Most companies use accrual basis accounting, recognizing revenue when it is earned (the goods are sold or the services performed) and recognizing expenses in the period incurred without regard to the time of receipt or payment of cash. Net income is revenue earned minus expenses incurred.
Although operating a business is a continuous process, there must be a cut-off point for periodic reports. Reports are prepared at the end of an accounting period.
Some transactions span more than one accounting period and they require adjustments. Adjustments are necessary for determining key profitability performance measures because they affect net income, assets, and liabilities. Adjustments, however, never affect the cash account in the current period. They provide information about future cash flow. For example, accounts receivable indicates expected future cash inflows.
The four basic types of adjusting entries are:
In some cases valuation adjustments entries are required for assets. For example, trading securities are always recorded at their current market value, which can change from time to time.
A. A portion of an asset is recognized as an expense.
When adjusting a prepaid expense, such as prepaid insurance, the required adjusting entry recognizes and transfers a portion of the prepaid expense to an appropriate expense account, reducing the balance of the prepaid expense account.
I. for proper statement of net income
An adjustment for depreciation expenses matches expenses with revenues for the period, thus contributing to the correct statement of net income for the period.
A. Unexpired insurance
Unexpired insurance is an asset account. It may also be called prepaid insurance and represents amounts paid for insurance that has not yet expired. The party that purchased insurance coverage uses this account. Unearned insurance fees is a liability account. It represents fees collected for insurance coverage provided to others that has not yet expired. The party that sells insurance uses this account.
A. Prepaid rent
Prepaid rent could appear in an entry in the lessee's books if rent is paid in advance. Rent payable could appear if rent is due but has not yet been paid and rent expense appears when rent payments are made. Unearned rent would not appear in the lessee's books regarding this particular lease because it represents rent received in advance from a lessee and is a liability to the lessor.
I. credit to cash
The receipt of cash is recorded as a debit to the cash account. Because services have not yet been performed, this transaction would also include a credit to unearned service fees.
A. A portion of a liability is recognized as an expense.
When adjusting an unearned revenue account, such as unearned service fees, the required adjusting entry transfers the earned portion of the unearned revenue account to an appropriate revenue account, reducing the balance of the unearned revenue account (liability).
The revenue is not earned when the cash is received, so we have to debit cash and credit unearned revenue. It is a liability account.
A. cash receipts/payments
Accrual net earnings reflect a realistic picture of performance because the recording of revenue and expense items is tied to the earnings process experienced by the firm. Thus, it follows that predictions of future profitability also tend to be more realistic when a firm uses the accrual basis.
A. Accrued liabilities
Payments received before the company performs services are recorded as a liability called unearned revenue.
I. If no errors are made in the daily recording of transactions, adjusting entries are unnecessary at the end of the period.
A. III and IV
I. The accumulated depreciation account has a credit balance and is increased by the year-end adjusting entry for depreciation.
A. I, II, III and IV
II. For most companies, adjusting entries are made on a monthly basis. Monthly adjustments provide a more accurate presentation of interim (monthly) statements.
III. Adjusting entries are made at the end of the accounting period for the purpose of recognizing revenue and expenses that are not properly measured as a result of journalizing transactions as they occur.
IV. For example, accruing unpaid wages at the end of the accounting period assigns the wages to the current time period even though they will be paid in the subsequent time period.
I. Adjusting entries may involve recording revenues before cash is received.
A. II, and IV
I. For example, accruing interest revenue on a note receivable will assign the interest to the current time period even though it will be collected in a subsequent time period.
II. Recording an accrued expense requires a corresponding change in an accrued liability. Recording accrued revenue requires a corresponding change in an asset account.
III. Rarely, if ever, do adjusting entries involve cash.
IV. Depreciation is the systematic allocation of the cost of an asset to expense during the periods of its useful life.
A. Unearned insurance fees
Unearned insurance fees is a liability account. Liability accounts represent an obligation to make payments, transfer assets, or provide services to other entities in the future. Asset accounts represent economic resources owned by a business. Prepaid insurance is an asset account because it represents insurance that has been paid for in advance.
A. cash and crediting prepaid insurance.
Assets are increased with debits and decreased with credits. The cash account must be decreased and the prepaid insurance account increased by the amount of the payment (both are asset accounts). This transaction would be recorded as a debit to prepaid insurance and a credit to cash.
A. asset account
This transaction affects an asset account and a liability account. The receipt of cash affects an asset account (cash) and a liability account (unearned revenue) because payment has been received for services not yet performed.
A. An expense is increased and a liability is increased.
When adjusting for an unpaid expense, such as accrued wages, an appropriate expense account (wages expense) is debited and an appropriate liability account (wages payable) is credited.