Legal Definitions - adjusting entry

An adjusting entry is a record made in a company's financial books, typically at the end of an accounting period (such as a month, quarter, or year). Its primary purpose is to ensure that the company's financial statements accurately reflect all revenues earned and expenses incurred during that specific period, regardless of when cash was actually received or paid. These entries also update the values of assets (what the company owns) and liabilities (what the company owes) to their correct amounts at that point in time. Essentially, adjusting entries are crucial for aligning financial records with the accrual basis of accounting, which recognizes economic events when they happen, rather than just when cash changes hands.

• Example 1: Accrued Utility Expense

  Imagine a small marketing agency that uses electricity and internet services throughout December. However, the utility bills for December's usage don't arrive until mid-January, and payment isn't due until the end of January. To accurately reflect its financial performance for December, the agency must record the estimated cost of those utility services as an expense in December, even though the bill hasn't been received or paid yet. An adjusting entry would be made on December 31st to recognize the utility expense for December and create a corresponding liability (an amount owed) on the balance sheet. This ensures December's financial statements show the true cost of operations for that month.

• Example 2: Prepaid Rent Amortization

  A new software startup pays its landlord $12,000 upfront on January 1st for six months of office rent. When the payment is made, the entire $12,000 is recorded as an asset called "prepaid rent" because the company has a right to use the office space for six months. At the end of January, one month of that rent has been "used up." An adjusting entry is necessary to reduce the "prepaid rent" asset by $2,000 (one-sixth of the total) and record $2,000 as "rent expense" for January. This process is repeated each month for the next five months, ensuring that the expense is recognized in the period the office space was actually used, and the asset's value is correctly reduced over time.

• Example 3: Unearned Subscription Revenue

  A fitness app company receives $600 from a customer on March 1st for a one-year premium subscription. At the time of payment, the company hasn't yet provided the service, so the $600 is recorded as a liability called "unearned revenue." This signifies an obligation to provide the service over the next year. At the end of March, after one month of service has been provided, the company has earned one-twelfth of the revenue. An adjusting entry would be made on March 31st to reduce the "unearned revenue" liability by $50 ($600 / 12 months) and recognize $50 as actual "subscription revenue" for March. This ensures that revenue is recognized only as the service is delivered, providing an accurate picture of the company's earnings each month.