Adjusting entries, explained with real numbers.

What are adjusting entries?

Adjusting entries are journal entries passed at the end of an accounting period, before the trial balance is turned into final accounts, to make sure every rupee of income and expense is recorded in the period it actually relates to — regardless of when cash was paid or received. They are the bridge between the raw, day-to-day cash-driven entries in your books and the true accrual-basis profit the matching principle demands.

Without them, a business that pays a year's rent in advance, or hasn't yet paid March's salary, would show a profit figure that belongs to no real period at all — too high in one year, too low in the next.

Why adjusting entries are needed

A trial balance only proves arithmetic — that total debits equal total credits. It says nothing about whether those debits and credits sit in the correct year. Four everyday situations break that alignment, and a fifth (closing stock) simply hasn't been recorded at all yet:

• Outstanding (accrued) expenses — the expense belongs to this year but hasn't been paid.
• Prepaid expenses — cash was paid this year, but part of it belongs to next year.
• Accrued income — income has been earned this year but not yet received.
• Income received in advance (unearned income) — cash was received this year, but the work isn't done yet.
• Depreciation — a fixed asset's cost must be spread across its useful life, not expensed once.
• Closing stock — unsold goods on hand at year-end must be brought into the books to correctly state cost of goods sold.

The rule for each type, in plain language

Notice the pattern: whenever cash and the related income/expense fall in different years, one side of the entry is always a balance sheet item (an asset or a liability) and the other is a profit & loss item. That balance sheet item then becomes the opening balance for next year — see accrual vs cash basis for the bigger picture this fits into.

Worked example 1 — Outstanding & prepaid expenses

A firm's accounting year ends 31 March. Rent of ₹1,20,000 was paid during the year for the 12 months from 1 June to 31 May next — so 10 months (June to March) are used up in this year, and 2 months (April & May of next year) are prepaid, worth ₹20,000. Separately, March's salary of ₹45,000 is due but unpaid at year end.

Debit total ₹65,000 equals credit total ₹65,000 — it ties out. Rent expense in the P&L falls by ₹20,000 (it reduces the Rent A/c), while Prepaid Rent ₹20,000 appears as a current asset on the balance sheet. Salary expense rises by ₹45,000, and Outstanding Salary ₹45,000 appears as a current liability.

Worked example 2 — Accrued income & income received in advance

The same firm has a fixed deposit that has earned ₹9,000 of interest for the year, credited by the bank only after 31 March. It has also received ₹30,000 commission in advance from a client, of which only ₹20,000 worth of work was completed by year-end — the remaining ₹10,000 is still unearned.

Debits ₹19,000 equal credits ₹19,000. Interest income rises by ₹9,000 even though no cash has been received — Accrued Interest ₹9,000 sits as a current asset. Commission income falls back by ₹10,000 because it hasn't been earned yet — that amount becomes a current liability, Commission Received in Advance, until the work is done.

Worked example 3 — Depreciation

The firm owns machinery costing ₹8,00,000, depreciated at 10% p.a. on the straight line method — an annual charge of ₹80,000.

Machinery's book value falls from ₹8,00,000 to ₹7,20,000, and ₹80,000 is charged to the P&L as an expense — non-cash, but very real for measuring the year's true profit. For the full SLM vs WDV comparison and a multi-year schedule, see our depreciation page.

Worked example 4 — Closing stock

A physical count at 31 March values unsold goods on hand at ₹3,50,000 (cost, which is lower than net realisable value, so cost is used per AS-2).

Closing Stock A/c ₹3,50,000 appears as a current asset on the balance sheet, and the same figure is credited to the Trading A/c, which reduces cost of goods sold and raises gross profit for the year — see how this feeds the full statement on our trading account page.

Common mistakes students make

• Swapping outstanding and prepaid — outstanding expense increases this year's charge (it's owed, not yet paid); prepaid expense decreases it (paid, but for next year). Say the sentence out loud before you post the entry.
• Forgetting the balance sheet side — every adjusting entry has one leg in the P&L and one leg on the balance sheet. If your entry only touches an expense or income account, you've missed half of it.
• Posting closing stock to Purchases instead of Trading A/c — closing stock never touches the Purchases account; it goes to the Trading Account (or directly reduces cost of goods sold if that's how your final accounts are laid out).
• Treating accrued income as a sale — accrued income is unbilled/unreceived income already earned, not a receivable created by an invoice; the double entry recognises income before any invoice or cash movement.
• Applying the adjustment in the wrong year — a prepaid expense set up this year must be reversed and expensed in the following year, otherwise the expense simply vanishes forever instead of moving forward one period.

In TatvaBooks, this happens automatically

Working out and remembering every outstanding, prepaid, accrued and unearned figure by hand at year-end is exactly the kind of bookkeeping accounting software should carry for you. In TatvaBooks, you record the underlying fact once — this rent covers 12 months from 1 Feb, this FD earns interest quarterly — and the correct adjusting entries post themselves each period, the resulting asset or liability rolls forward automatically, and your trial balance is always ready for final accounts without a manual year-end scramble.

See how depreciation specifically is automated on our depreciation calculator, or explore the full cloud accounting software.

Frequently asked questions