After completing this lesson, you’ll be able to explain why end-of-period adjustments are necessary, record the four main types of adjusting entries (plus depreciation), and describe the full accounting cycle from the moment a transaction occurs through the preparation of financial statements.
Why adjustments exist
Imagine a consulting business pays 1,000 of that rent applies to January — the other $5,000 covers February through June. Without an adjustment, January’s income statement is wrong in one of two ways:
- If the bookkeeper recorded the entire 5,000.
- If the bookkeeper recorded it as Prepaid Rent and made no adjustment, January’s expenses are understated by $1,000 because no rent expense appears at all.
Neither version reflects what actually happened in January. Under accrual accounting, revenues and expenses must match the period they belong to — not the period cash happens to move. Adjusting entries fix this mismatch at the end of each accounting period.
The four types of adjusting entries
Every adjusting entry falls into one of four categories: accrued revenue, accrued expense, deferred revenue, or deferred expense. Walk through each one below.
Accrued revenue
The consulting business completed $2,000 of work for a client in March but won’t send the invoice until April. The revenue was earned in March, so March’s books need to reflect it.
| Account | Debit | Credit |
|---|---|---|
| Accounts Receivable | $2,000 | |
| Service Revenue | $2,000 |
This entry records the revenue in the correct period and creates a receivable — the client owes the business money.
Accrued expense
Employees earned $3,000 in wages during the last week of March, but payday falls in April. The expense belongs to March even though no cash has left the bank yet.
| Account | Debit | Credit |
|---|---|---|
| Wages Expense | $3,000 | |
| Wages Payable | $3,000 |
March’s income statement now includes the wages employees earned, and the balance sheet shows the obligation to pay them.
Deferred revenue (unearned revenue)
A client paid 12,000 is a liability because the business owes 12 months of future services.
Initial entry on March 1:
| Account | Debit | Credit |
|---|---|---|
| Cash | $12,000 | |
| Unearned Revenue | $12,000 |
By March 31, one month of service has been delivered. The business has earned 12,000 / 12 months), so the adjustment moves $1,000 from the liability to revenue.
Month-end adjusting entry:
| Account | Debit | Credit |
|---|---|---|
| Unearned Revenue | $1,000 | |
| Service Revenue | $1,000 |
After this entry, Unearned Revenue shows 1,000 earned in March.
Deferred expense (prepaid expense)
This is the $6,000 prepaid rent from the opening example. When the business paid cash on January 1, it received an asset — the right to use office space for six months.
Initial entry on January 1:
| Account | Debit | Credit |
|---|---|---|
| Prepaid Rent | $6,000 | |
| Cash | $6,000 |
At the end of January, one month of that asset has been consumed. The adjustment transfers $1,000 from the asset to an expense.
Month-end adjusting entry:
| Account | Debit | Credit |
|---|---|---|
| Rent Expense | $1,000 | |
| Prepaid Rent | $1,000 |
After this entry, Prepaid Rent drops to 1,000 for January.
A key rule and one more common adjustment
Notice that none of the adjusting entries above touch the Cash account. That’s not a coincidence — it’s a rule. If cash moved, it was already recorded in a regular journal entry. Adjusting entries correct the non-cash side: they recognize revenue that was earned but not yet billed, expenses that were incurred but not yet paid, or they allocate previously recorded amounts to the correct period.
One more adjustment you’ll encounter frequently is depreciation. Long-lived assets like vehicles and equipment lose value over time, and that cost must be spread across the asset’s useful life.
Example: The business bought a delivery vehicle for 200 of the vehicle’s cost is recognized as an expense.
| Account | Debit | Credit |
|---|---|---|
| Depreciation Expense | $200 | |
| Accumulated Depreciation | $200 |
Accumulated Depreciation is a contra-asset account — it reduces the vehicle’s carrying value on the balance sheet without changing the original cost recorded in the asset account.
The full accounting cycle
Now that you understand adjusting entries, you can see the complete accounting cycle — the sequence of steps a business follows each period to go from raw transactions to finished financial statements.
-
Analyze and record transactions in the journal. Every business event that has a financial impact gets recorded as a journal entry with equal debits and credits.
