depreciation on the books depends heavily on which depreciation method you use. It’s a pretty complex operation involving large sums. Considering the amount of cash and tax liability on the line, it’s smart to consult with your accountant before recording any depreciation on the books. To get started, though, check out our guide to small business depreciation.

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