What impact do adjusting entries have on retained earnings?

Adjusting entries are crucial in the accounting cycle as they ensure that the financial statements reflect the true financial position of the business at the end of an accounting period. These entries are made to update account balances before preparing financial statements and are essential for recognizing revenues and expenses in the period they occur, adhering to the accrual basis of accounting.

The impact on retained earnings arises because adjusting entries affect the income statement, which, in turn, influences net income for the period. If adjusting entries increase revenues or decrease expenses, they lead to a higher net income, ultimately increasing retained earnings. Conversely, if they decrease revenues or increase expenses, they result in a lower net income, which decreases retained earnings.

Given this dual capacity to either positively or negatively influence retained earnings, the correct answer acknowledges that adjusting entries can either increase or decrease retained earnings depending on the nature of the adjustments being made. This comprehensive approach to understanding adjusting entries is fundamental in determining a company’s overall financial health.