Accrual Accounting and Adjusting Entries
Principles of Accrual Accounting
Accrual accounting recognizes revenue when it's earned and expenses when they're incurred, regardless of when cash actually changes hands. This is the foundation of adjusting entries, and understanding why it works this way makes the rest of this unit much easier.
Think about it this way: a company performs services for a client in December but doesn't get paid until January. Under accrual accounting, that revenue belongs in December because that's when the work happened. The same logic applies to expenses. If employees work the last week of December but don't get their paychecks until January, the expense still belongs in December.
This approach matters because it gives a more accurate picture of profitability and financial health. It matches revenues and expenses to the period when the economic activity actually occurred (monthly, quarterly, or annually).
How cash basis differs: Cash basis accounting records revenue when cash is received and expenses when cash is paid. It's simpler, but it ignores the timing gap between economic events and cash flows. That gap can distort profitability and financial ratios like liquidity and solvency. For this reason, GAAP requires accrual accounting for most businesses.
Types of Financial Reporting Periods
The time period principle (also called the periodicity assumption) says we divide a business's ongoing activities into artificial time periods so we can measure and report performance at regular intervals. Without it, you'd have to wait until a company closed its doors to know whether it was profitable.
- Fiscal year — A 12-month reporting period that doesn't have to line up with the calendar year. A retailer might use February 1 through January 31 so its fiscal year ends after the holiday season wraps up.
- Calendar year — Runs January 1 to December 31. Many companies and most individual taxpayers use this.
- Interim periods — Any reporting period shorter than a full fiscal year, typically quarterly. These give investors and creditors more frequent updates on financial performance.
Purpose of Adjusting Entries
Adjusting entries update account balances at the end of an accounting period so the financial statements reflect what actually happened during that period. They're recorded before preparing the financial statements (income statement, balance sheet, etc.) and are the mechanism that makes accrual accounting work in practice.
There are five main categories of adjustments:
- Accrued revenues — Revenue that's been earned but not yet recorded or billed. Example: a consulting firm completes work in March but won't invoice the client until April. The revenue still belongs in March.
- Accrued expenses — Expenses that have been incurred but not yet recorded or paid. Example: employees earn $5,000 in wages during the last week of the period, but payday falls in the next period.
- Deferred revenues (unearned revenue) — Cash received in advance for goods or services not yet provided. Example: a magazine company collects $120 for a 12-month subscription upfront. Each month, $10 shifts from a liability (unearned revenue) to revenue as issues are delivered.
- Deferred expenses (prepaid expenses) — Cash paid in advance for goods or services not yet used. Example: a company pays $6,000 for six months of insurance. Each month, $1,000 moves from the prepaid asset to insurance expense.
- Depreciation — Allocating the cost of a long-term asset (equipment, buildings) over its useful life. This isn't about tracking the asset's market value; it's about spreading the cost across the periods that benefit from using the asset.
The Adjustment Process
Making adjusting entries follows a consistent set of steps:
- Identify accounts that need adjustment — Review account balances and ask: does this balance reflect reality as of the end of the period?
- Determine the amount of the adjustment — Calculate how much revenue was earned, how much expense was incurred, or how much of a prepaid item was used up.
- Record the adjusting entry in the general journal — Each adjusting entry affects at least one income statement account (revenue or expense) and one balance sheet account (asset or liability).
- Post the adjusting entry to the appropriate ledger accounts — Update the general ledger so the new balances carry through to the financial statements.
Key Principles That Guide Adjustments
Two principles come up repeatedly when deciding whether and how to adjust:
- Revenue recognition principle — Revenue is recorded in the period when it's earned, not necessarily when cash is received. This principle drives accrued revenue and deferred revenue adjustments.
- Expense recognition (matching) principle — Expenses are recorded in the same period as the revenues they help generate. This drives accrued expense, prepaid expense, and depreciation adjustments.
You should also consider the materiality principle: if an adjustment amount is too small to influence a user's decision, it may not warrant a separate entry. But for your coursework, assume all adjustments are material unless told otherwise.