Creating financial statements based on cash movements may seem like an intuitive approach, however, a cash perspective tends not to capture economic reality. Numerous variables (unrecognised expenses, discounts, etc.) can result in reporting inaccuracies that not only distort business performance but can make tax season far more arduous than it needs to be.
In this article, we’ll explore how adjusting journal entries transforms rough financial data into accurate reporting, the best practices for implementing adjustment mechanisms, and how technological platforms like Harness can streamline the process.
Key takeaways
- Adjusting entries aligns financial records with economic reality, ensuring transactions appear in proper periods regardless of cash timing.
- Proper adjustments improve decision-making with accurate data, while their absence leads to compliance issues and misguided strategies.
- Careful attention to timing differences maintains the integrity of financial statements and preserves stakeholder trust.
Table of Contents
- Understanding the fundamentals of adjusting entries
- The five categories of adjusting entries every tax advisor should know
- Core accounting principles that require adjusting entries
- Common scenarios that require adjusting entries
- The hidden costs of neglecting adjusting entries
- Step-by-step process for creating effective adjusting entries
- Best practices for managing adjusting entries in your accounting workflow
- How technology is transforming the adjusting entry process
- How Harness can help
Understanding the fundamentals of adjusting entries
A company’s financial records tend to operate in a state of flux as opposed to being a series of distinct sections. Adjusting entries makes sure that any individual snapshot of financial performance tells an accurate story. These special journal entries, made at period-end, bridge the gap between raw transaction data and accurate financial statements.
Business operations naturally create timing mismatches between economic events and cash movements. Consider a December advertising campaign paid for in January: the economic impact belongs to December, even though the money moves later. This is where adjusting entries keep a company’s financial story coherent across these timelines.
For businesses using accrual accounting— which is most companies beyond the smallest sole proprietorships—adjusting entries is a necessity. Although cash-basis operators might skip this step, they miss out on the deeper insights that proper period matching provides.
The five categories of adjusting entries every tax advisor should know
At the heart of adjusting entries are five distinct categories, each addressing a specific timing mismatch.
Accrued Revenues
Consider a consultant who completes a project on December 31 but will not issue an invoice until January. Without an adjusting entry, December’s financial statements would understate the firm’s actual performance.
Accrued Expenses
Accrued expenses operate in reverse, capturing costs that have been incurred but not yet paid. For instance, if a company’s team worked overtime in the last week of March, those wages belong to March’s expenses, even if payday occurs in April.
Deferred Revenues
With deferred revenues, timing becomes even more important. When a software company, for example, receives annual subscription payments upfront, that money is not immediately recognized as revenue—it’s essentially a liability until the service is delivered. Tax advisors need to adjust entries to transform prepaid amounts into revenue, month-by-month as services are rendered, maintaining compliance with revenue recognition standards.
Prepaid Expenses
Prepaid expenses reflect deferred revenues from the buyer’s perspective. For example, an annual insurance premium paid in January needs to be allocated across all twelve months through adjusting entries.
Depreciation Entries
When considering long-term assets, depreciation entries acknowledge an often-overlooked reality—that long-term assets don’t suddenly lose value but gradually decline over time. These adjustments spread major investment costs across their useful life, providing a more accurate picture of asset values, operating costs, and overall financial health.
Core accounting principles that require adjusting entries
Revenue recognition guidelines have changed significantly in recent years. Today’s standards insist on recording income when earned—not when cash hits your bank account—a principle that habitually creates timing gaps.
Further to this, the matching principle (the basis of modern accounting) requires expenses to appear alongside the revenues they helped create. With cash flows rarely aligning perfectly with economic events, adjusting entries serves to maintain this relationship.
Common scenarios that require adjusting entries
Payroll frequently triggers the need for adjusting entries, particularly when pay periods cross month-end boundaries. Imagine a biweekly payroll running from December 25 to January 7—part of those wages belong to December’s expenses, even though payment happens in January.
Interest calculations present another common adjustment scenario. A loan payment due on January 5 includes interest that accumulated during December. Without an adjusting entry, December’s financial statements would understate a business’s interest expense and liabilities.
Physical inventory counts often reveal discrepancies from book records, requiring adjustments to both inventory and cost of goods sold accounts. These adjustments make sure a company’s financial statements reflect actual inventory levels rather than theoretical calculations.
