Definition of adjusting entry

An adjusting entry is a journal entry used to record internal economic events at the end of any period when financial statements are prepared. [01]

Adjusting entries are needed in three situations

Prepayments

• Transactions in which the cash flow comes before the recognition of revenue or expense. Examples:

  1. A company pays cash for supplies but has not yet incurred expense because it hasn't used the supplies. 

  2. A company receives cash from a customer but, because the company hasn't delivered the product yet, it hasn't recorded revenue.

Accruals

• Cash outflows to suppliers or others comes after the company experiences the expense. Example: 

  1. A company buys merchandise on account and resells it to a customer before it pays its supplier.

Estimates

• Predictions of future events. Example:

  1. A company buys a machine for $100,000 and expects it will last 10 years. So each year, it records $10,000 in "depreciation" expense ($100,000 ÷ 10 years = $10,000 per year). [02]

Prepayments: prepaid expenses vs. deferred revenue

• A prepaid expense exists when a firm pays cash before a good or service is received in return. This is an asset. 

• Deferred revenue exists when cash is received from a customer prior to the firm providing a good or service. This is a liability.

Accruals: Accrued liabilities vs. accrued receivables

• An accrued liability exists when expense is recorded before cash is disbursed. 

• An accrued receivable exists when revenue is recorded before cash is received.