Adjustments to the Accounts

• Most transactions are recorded when they occur.

• Some transactions might not even seem like transactions and are recognized only at the end of the accounting period.– The difference in these transactions depends on

how obvious or explicit they are.

Adjustments to the Accounts• Explicit transactions - events such as cash

receipts and disbursements, credit purchases, and credit sales that trigger nearly all day-to-day routine entries– Entries are supported by

source documents.– These transactions involve

events that have actually happened.

Adjustments to the Accounts

• Implicit transactions - events such as the passage of time that do not generate evidence that the transaction happened and are recognized via end-of-period adjustments– Examples include depreciation

expense and the expiration of prepaid rent.

June 2002

Adjustments to the Accounts• Adjustments (adjusting entries) - end-of-period

entries that assign the financial effects of implicit transactions to the appropriate time periods– Adjustments are usually made when

the financial statements are about to be prepared.

– They are made in the form of journal entries that are posted to the general ledger.

Ledger

Adjustments to the Accounts

• Most entities use accrual accounting.– Adjusting entries are at the heart of accrual

accounting.

• Accrue - to accumulate a receivable or payable during a given period even though no explicit transaction occurs– The receivable or payable grows with time, but

nothing changes hands.

Adjustments to the Accounts

• The goal of adjusting entries is to assure that assets, liabilities, and owners’ equity are properly stated.

• Four basic types of transactions that trigger adjusting entries:– Expiration of unexpired costs– Earning of revenues received in advance– Accrual of unrecorded expenses– Accrual of unrecorded revenues

Expiration of Unexpired Costs

• Originally cash is paid and an asset is created.

• An adjustment recognizes an expense and reduces the corresponding asset.

– The cost is “expired” because of the passage of time.

– An explicit transaction has created an asset, and an implicit transaction adjusts the value of the asset.

– Examples include prepaid rent, prepaid insurance, and depreciation expense.

Earning of Revenues Receivedin Advance

• Unearned revenue (deferred revenue) - revenue received and recorded before it is earned

– Payment is received in exchange for a commitment to provide services or goods at a later date.

– This commitment is a liability – the service or goods are owed to someone.

– For example, when a magazine publisher receives cash for a subscription, revenue is not earned until the publisher provides the subscriber with an issue of the magazine even though cash has been received

Accrual of Unrecorded Expenses

• The balances of accrued expenses are only important when financial statements are prepared.– Consequently, adjustments to bring these

accounts up to date are made at the end of an accounting period to match the expenses to the period.

Accrual of Unrecorded Revenues

• The accrual of unrecorded revenues is the mirror image of the accrual of unrecorded expenses.

• The adjusting entries show the recognition of revenues that have been earned, but the entity has not received cash.– Examples include “unbilled” fees. Fees have been

earned, but the customers have not yet been billed.

The Adjusting Process in Perspective

• Each adjusting entry affects at least one income statement account (revenue or expense) and one balance sheet account (asset or liability).

• Never debit or credit Cash in an adjusting entry.

Adjust Cash