Professional service firms face unique challenges with work-in-progress. A law firm might complete substantial work in March but not bill until April. Without proper adjusting entries, March’s revenue would be understated while April’s would be inflated.
Subscription-based businesses, as mentioned, must carefully manage revenue recognition through adjusting entries. When a customer pays $1,200 for an annual subscription, that amount needs to be recognized as revenue at $100 per month through adjustment entries.
The hidden costs of neglecting adjusting entries
Alongside the distorted perspective on company performance that inadequate adjustments create, mismatched revenue and expense recognition can trigger unnecessary tax liabilities. Accounts that haven’t been properly adjusted can draw unwanted attention from tax authorities, with these oversights potentially resulting in penalties and audits.
From a strategic point of view, stakeholders rely on accurate financial reporting to make key decisions. When adjusting entries are neglected, trust in financial statements rapidly diminishes. Banks may hesitate to extend credit, investors might question their commitments, and strategic partners could reconsider their relationships.
Step-by-step process for creating effective adjusting entries
Effective entry adjustment begins with a thorough review of your unadjusted trial balance. Accounts that typically require adjustment—prepaid expenses, unearned revenues, and accrued liabilities—often hide timing discrepancies that will need addressing.
After reviewing the trial balance, all supporting documentation—contracts, invoices, payment schedules, and other relevant records—need to be gathered. These documents provide the precise figures needed for accurate adjustments and serve as your audit trail for future reference.
Creating the actual journal entries requires both technical precision and professional judgment. Each entry must properly reflect the economic substance of the transaction while maintaining the fundamental accounting equation through carefully balanced debits and credits.
After posting these entries to a company’s general ledger, each affected account should now display its true, up-to-date balance. An adjusted trial balance should then be generated to verify that all accounts reflect their correct amounts and that the books remain in perfect balance.
Best practices for managing adjusting entries in your accounting workflow
A standardized approach to adjusting entries transforms this potentially chaotic process into a smooth, reliable operation. Tax advisors should develop a comprehensive checklist that guides them through common adjustment scenarios, ensuring no necessary entries slip through the cracks.
To deliver accuracy during month-end closing, dedicated time needs to be set aside for adjusting entries. A rushed adjustment process often leads to errors or oversights that could cause major issues in future periods. Instead, build your closing schedule with explicit windows for identifying, preparing, and reviewing these necessary entries.
Most importantly, each adjusting entry should come with a clear explanation of its purpose and calculations. This is invaluable for future reference and a key factor when defending your position during potential audits.
How technology is transforming the adjusting entry process
Modern accounting platforms have transformed the handling of recurring adjustments. Gone are the days of manually calculating depreciation or laboriously spreading prepaid expenses across multiple periods. Today’s software automates these routine tasks, dramatically reducing both effort and error rates.
The rise of cloud-based accounting systems has introduced unprecedented collaboration capabilities. Now, team members can simultaneously review proposed adjustments, share supporting documentation, and approve entries from anywhere with internet access. This real-time collaboration streamlines the entire adjustment process while maintaining proper controls.
The smooth integration between accounting systems and other business applications represents perhaps the most significant technological advance. When your accounting software automatically captures data from other systems, it reduces the risk of missing transactions that require adjustment while ensuring more complete and accurate financial records.
How Harness can help
At Harness, we offer tax advisors advanced technologies like AI-driven optical character recognition (OCR) to accurately import client data into tax software. This effectively removes errors and enhances the accuracy and ease of adjustments.
With our client portal keeping everyone in the adjustment loop quickly and simply, we help tax firms deliver accurate, prompt, and complete financial statements without the stress that traditionally comes with it. Get started with Harness and discover a more efficient way to make period-end adjustments.
Disclaimer:
Tax-related products and services provided through Harness Tax LLC. Harness Tax LLC is affiliated with Harness Wealth Advisers LLC, collectively referred to as “Harness Wealth”. Harness Wealth Advisers LLC is a paid promoter, internet registered investment adviser. Registration does not imply a certain level of skill or training. This article should not be considered tax or legal advice and is provided for informational purposes only. Please consult a tax and/or legal professional for advice specific to your individual circumstances. This article is a product of Harness Tax LLC.
Content was prepared by a third-party provider and not the adviser. Content should not be regarded as a complete analysis of the subjects discussed. Although we believe the content is reliable, it is not guaranteed as to accuracy and does not purport to be complete nor is it intended to be the primary basis for financial or tax decisions.