What are adjusting entries?

Adjusting entries are journal entries made at the end of an accounting period to record revenues and expenses in the correct periods, ensuring that the financial statements follow accrual accounting principles. For professional service firms, common adjusting entries include accruing unbilled revenue (work completed but not invoiced), prepaid expenses (insurance paid for future months), accrued expenses (contractor invoices not received but work completed), and depreciation (allocating equipment cost over time). Adjusting entries never involve cash; they correct timing mismatches between when cash moves and when economic activity occurs.

Key characteristics of adjusting entries

1. Timing: Made at period-end (monthly, quarterly, annually)

2. No cash impact: Adjust non-cash accounts like receivables, payables, prepaid, and accrued

3. Types: Accruals (revenue/expenses before cash), deferrals (cash before revenue/expenses), depreciation

4. Reversing option: Some entries reverse automatically in the next period

5. Required for accuracy: Transform cash-basis records into accrual-basis statements

Why adjusting entries matters for service firms

Adjusting entries ensure P&L reflects actual business performance, not just cash timing. A consulting firm that completes $80,000 of work in December but invoices in January shows $0 December revenue without adjusting entries, thereby misrepresenting monthly performance. Annual insurance premiums paid in January are recorded as a $36,000 January expense, with no adjusting entries to spread the cost over 12 months at $3,000 per month. Adjusting entries are required for tax compliance: businesses over $25M must use accrual accounting. Even smaller firms benefit from accrual-based management reports showing true profitability.

Example: Common adjusting entries for consulting firm (December 31)

Adjusting entry 1: Accrue unbilled revenue

1. Work completed in December but not invoiced: $42,000

2. Debit: Accounts Receivable $42,000

3. Credit: Consulting Revenue $42,000

4. Reasoning: Revenue earned in December, so recognize in December

Adjusting entry 2: Prepaid expense allocation

1. Annual insurance paid January 1: $24,000 for 12 months

2. Monthly allocation: $24,000 / 12 = $2,000

3. Debit: Insurance Expense $2,000

4. Credit: Prepaid Insurance $2,000

5. Reasoning: December's portion of the annual premium

Adjusting entry 3: Accrue contractor expense

1. Contractor completed work in December, invoice arrives January 5

2. Debit: Contractor Expense $6,500

3. Credit: Accrued Expenses $6,500

4. Reasoning: Expense incurred in December, recognized in December

Adjusting entry 4: Record depreciation

1. Equipment original cost: $60,000, 5-year life

2. Monthly depreciation: $60,000 / 60 months = $1,000

3. Debit: Depreciation Expense $1,000

4. Credit: Accumulated Depreciation $1,000

5. Reasoning: Allocate December's equipment cost

Adjusting entry 5: Accrue interest expense

1. Line of credit balance: $150,000, 8% annual rate

2. December interest: $150,000 × 8% / 12 = $1,000

3. Debit: Interest Expense $1,000

4. Credit: Interest Payable $1,000

5. Reasoning: December's interest expense has not yet been paid

6. Impact: These entries increase December revenue by $42,000 and costs by $10,500, netting +$31,500 to December profit