Adjusting Accounting Entries| Accrual Accounting | Financial Accounting.

These lectures covers adjusting entries including, accrual accounting, revenue recognition principle, expense recognition principle, prepaid adjustments, accrued revenues and expense.

Introduction to Adjusting Entries

Prepaid Expenses Deferral Adjustments

Unearned Revenues Deferral Adjustments

Example: Deferral Adjustments

Accrued Revenue Accrual Adjustments

Accrued Expense Accrual Adjustments

Example: Adjusting Journal Entries

Relevance and Faithful Representation

Alternative Method: Adjusting Entries

Example: Preparing Financial Statements

Adjusted Trial Balance

 Under the accrual basis, companies record transactions that change a company’s financial statements in the periods in which the events occur. For example, using the accrual basis to determine net income means companies recognize revenues when they perform services (rather than when they receive cash). It also means recognizing expenses when incurred (rather than when paid).
An alternative to the accrual basis is the cash basis. Under cash-basis accounting, companies record revenue at the time they receive cash. They record an expense at the time they pay out cash. The cash basis seems appealing due to its simplicity, but it often produces misleading financial statements. For example, it fails to record revenue for a company that has performed services but has not yet received payment. As a result, the cash basis may not recognize revenue in the period that a performance obligation is satisfied.
Accrual-basis accounting is therefore in accordance with generally accepted accounting principles (GAAP). Individuals and some small companies, however, do use cash-basis accounting. The cash basis is justified for small businesses because they often have few receivables and payables. Medium and large companies use accrual-basis accounting.

Recognizing Revenues and Expenses

It can be difficult to determine when to report revenues and expenses. The revenue recognition principle and the expense recognition principle help in this task.

REVENUE RECOGNITION PRINCIPLE

When a company agrees to perform a service or sell a product to a customer, it has a performance obligation. When the company meets this performance obligation, it recognizes revenue. The revenue recognition principle therefore requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. A company satisfies its performance obligation by performing a service or providing a good to a customer.

EXPENSE RECOGNITION PRINCIPLE

Accountants follow a simple rule in recognizing expenses: “Let the expenses follow the revenues.” Thus, expense recognition is tied to revenue recognition. In the dry cleaning example, this means that Dave’s should report the salary expense incurred in performing the June 30 cleaning service in the same period in which it recognizes the service revenue. The critical issue in expense recognition is when the expense makes its contribution to revenue. This may or may not be the same period in which the expense is paid. If Dave’s does not pay the salary incurred on June 30 until July, it would report salaries payable on its June 30 balance sheet.
This practice of expense recognition is referred to as the expense recognition principle. It requires that companies recognize expenses in the period in which they make efforts (consume assets or incur liabilities) to generate revenue. The term matching is sometimes used in expense recognition to indicate the relationship between the effort expended and the revenue generated.

The Need for Adjusting Entries

In order for revenues to be recorded in the period in which services are performed and for expenses to be recognized in the period in which they are incurred, companies make adjusting entries. Adjusting entries ensure that the revenue recognition and expense recognition principles are followed.

Adjusting entries are necessary because the trial balance—the first pulling together of the transaction data—may not contain up-to-date and complete data. This is true for several reasons:

  • 1.Some events are not recorded daily because it is not efficient to do so. Examples are the use of supplies and the earning of wages by employees.
  • 2.Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions. Examples are charges related to the use of buildings and equipment, rent, and insurance.
  • 3.Some items may be unrecorded. An example is a utility service bill that will not be received until the next accounting period.
Adjusting entries are required every time a company prepares financial statements. The company analyzes each account in the trial balance to determine whether it is complete and up-to-date for financial statement purposes. Every adjusting entry will include one income statement account and one balance sheet account.

Types of Adjusting Entries

Adjusting entries are classified as either deferrals or accruals.
Deferrals:
1. Prepaid expenses: Expenses paid in cash before they are used or consumed.
2. Unearned revenues: Cash received before services are performed.
Accruals:
1. Accrued revenues: Revenues for services performed but not yet received in cash or recorded.
2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded.