adjusting entry

Imagine you run a small shop and, at the end of the year, you sit down to figure out how you really did. During the year you wrote things down only when cash changed hands. But some things happened that the cash record missed: you used up three months of an insurance policy you paid for last January, your one employee earned two days of wages you have not yet paid, and a customer is using a service you have not yet billed. The books, as written, are slightly wrong. An adjusting entry is the journal entry you make to fix each of these gaps before you prepare the financial statements.

More precisely, an adjusting entry is recorded at the end of an accounting period to bring revenue and expense accounts in line with accrual accounting, where income is recognised when it is earned and expenses when they are incurred, regardless of when cash moves. Every adjusting entry touches at least one income statement account (a revenue or expense) and at least one balance sheet account (an asset or liability), and it never involves cash, because the cash event has already happened or has not happened yet. For example, if rent of 1,200 was paid for a full year and four months have passed, an adjusting entry records 400 of rent expense and reduces the prepaid rent asset by 400.

Adjusting entries are the heart of the period-end 'truing-up' process and the reason accrual statements are more truthful than a raw cash log. They fall into a few standard families — accruals (revenue earned or expenses incurred but not yet recorded) and deferrals (cash received or paid in advance, now partly used up), plus depreciation. A common misconception is that adjustments are optional tidying; in fact, skipping them leaves profit and the balance sheet materially misstated.