BUS103: Introduction to Financial Accounting

3a. Identify why adjusting entries are necessary 

• What is the difference between cash accounting and accrual accounting?
• Why does a company that uses accrual accounting have to make adjusting entries?
• What would be the result if adjusting entries were not made?
  

Companies that use cash-basis accounting record business transactions only when cash is paid out or received. Most organizations use accrual-basis accounting, which records transactions according to the GAAP rules for revenue recognition and matching. This results in revenues and expenses sometimes being recorded in a different period than when the associated cash is received or paid.
 
Accrual accounting also creates the need to make adjusting entries. Adjusting entries are necessary because the accounting period ends on a particular date, and all relevant revenues and expenses must be recorded even if the cash hasn't changed hands. Adjusting entries never involves the cash account. Failure to record adjusting entries at the end of an accounting period results in inaccurate income statements and balance sheets.
 
To review, see Adjustments for Financial Reporting and Cash vs. Accrual Accounting.
 

3b. Distinguish among various types of adjusting entries 

• What are the major types of adjusting entries?
• What is the difference between a deferral and an accrual?
  

There are five main categories of adjusting entries:

1. Prepaid expenses – adjusting is necessary to show the portion of the asset that has been consumed during the period, such as prepaid rent or prepaid insurance.
2. Depreciation – adjusting entry required to show the decline in the value of a plant asset.
3. Accrued Expense – expenses that are incurred but not recorded, such as wages or interest.
4. Accrued revenue – this is revenue that has been earned but not yet billed,
5. Unearned revenue – adjustment is required to show that cash has been received, but the associated revenue has not been earned yet.
   

A deferral is money paid or received before the expense or revenue should be recognized. Deferred expenses involve payments made in advance, such as for rent or insurance, which will only become an expense with the passage of time, to adhere to the matching principle. Deferred revenue happens when a company receives money in advance of earning it.
 
An accrual is when the expense or revenue needs to be recognized before the money is paid or received. Accrued expenses are when it is necessary to record the expense and liability in the accounting period before payment is made, such as a utility bill that won't be invoiced until next month even though the utility was used. Accrued Revenue is the reporting of revenue that we earned, but before processing the invoice or receiving the money.
 
To review, see Adjustments for Financial Reporting.
 

3c. Apply the revenue recognition and matching principles to transaction analysis

• What is the revenue recognition principle?
• What is the matching principle?
  

The revenue recognition principle requires that to record revenue, a company must show that the revenue was earned and that collection of the payment is reasonably assured. A company earns revenue by delivering the product or service. The matching principle requires that expenses incurred in producing revenues be deducted from the revenues they generated during the accounting period. In other words, you must match the recognition of the expense with the revenue that it helped generate.
 
Adjusting entries are used to ensure that the revenue recognition and matching principles are followed. For example, let's say a roofing company took a deposit from a customer for a roof that they would install in the coming months. When the deposit was received, the company had not yet provided a product or service. As such, that cash represented a liability, as the company owed the customer a roof. At the time of deposit, cash would be debited, and the liability, unearned revenue, would be credited. Once the roof was installed, the company could remove (debit) the liability unearned revenue and credit their revenue account.
 
To review, see Adjustments for Financial Reporting.
 

3d. Interpret economic transactions and create appropriate adjusting entries 

• What adjustment is needed when a company has paid rent in advance?
• What adjustment is required to show the loss in value of a plant asset?
• What adjustment is needed when a company completes a service that the client had prepaid for?
  

It is important to practice the various adjusting entries.
 
If a company paid for rent in advance, it must make an adjustment to show that some of the value of that prepayment has been used up. The entry would be a Debit to Rent Expense and a credit to Prepaid Rent.
 
Depreciation is how a loss in value of a plant asset is recorded. After calculating the appropriate amount of loss, the adjusting entry involves debiting Depreciation Expense and crediting the contra-asset account Accumulated Depreciation.
 
When a company completes a service, it has earned the revenue. Since the cash was previously received, the original entry would have debited cash and credited unearned revenue. Now that the revenue has been earned, the adjusting entry is to debit Unearned Revenue and credit Revenue.
 
To review, see Adjustments for Financial Reporting.
 

3e. Prepare an adjusted trial balance 

• When is the adjusted trial balance created?
• What is the adjusted trial balance used for?
  

After adjusting entries have been recorded and posted, an adjusted trial balance is prepared by listing all the accounts and their balances. If the adjusting entries were posted correctly, then the total debits will equal the total credits. The adjusted trial balance is another check for accuracy after the adjusting entries are completed. The financial statements are prepared using the adjusted trial balance. Some account balances will not change between the trial balance and the adjusted trial balance. Those affected by the adjusting entries will change. It is important to remember that the fact that the adjusted trial balance has equal debits and credits does not mean it is error-free. If an adjusting entry is not made, the totals will still balance, but the statement will be incorrect.
 
To review, see Completing the Accounting Cycle.
 

Unit 3 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• accrual
• accrual-basis accounting
• adjusted trial balance
• adjusting entry
• cash-basis accounting
• deferral
• matching principle
• revenue recognition principle