Before financial statements are prepared, additional journal entries, called adjusting entries, are made to ensure that the company's financial records adhere to the revenue recognition and matching principles. Adjusting entries are necessary because a single transaction may affect revenues or expenses in more than one accounting period and also because all transactions have not necessarily been documented during the period.
Each adjusting entry usually affects one income statement account (a revenue or expense account) and one balance sheet account (an asset or liability account). For example, suppose a company has a $1,000 debit balance in its supplies account at the end of a month, but a count of supplies on hand finds only $300 of them remaining. Since supplies worth $700 have been used up, the supplies account requires a $700 adjustment so assets are not overstated, and the supplies expense account requires a $700 adjustment so expenses are not understated.
Adjustments fall into one of five categories: accrued revenues, accrued expenses, unearned revenues, prepaid expenses, and depreciation.