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)