Adjusting Journal Entries - Accruals and Deferrals

  • Purpose of Adjusting Journal Entries: To align financial records with the accrual basis of accounting at the end of an accounting period. This ensures revenue is recognized when earned and expenses when incurred, not solely based on cash transactions. This adheres to the realization and matching principles.
  • Accrual Basis of Accounting:
    • Revenue is recognized when earned, regardless of when cash is received.
    • Expenses are recognized when incurred, regardless of when cash is paid.
    • Cash transactions do not dictate revenue or expense recognition.
    • Example (Revenue): If a prepayment is received for goods/services not yet delivered, revenue cannot be recorded. If goods are delivered but cash hasn't been received, revenue is still recorded.
    • Example (Expense): An expense is incurred when the benefit is consumed, even if payment is delayed.
  • Types of Adjusting Journal Entries: Broken into two main categories.
    1. Deferrals: These entries postpone the recognition of an expense or revenue already involving a cash transaction.
      • Concept: Cash has already changed hands in a prior period, but the earning of revenue or incurring of expense happens in the current or future period.
      • Converting Assets to Expenses: Reduces an asset account and increases an expense account.
        • Scenario: Business paid cash for an expense that has not yet been incurred or fully utilized.
        • Examples:
          • Prepaid Expenses: Initial payment creates an asset. As the benefit is used, the asset is converted to an expense.
            • Example (Prepaid Insurance): If $1,200\$1,200 is paid in December for a 1-year policy starting January 1st, by January 31st, 1 month ($100\$100) of insurance has been