-
Post to the ledger. Transfer each journal entry to the appropriate accounts in the general ledger so you can see the running balance of every account.
-
Prepare an unadjusted trial balance. List all ledger accounts and their balances to verify that total debits equal total credits. This catches posting errors but doesn’t guarantee the balances are correct for the period.
-
Record adjusting entries. Apply the accruals and deferrals covered in this lesson so that revenues and expenses reflect the current period.
-
Prepare an adjusted trial balance. Verify debits still equal credits after the adjustments. This trial balance feeds directly into the financial statements.
-
Prepare financial statements. Use the adjusted trial balance to build the income statement, statement of retained earnings, and balance sheet — in that order, because each statement provides numbers the next one needs.
-
Record closing entries. Transfer the balances of all revenue, expense, and dividend accounts to retained earnings. This resets temporary accounts to zero so they’re ready for the next period.
-
Prepare a post-closing trial balance. Confirm that only permanent accounts (assets, liabilities, equity) remain open and that debits equal credits. The books are now ready for the next period.
Self-check exercises
Exercise 1. On October 1, a business paid $2,400 for a 12-month insurance policy. By December 31, three months have passed. What type of adjustment is this, and what’s the adjusting entry?
Answer
This is a deferred expense (prepaid expense). The business paid cash upfront for a benefit that spans multiple periods.
Three months of coverage have been used: 200/month, so $600 total.
| Account | Debit | Credit |
|---|---|---|
| Insurance Expense | $600 | |
| Prepaid Insurance | $600 |
Exercise 2. A company has a savings account that earned $350 in interest during March. The bank won’t deposit the interest until April 5. Record the adjusting entry for March.
Answer
This is accrued revenue — the interest was earned in March but the cash hasn’t arrived yet.
| Account | Debit | Credit |
|---|---|---|
| Interest Receivable | $350 | |
| Interest Revenue | $350 |
Exercise 3. A colleague asks, “Why can’t an adjusting entry debit or credit Cash?” How do you explain it?
Answer
The Cash account only changes when cash physically moves into or out of the business. That movement is always captured by a regular journal entry at the time it happens — paying a bill, receiving a payment, etc. Adjusting entries exist to fix accounts that don’t yet reflect economic reality for the period. They handle timing differences between when cash moves and when the related revenue or expense belongs. Since the cash side was already recorded, adjustments only touch the non-cash accounts (revenues, expenses, receivables, payables, prepaids, or unearned amounts).
Exercise 4. Below is a simplified unadjusted trial balance for March. Prepare the adjusted trial balance after recording the following adjustments: (a) 800 of services have been performed from unearned revenue, (c) $1,200 of wages were earned by employees but not yet paid.
| Account | Unadjusted Debit | Unadjusted Credit |
|---|---|---|
| Cash | $10,000 | |
| Prepaid Rent | $3,000 | |
| Equipment | $15,000 | |
| Unearned Revenue | $4,000 | |
| Common Stock | $20,000 | |
| Service Revenue | $6,000 | |
| Wages Expense | $2,000 | |
| Totals | $30,000 | $30,000 |
Answer
Adjusting entries:
(a) Debit Rent Expense 500 (b) Debit Unearned Revenue 800 (c) Debit Wages Expense 1,200
Adjusted trial balance:
| Account | Adjusted Debit | Adjusted Credit |
|---|---|---|
| Cash | $10,000 | |
| Prepaid Rent | $2,500 | |
| Equipment | $15,000 | |
| Unearned Revenue | $3,200 | |
| Wages Payable | $1,200 | |
| Common Stock | $20,000 | |
| Service Revenue | $6,800 | |
| Wages Expense | $3,200 | |
| Rent Expense | $500 | |
| Totals | $31,200 | $31,200 |
Notice that Cash didn’t change in any of the adjustments, two new accounts appeared (Wages Payable and Rent Expense), and total debits still equal total credits.
What comes next
You now understand the full cycle from recording a transaction to producing financial statements — including the adjusting entries that make those statements accurate. The next step is learning how to analyze financial statements: using ratios and comparisons to extract meaning from the numbers and evaluate a business’s performance, liquidity, and financial health.