Adjusting and Closing Entries Explained

Adjusting and closing entries are the crucial period-end steps that ensure financial statements are accurate and the books are ready for the next period. Often overlooked by beginners, they are essential to proper accrual accounting and reliable reporting. This guide explains what adjusting and closing entries are, the types of each, and why both are vital to producing accurate, properly periodized financial statements each period.

What are adjusting entries?

Adjusting entries are journal entries made at the end of an accounting period, before preparing the financial statements, to ensure that revenues and expenses are recorded in the correct period under accrual accounting. They account for items that have occurred economically but have not yet been fully recorded — such as revenue earned but not yet recorded, expenses incurred but not yet recorded, and the using-up of prepaid items or assets.

Adjusting entries are necessary because not all economic activity is captured by routine transaction recording — some items (like accrued or deferred amounts and depreciation) need period-end adjustments to reflect the correct picture. They embody the accrual and matching principles. Understanding adjusting entries as period-end entries ensuring revenues and expenses land in the correct period — making the financial statements accurate under accrual accounting — is the foundation for grasping this essential step in the accounting cycle.

What are the types of adjusting entries?

The main types of adjusting entries are: accrued revenues (revenue earned but not yet recorded or received), accrued expenses (expenses incurred but not yet recorded or paid), deferred revenues (cash received for revenue not yet earned, recognized as earned over time), prepaid expenses (cash paid for expenses not yet used, recognized as used over time), and depreciation (allocating the cost of a long-term asset over its useful life). Each adjusts the records to reflect the correct period.

These types all address timing differences between when cash moves and when revenue is earned or expenses incurred — ensuring the financial statements reflect the period’s actual economic activity. They are the practical application of accrual accounting at period-end. Understanding the types of adjusting entries — accruals, deferrals, prepaid items, and depreciation — reveals how period-end adjustments correct the timing of revenue and expense recognition, ensuring the financial statements accurately reflect the period under accrual accounting.

What are closing entries?

Closing entries are journal entries made at the very end of the accounting period, after the financial statements are prepared, to reset the temporary accounts — revenues and expenses — to zero, and transfer their net result (the period’s profit or loss) to equity (retained earnings). This clears the temporary accounts so they start fresh at zero for the next period, while permanent accounts (assets, liabilities, equity) carry forward.

Closing entries are necessary because revenue and expense accounts measure activity for one period only — they must be reset so the next period’s activity is measured separately, while the period’s net result is preserved in equity. They mark the end of one cycle and prepare for the next. Understanding closing entries as the period-end entries that reset temporary accounts and transfer the net result to equity — readying the books for the next period — reveals the final step of the accounting cycle that maintains period-by-period reporting.

What is the difference between temporary and permanent accounts?

Temporary accounts — revenues, expenses (and dividends/withdrawals) — measure activity for a single period and are reset to zero at period-end via closing entries, so each period’s activity is measured separately. Permanent accounts — assets, liabilities, and equity — carry their balances forward from period to period, representing the ongoing financial position. The distinction is central to why closing entries exist.

Closing entries reset the temporary accounts (so revenue and expenses start fresh each period) while leaving permanent accounts to carry forward (since position is continuous). This is why the income statement covers a period (temporary accounts) while the balance sheet is cumulative (permanent accounts). Understanding the difference between temporary and permanent accounts — temporary measuring single-period activity and reset by closing, permanent carrying forward — clarifies the logic of closing entries and the distinction between period performance and ongoing position.

Why are adjusting and closing entries important?

Adjusting and closing entries are important because they ensure the financial statements are accurate and the books are correctly maintained period by period. Adjusting entries ensure revenues and expenses are recorded in the correct period (essential for accurate statements under accrual accounting), while closing entries reset temporary accounts so each period’s performance is measured separately and the net result is preserved in equity. Without them, statements would be inaccurate and periods would blur together.

These period-end steps are where accrual accounting and proper periodization are enforced — skipping them produces misstated, improperly periodized financial information. They are essential to the integrity of the accounting cycle. Understanding why adjusting and closing entries matter — ensuring accurate, properly periodized statements and correctly maintained books — reveals these period-end steps as crucial to reliable financial reporting, completing the accounting cycle and upholding the accuracy on which financial statements depend.

How do they fit into the accounting cycle?

Adjusting and closing entries are key steps near the end of the accounting cycle. After transactions are recorded and posted and an unadjusted trial balance is prepared, adjusting entries are made (and an adjusted trial balance prepared), then the financial statements are prepared, and finally closing entries are made to reset the books for the next period. They bracket the preparation of the financial statements — adjustments before, closing after.

This placement reflects their roles: adjusting entries ensure the statements are accurate (so they come before preparing the statements), while closing entries reset for the next period (so they come after). Together they ensure each cycle produces accurate statements and ends cleanly. Understanding how adjusting and closing entries fit into the accounting cycle — adjustments before the statements, closing after — places these period-end steps in the full process, showing how they ensure the cycle reliably produces accurate financial information period after period.

What is depreciation and how is it adjusted?

Depreciation is the allocation of the cost of a long-term asset (like equipment or a building) over its useful life, recognizing a portion of the cost as an expense each period rather than all at once when purchased. The adjusting entry for depreciation records this periodic expense — debiting depreciation expense and crediting accumulated depreciation (a contra-asset reducing the asset’s book value) — spreading the cost over the periods that benefit from the asset.

Depreciation embodies the matching principle, matching the asset’s cost to the periods it helps generate revenue, rather than distorting one period with the full cost. It is a key recurring adjusting entry. Understanding depreciation and its adjusting entry — allocating an asset’s cost over its useful life through periodic expense — reveals an important application of accrual accounting at period-end, ensuring the cost of long-term assets is matched to the periods they benefit, a common and essential adjustment.

What are accruals and deferrals in detail?

Accruals and deferrals are the core of adjusting entries. Accruals record items that have occurred but not yet been recorded: accrued revenue (earned but not yet recorded or received, e.g., work done but not yet invoiced) and accrued expenses (incurred but not yet recorded or paid, e.g., wages owed at period-end). Deferrals adjust items recorded before they are earned or used: deferred revenue (cash received before earning it, recognized as earned over time) and prepaid expenses (paid before using them, recognized as used over time).

Both ensure revenue and expenses land in the correct period — accruals bring forward unrecorded items, deferrals spread already-recorded cash items to the right periods. They are the practical mechanics of accrual accounting at period-end. Understanding accruals and deferrals in detail — how each type adjusts the timing of revenue and expense recognition — deepens comprehension of adjusting entries and reveals precisely how accrual accounting achieves accurate period matching through these period-end adjustments.

How is the income summary used in closing?

The income summary is a temporary account sometimes used in the closing process to facilitate transferring the net result to equity. In closing, revenue accounts are closed to the income summary (transferring their balances there), expense accounts are closed to the income summary, and then the income summary’s balance — the net profit or loss — is closed to equity (retained earnings). It serves as an intermediary that gathers the period’s revenues and expenses before transferring the net result.

Using the income summary makes the closing process clear — it collects all the temporary income-statement account balances, nets them to profit or loss, and transfers that to equity, after which it too is zero. Not all systems use it explicitly, but it illustrates the logic of closing. Understanding how the income summary is used in closing — as an intermediary gathering revenues and expenses to transfer the net result to equity — clarifies the mechanics of closing entries and how the period’s performance flows into the permanent equity account.

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