Adjusting Entries are journal entries that are made at the end of the accounting period, to adjust expenses and revenues to the accounting period where they actually occurred. Adjusting entries are used to obtain an accurate measure of the period’s income , to bring the accounts up to date for preparation of financial statements and to properly record the effect of transactions that go beyond the accounting period. There is a difference between closing entries and adjusting entries.

Adjusting entries are required to update certain accounts in the general ledger at the end of an accounting period. There are five categories of adjusting entries:

Prepaid expenses

Depreciation

Accrued Expenses

Accrued Revenues

Unearned Revenue
Prepaid expenses are expenses paid in advance and are considered an asset because its benefits extend beyond the current accounting period. Once a prepaid expense is used up it becomes an expense. The entry to reflect it always affects an asset account and an expense account. Examples of prepaid expenses are: Insurances, office supplies, rent, and advertising.

Depreciation records the wearing out of assets declining in usefulness as time goes by. Examples of assets that depreciate are plant assets: Buildings, office equipment, office furniture, and machinery. The reduction of the value of assets is recorded in Accumulated Depreciation, a contra asset account, which has a credit balance that reduces the amount of the assets, bringing them to the book value. The entry is a debit to depreciation expense and a credit to accumulated depreciation.

Accrued expense is an expense incurred not yet paid. For example for those who earn commissions on sales, they receive their accumulated commissions in a monthly or quarterly basis. Although it has not been paid the company owes that money and it has to be reflected as a liability. The entry records a debit to the commission expense with a credit to an account payable.

Accrued revenues are revenues earned but payment has not been received nor has the client been billed. If I prepared a fraud vulnerability assessment for a doctor’s office and I completed it by August 29 but I received the payment in September 5, my consulting firm reflects that amount as an asset represented by a debit to the account receivable and a credit to a revenue account.

Unearned revenue is a liability that occurs when cash is received from a customer before a service is performed. In the example above, if my client had given me the money for the fraud vulnerability assessment in July 20, it would have been an unearned revenue to my consulting firm because I had to actually deliver the fraud vulnerability assessment in order to earn that revenue. When I received the payment my entry was a debit to cash and a credit to unearned revenue. The adjusting entry generated when I delivered the service is always a debit to unearned revenue and a credit to revenue.

Note that prepaid expenses and unearned revenue are called deferrals while accrued expenses and accrued revenues are called accruals.

The process of preparing closing entries involves clearing out revenue and expenses accounts and getting ready to start a brand new accounting period. The process is:
1. Close all the revenue accounts with a journal entry that debits all the revenue accounts and credit the account called "income summary" for the total.
   Close all the expense accounts with a journal entry that credits all the expense accounts and debit the total to the "income summary" account
   Transfer the "income summary" balance to a capital account, by closing the "income summary" account and transferring the net income or loss to the owners’ equity account.
   Close the drawing account. It is setup for sole proprietorships or partnerships in which case the drawing account is closed with a credit to the drawing account and a debit to the owners’ equity account.
Preparing adjusting entries and closing entries is the step preview to completing the accounting cycle. The accounting cycle is the process by which companies produce financial statements for a specific period. Accurately reflecting the balances of prepaid expenses, depreciation, accrued expenses, accrued revenues, and unearned revenues ensures the accuracy of the financial statements.