Adjusting Entries and Closing the Books

During the month you record what comes with paperwork: invoices, bills, deposits, payroll. But some economic events don't produce a document on the day they happen. The insurance you paid in January covers the whole year. Your baristas worked the last three days of the month but get paid next week. A customer probably won't pay. Adjusting entries bring those events into the books before you prepare financial statements. Without them, every month's profit would be misleading.

The five types of adjustments

1. Prepaid expenses

In January, Brightside pays $2,400 for a year of general liability insurance. That's not a January expense; it's an asset, the right to be insured for 12 months, which gets used up a little each month.

2. Accrued expenses

Brightside's baristas worked the last days of the month and earned $900 that will be paid on the 5th of next month. The expense belongs to this month:

The same logic applies to the bank loan. At 6% a year, $10,000 accrues $50 of interest a month ($10,000 × 6% ÷ 12): debit Interest Expense, credit Interest Payable. When the cash finally goes out, you debit the liability and credit Cash; the expense was already recorded.

3. Unearned revenue, including gift cards

A tech company down the street pays Brightside $2,700 up front for three months of office coffee service. That cash isn't revenue yet; it's an obligation to deliver, so it's a liability:

Gift cards work the same way, and they're a big deal for U.S. coffee shops and retailers around the holidays. A $25 gift card sold in December is a $25 liability, not December revenue. It becomes revenue when the card is redeemed. The portion customers never redeem ("breakage") is recognized based on redemption patterns, and many states have unclaimed property rules for it, so ask your CPA how they apply in your state.

4. Accrued revenue

If you've delivered work at month-end that you'll invoice next month, recognize it now: debit Accounts Receivable (or Unbilled Receivables) and credit the revenue account. For example, Brightside catered three events in the last week of the month and will send one combined invoice on the 2nd.

5. Estimates: depreciation, bad debts and accruals

Depreciation

You've already seen it in lessons 3 and 5: each month, debit Depreciation Expense and credit Accumulated Depreciation.

Bad debts: the allowance method

If you sell on credit, some customers won't pay. GAAP requires you to estimate those losses before you know exactly who won't pay (today's standard calls it the expected credit loss model). Say Brightside's catering receivables total $16,000 and experience suggests 3% won't be collected:

On the balance sheet, accounts receivable appear at $16,000 − $480 = $15,520, what Brightside realistically expects to collect. When a specific customer is confirmed as uncollectible, debit the allowance and credit Accounts Receivable; the expense was already recognized.

Other accruals

Accrued paid time off that employees have earned, warranty costs on products sold and probable losses from a lawsuit are recorded as expenses and liabilities based on the best estimate. Under U.S. GAAP, a loss contingency is accrued when it's probable and the amount can be reasonably estimated.

Closing the books

At the end of the fiscal year (or each month, if you want to practice), revenue, expense and draw accounts are closed. They're temporary accounts (lesson 3), so their balances move into owner's equity, and they start the next period at zero. The classic method uses a temporary account called Income Summary and four entries:

1. Close revenue accounts to Income Summary.
2. Close expense accounts to Income Summary.
3. Close Income Summary (now equal to net income) to Owner's Capital, or Retained Earnings for a corporation.
4. Close Owner's Draws to Owner's Capital (Dividends to Retained Earnings for a corporation).

Here's how it looks with Brightside's first month (revenue $18,000; expenses $5,000 + $3,500 + $7,000 + $200 = $15,700). Maya took no draws yet, so entry 4 isn't needed:

Income Summary briefly held a $2,300 credit, Brightside's net income, before moving it into equity. That's exactly the profit you'll see on the income statement in the next lesson. After closing, a post-closing trial balance lists only the permanent accounts: Cash $45,500, Inventory $1,000 and Equipment $12,000 on the debit side ($58,500), and Accumulated Depreciation $200, Accounts Payable $6,000, Notes Payable $10,000 and Owner's Capital $42,300 on the credit side ($58,500).

A month-end close you can follow

1. Days 1–2Capture everythingEnter all bills and invoices for the month, and chase missing receipts.
2. Days 2–3ReconcileReconcile every bank, credit card and loan account, plus your payment processor.
3. Day 4AdjustRecord depreciation, accruals, prepaids, unearned revenue and the bad debt estimate.
4. Day 5Review and lockRead the statements, investigate surprises, then lock the period.

• All sales and purchase invoices for the month are recorded.
• Every bank and credit card account is reconciled to its statement.
• Inventory is counted (or spot-checked) and adjusted.
• Overdue receivables are reviewed and the bad debt allowance updated.
• No services received are missing a bill (utilities, contractors, software).
• Depreciation, accruals and prepaid and unearned items are adjusted.
• The trial balance has no odd signs or unexpected amounts.

1) Software Expense                       150
       Prepaid Software                         150     ($1,800 ÷ 12)
2) Utilities Expense                      210
       Accounts Payable (or Accrued Liabilities) 210
3) Unearned Revenue                     1,500
       Service Revenue                        1,500     ($4,500 ÷ 3)
4) Bad Debt Expense                       350
       Allowance for Doubtful Accounts          350     ($14,000 × 2.5%)

Summary

• Adjusting entries apply the accrual basis: revenue and expenses land in the period they belong to.
• Prepaid expenses and unearned revenue (like gift cards) start on the balance sheet and move to the income statement over time.
• Accrued expenses and revenue capture what happened before the paperwork arrives.
• Estimates such as depreciation and the bad debt allowance reflect conservatism; tax rules for bad debts differ.
• Closing entries move net income and draws into equity and reset temporary accounts to zero.

Next lesson: The Income Statement (Profit and Loss) and Break-Even Point. You'll build Brightside's P&L, read its margins and find the sales level where it stops losing money.