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Financial Accounting Unit 3: Adjusting Entries and Accrual Accounting

Adjusting entries make accrual-basis accounting work by putting each revenue and expense in the period it belongs to. They are among the most tested topics in any intro accounting course.

Covers: Accrual vs cash basis, Revenue and expense recognition, Prepaid expenses and supplies, Unearned revenue, Accrued revenues and expenses, Depreciation adjustments, Adjusted trial balance

Study guide

Under the cash basis, revenue is recorded when cash is received and expenses when cash is paid. GAAP requires the accrual basis instead. The revenue recognition principle says revenue is recorded when the company satisfies a performance obligation, that is, when it delivers the goods or services it promised. The expense recognition principle, often called matching, says expenses are recorded in the period they help generate revenue. Because cash often moves in a different period from the earning activity, accounts are out of date at the end of each period, and adjusting entries are needed before financial statements are prepared.

Adjustments come in two families. Deferrals occur when cash moves first and recognition comes later. A prepaid expense, such as insurance, rent or supplies paid in advance, starts as an asset and is expensed as it is used: debit the expense and credit the prepaid asset. Unearned revenue, cash received before service, starts as a liability and becomes revenue as the work is done: debit Unearned Revenue and credit revenue. Depreciation is a special deferral: the cost of equipment is spread over its useful life by debiting Depreciation Expense and crediting Accumulated Depreciation, a contra-asset account. Book value equals cost minus accumulated depreciation.

Accruals occur when recognition comes first and cash moves later. Accrued revenue is revenue earned but not yet billed or collected, such as interest earned on a note or services finished at month end: debit a receivable and credit revenue. Accrued expenses are costs incurred but not yet paid, such as wages earned by employees, interest owed on a loan, or utilities used: debit the expense and credit a payable. Interest is calculated as principal × annual rate × fraction of a year. Count months or days carefully; a note signed October 1 has three months of interest by December 31.

Every adjusting entry affects one income statement account and one balance sheet account, and none affect Cash. This makes the effects of a missed adjustment predictable. Forgetting to accrue an expense understates expenses and liabilities and overstates net income. Forgetting depreciation or the expiration of a prepaid overstates assets and net income. Forgetting to record earned unearned revenue understates revenue and overstates liabilities. Watch the original entry: if a prepayment was first debited to an expense rather than an asset, the year-end adjustment moves the unused part back into the asset.

After adjustments are journalized and posted, the company prepares an adjusted trial balance to confirm debits still equal credits. The income statement, statement of retained earnings and balance sheet are prepared from it. Accrual-basis income usually differs from cash flow. A growing company that sells on credit may report strong net income while its cash lags because receivables are piling up. Converting between the two bases uses the same logic as adjustments: cash collected plus the increase in receivables gives revenue, and cash paid adjusted for changes in payables and prepaids gives expense.

Key ideas

• Accrual accounting records revenue when earned and expenses when incurred, not when cash moves.
• Deferrals (prepaids, unearned revenue, depreciation) involve cash first and recognition later.
• Accruals (accrued revenues and expenses) involve recognition first and cash later.
• Each adjusting entry touches one income statement and one balance sheet account, and never Cash.
• Depreciation is credited to Accumulated Depreciation, a contra-asset, not to the asset itself.
• Missed adjustments have predictable effects on net income, assets and liabilities.
• Statements are prepared from the adjusted trial balance.

Formulas and rules

Common mistakes

• Expensing the supplies on hand instead of the supplies used.
• Miscounting months, such as treating September 1 to December 31 as three months instead of four.
• Including Cash in an adjusting entry.
• Adjusting as if a prepayment went to an asset when it was originally debited to an expense.
• Forgetting that earning unearned revenue reduces a liability and increases revenue.

Before the test, make sure you can

• Explain the difference between accrual-basis and cash-basis accounting.
• Classify an adjustment as a prepaid expense, unearned revenue, accrued revenue, accrued expense or depreciation.
• Write the adjusting entry for each type, with correct amounts.
• Calculate accrued interest and straight-line depreciation for partial periods.
• Determine the effect of an omitted adjustment on net income, assets and liabilities.
• Convert cash collected or paid into accrual-basis revenue or expense.
• Explain why adjusting entries never affect Cash.

Words to know

Accrual basis

Accounting that records revenues when earned and expenses when incurred, regardless of cash timing; required by GAAP.

Cash basis

Accounting that records revenue when cash is received and expenses when cash is paid; not GAAP.

Revenue recognition principle

Revenue is recognized when a performance obligation is satisfied by transferring goods or services to the customer.

Expense recognition (matching)

Expenses are recorded in the same period as the revenues they help produce.

Adjusting entry

A period-end entry that updates accounts so revenues and expenses are in the correct period.

Deferral

An adjustment where cash was paid or received before the expense or revenue is recognized.

Accrual

An adjustment where revenue or expense is recognized before cash is received or paid.

Prepaid expense

An asset for costs paid in advance, such as insurance or rent, that will be expensed as used.

Unearned revenue

A liability for cash received before goods or services are delivered.

Accrued revenue

Revenue earned but not yet billed or collected, recorded with a receivable.

Accrued expense

An expense incurred but not yet paid, recorded with a payable.

Depreciation

The allocation of a long-term asset's cost to expense over its useful life.

Accumulated depreciation

A contra-asset account holding total depreciation recorded on an asset to date.

Book value

An asset's cost minus its accumulated depreciation.

Adjusted trial balance

A trial balance prepared after adjusting entries are posted; the source for financial statements.

Periodicity assumption

The idea that a company's life can be divided into periods such as months or years for reporting.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.