Accruals Adjusting Entry Overview

Adjusting Entries

• A step in the company's accounting cycle.
• Purpose: To update or change specific accounts.

Accounting Methods

• Cash Basis Accounting:
  • Revenue is recorded only when cash is received.
  • Expenses are recorded only when cash is paid.
  • Creates timing difference between effort and reward.
• Accrual Basis Accounting:
  • Revenues and expenses are recorded regardless of when cash changes hands.
  • Required by GAAP (Generally Accepted Accounting Principles) for material or significant transactions.
  • If revenue is earned, but cash is not received, it creates a receivable (e.g., Accounts Receivable).
  • If expenses are incurred, but cash is not paid, it creates a payable (e.g., Accounts Payable).

Revenue Recognition Principle

• States that revenue is recognized when it's earned, regardless of when cash is collected. Consistent with accrual accounting.

Trial Balance

• A list of all active accounts and their balances.
• Used to prepare financial statements.
• Equality of debits and credits in the trial balance does NOT mean all expenses have been recorded.
• The trial balance before adjusting entries is called the "unadjusted trial balance."

Adjusting Entries

• Must be recorded before preparing financial statements.
• Two types:
  • Accruals
  • Deferrals

Accruals

• Situation where no cash has been received or paid.
• The event occurs daily, weekly, or monthly, and accounts need adjustment.
• Necessary to recognize revenue or expense even without cash exchange.

Deferrals

• Situation in which cash has been received or paid, but revenue or expense recognition is postponed to a later period.
• Cash is received/paid BEFORE recognition.

Identifying Accruals

• Look for:
  • Services performed for a customer, but revenue not recorded.
  • Expenses incurred, but not recorded

Rules of Debits and Credits

• Assets:
  • Increase on the left (debit).
  • Decrease on the right (credit).
• Liabilities:
  • Increase on the right (credit).
  • Decrease on the left (debit).
• Revenues:
  • Increase on the right (credit).
  • Decrease on the left (debit).
• Expenses:
  • Increase on the left (debit).
  • Decrease on the right (credit).

Example: Office Cleaning Services

• Company offers cleaning services to 8 customers, Sunday-Thursday, at 30 per day.
• Billing is done every Friday.
• Revenue is recorded when billing is done.
• This scenario is an accrual event because revenue is earned daily regardless of cash collection.
• Assume the month ends on a Tuesday. Revenue has been earned for Sunday, Monday, and Tuesday but not yet recorded.
• Adjusting entry is needed to increase assets and increase revenue.

Adjusting Entry Example:

• End of March falls on Tuesday, so three days (Sunday, Monday, Tuesday) of revenue are unrecorded.
• The adjusting entry will be:
  • Debit Account Receivable: 3 \, \text{days} \times $30 \, \text{per day} = $90
  • Credit Cleaning Revenue (or Service Revenue): 90

Recap

• Adjusting entries update accounts at the end of the period.
• Cash basis: Recognize revenues/expenses when cash is paid/received.
• Accrual basis: Recognize revenues/expenses regardless of cash, creating receivables/payables.
• Accruals: Cash not yet collected or paid.
• Deferrals: Cash already collected or paid (postponement).

Normal Balances and Effects of Debits/Credits

• Assets: Increase (Debit), Decrease (Credit)
• Liabilities: Increase (Credit), Decrease (Debit)
• Revenues: Increase (Credit), Decrease (Debit)
• Expenses: Increase (Debit), Decrease (Credit)