Lesson 71 - Beginner accounting course

71. Why Adjusting Entries are Needed

Adjusting entries are essential in accounting because they ensure that revenues and expenses are recorded in the correct accounting period. Without them, financial statements would not accurately reflect a company's financial position, violating the accrual basis of accounting.

1. What Are Adjusting Entries?

Adjusting entries are journal entries made at the end of an accounting period to update account balances before financial statements are prepared. They ensure that:

• Revenues are recorded when earned, not necessarily when cash is received (Revenue Recognition Principle).

• Expenses are recorded when incurred, not necessarily when paid (Matching Principle).

• Assets and liabilities reflect their true value at the reporting date.

Adjusting entries never involve cash—they only update revenues, expenses, assets, and liabilities.

2. Why Are Adjusting Entries Important?

Without adjusting entries, financial statements may be inaccurate and misleading. Here’s why they matter:

3. Types of Adjusting Entries

There are four main types of adjusting entries:

4. Examples of Adjusting Entries

a) Accrued Revenues (Revenue earned but not yet received)

Example:

A law firm provides legal services worth $5,000 in December but won’t receive payment until January.

This ensures that revenue is recognized in December, when it was earned. 

b) Accrued Expenses (Expense incurred but not yet paid)

Example:

A company’s employees earned $3,000 in wages in December, but payday is in January.

This ensures that expenses are recognized in December, when employees worked. 

c) Deferred Revenues (Unearned Revenue) (Cash received in advance for future services)

Example:

A magazine company receives $12,000 in December for a one-year subscription but must recognize $1,000 per month.

Initial Entry (when cash is received):

Adjusting Entry (recognizing revenue for one month): 

This ensures revenue is properly recognized over time. 

d) Deferred Expenses (Prepaid Expenses) (Cash paid in advance for future expenses)

Example:

A company prepays $6,000 for six months of rent in December.

Initial Entry (when rent is paid):

Adjusting Entry (recognizing one month of rent expense): 

This ensures expenses are recognized gradually, not all at once. 

5. Consequences of Not Making Adjusting Entries

If a company fails to record adjusting entries, financial statements may be misstated:

These errors can mislead investors, result in regulatory penalties, or cause financial mismanagement. 

6. Key Takeaways

• Adjusting entries ensure financial statements reflect the accrual basis of accounting.

• They update revenues and expenses to the correct period, ensuring compliance with GAAP and IFRS.

• Adjusting entries never involve cash transactions—they adjust accounts like receivables, payables, and prepaid items.

• Failure to make adjusting entries can lead to financial misstatements and poor business decisions.

By applying adjusting entries correctly, businesses can present accurate and reliable financial statements.