Accounting: The Language of Business (Part 13)

“Balance Sheets are meaningless. Our accounting systems are still based on the assumption that 80% of costs are manual labor.” —Peter Drucker

The Matching Concept and the Adjusting Process (Part B)

by

Charles Lamson

Nature of the Adjusting Process

At the end of an accounting period, many of the balances of accounts in the ledger can be reported, without change, in the financial statements. For example, the balance of the cash account is normally the amount reported on the balance sheet.

Some accounts in the ledger, however, require updating. For example, the balances listed for prepaid expenses are normally overstated because the use of these assets is not recorded on a day-to-day basis. The balance of the supplies account usually represents the cost of supplies at the beginning of the period plus the cost of supplies acquired during the period. To record the daily use of supplies would require many entries with small amounts. In addition, the total amount of supplies is small relative to other assets, and managers usually do not require day-to-day information about supplies.

The journal entries that bring the accounts up-to-date at the end of the accounting period are called adjusting entries. All adjusting entries affect at least one income statement account and one balance sheet account. Thus, an adjusting entry will always involve a revenue or an expense account and an asset or a liability account.

Is there an easy way to know when an adjusting entry is needed? Yes, four basic items require adjusting entries. The first two items are deferrals. Deferrals are created by recording a transaction in a way that delays or defers the recognition of an expense or revenue, as described below.

• Deferred expenses, or prepaid expenses, are items that have been initially recorded as assets but are expected to become expenses over time or through the normal operations of the business. Supplies and prepaid insurance are two examples of prepaid expenses that may require adjustments at the end of an accounting. Other examples include prepaid advertising and prepaid interest.

• Deferred revenues, or unearned revenues, are items that have been initially recorded as liabilities but are expected to become revenues over time or through the normal operations of the business. An example of deferred revenue is unearned rent. Other examples include tuition received in advance by a school, an annual retainer fee received by an attorney, premiums received in advance by an insurance company, and magazine subscriptions received in advance by a publisher.

The second two items that require adjusting entries are accruals. Accruals are created by an unrecorded expense that has been incurred or an unrecorded revenue that has been earned, as described below.

• Accrued expenses, or accrued liabilities, are expenses that have been incurred but have not been recorded in the accounts. An example of an accrued expense is accrued wages owed to employees at the end of a period. Other examples include accrued interest on notes payable and accrued taxes. 

• Accrued revenues, or accrued assets, are revenues that have been earned but have not been recorded in the accounts. An example of an accrued revenue is fees for services that an attorney has provided but hasn't billed to the client at the end of the period. Other examples include unbilled commissions by a travel agent, accrued interest on notes receivable, and accrued rent on property rented to others.

How do you tell the difference between deferrals and accounts? Determine when cash is received or paid, as shown in Exhibit 1. If cash is received (or revenue) or paid (or expense) in the current period, but the revenue or expense relates to a future period, the revenue or expense is a deferred item. If cash will not be received or paid until a future period, but the revenue or expense relates to the current period, the revenue or expense is in accrued item. 

EXHIBIT 1 Deferrals and Accruals

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 103-104*

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