Adjusting Entries: The Complete Guide

Why Adjusting Entries Exist

During a period, transactions are recorded when cash changes hands or when documents arrive. But by the end of the period, several things will be true that haven't been recorded yet:

• Insurance you paid for three months ago has partially expired
• Employees have worked days for which they haven't been paid yet
• A client paid you in advance, and you've now delivered part of the work
• Your bank loan has been accumulating interest that you haven't paid yet

Adjusting entries fix these gaps. Without them, the financial statements wouldn't reflect economic reality.

Two rules about adjusting entries: - They are always recorded on the last day of the accounting period - They never involve the Cash account — if cash moved, it was already recorded

The Four Types of Adjustments

Every adjusting entry falls into one of four categories:

The first two are deferrals — something was recorded earlier and is now being allocated to the correct period. The last two are accruals — something happened that hasn't been recorded yet.

Prepaid Expenses (Deferrals)

When a company pays for something in advance, the payment creates an asset — not an expense. The asset is "used up" over time, and adjusting entries record that consumption.

Scenario: On January 1, Petra Trading pays SAR 24,000 for a 12-month insurance policy.

Initial entry (January 1):

At this point, Prepaid Insurance is an asset — the company owns 12 months of coverage.

Adjusting entry (January 31): One month has passed. SAR 2,000 of insurance has been consumed (24,000 ÷ 12).

The asset decreases and the expense increases. After this entry, Prepaid Insurance shows SAR 22,000 (11 months remaining), and the income statement correctly reports SAR 2,000 of insurance expense for January.

Unearned Revenue (Deferrals)

When a customer pays before you deliver the service, that payment is a liability — you owe them the work. As you deliver, the liability converts to revenue.

Scenario: On March 1, Cornerstone Academy receives SAR 36,000 from a student for a 6-month training program.

Initial entry (March 1):

No revenue yet — the Academy hasn't delivered anything.

Adjusting entry (March 31): One month of training delivered. SAR 6,000 earned (36,000 ÷ 6).

The liability decreases and revenue increases. The student's balance drops to SAR 30,000 (5 months of training still owed).

Common mistake: Recording the full SAR 36,000 as revenue when the cash arrives. Under accrual accounting, you only recognize revenue when you earn it — not when the money lands in your account.

Accrued Expenses

Sometimes an expense accumulates silently throughout the period. No invoice has arrived. No cash has been paid. But the expense is real.

Scenario: Employees at Zenith Corp earn SAR 15,000 per week (Mon–Fri). The accounting period ends on Wednesday. Three days of salaries (SAR 9,000) have been earned by employees but won't be paid until Friday.

Adjusting entry (Wednesday, period-end):

The expense is recognized now, and the liability shows that the company owes employees SAR 9,000. When payday arrives in the next period, the entry to pay will debit Salaries Payable (clearing the liability) and credit Cash.

Interest accrual works the same way. If a company has a SAR 200,000 loan at 6% annual interest, one month of accrued interest is SAR 1,000 — even if the payment isn't due until next quarter.

Accrued Revenue

Revenue can be earned before cash arrives or before an invoice is sent.

Scenario: Riyadh Engineering completed a SAR 40,000 consulting phase on December 28. The invoice won't go out until January 5, and the client will pay in February.

Adjusting entry (December 31):

The work is done. Under accrual accounting, the revenue belongs in December — the period when it was earned. The receivable records the client's obligation to pay.

Without this entry, December revenue would be understated by SAR 40,000 and January revenue would be overstated by the same amount.

How to Spot Missing Adjustments

At period-end, run through this checklist:

• Prepaid accounts: Do any prepaid balances represent services or coverage that's been partially used?
• Unearned revenue: Has any work been completed for which you received payment in advance?
• Employee costs: Are there any days of work between the last paycheck and the period-end date?
• Interest: Does the company have any loans or notes payable? Interest accrues daily.
• Revenue: Has any work been completed that hasn't been invoiced yet?
• Supplies: Has the supplies account been adjusted for items actually consumed?
• Depreciation: Has this period's depreciation been recorded for fixed assets?

Depreciation deserves special mention. It's technically a prepaid expense deferral — you paid for equipment upfront, and its cost is allocated over its useful life. But unlike insurance, there's no "prepaid" account. The credit goes to Accumulated Depreciation, a contra-asset.

Missing one adjustment might seem minor, but the effects cascade. If you understate an expense, net income is overstated, retained earnings are overstated, and the balance sheet is wrong. Practice catching these on Accountery — the platform presents realistic end-of-period scenarios and checks whether your adjustments are complete.