Chapter 3: The adjusting process

Revenues and expenses must be reported in the period in which they belong, not simply when cash comes in or goes out. This chapter explains the difference between cash basis and accrual basis accounting, the principles that decide when revenue and expenses are recorded, and the adjusting entries that bring the accounts up to date at the end of a period. Adjusting entries are one of the most tested topics of the course, and the case Lucy's lemonade stand shows why they matter.

Cash basis versus accrual basis

Example: on 1 May a company pays $1,200 for six months of insurance. Under cash basis May shows an expense of $1,200 and June to October show nothing. Under accrual basis the $1,200 is first an asset (prepaid insurance) and each month $200 becomes insurance expense. Similarly, if a customer pays $600 on 30 April for six months of service, accrual accounting records $100 revenue in each month from May to October.

The principles behind accrual accounting

• Time period concept. Business activities are sliced into periods (month, quarter, year) so statements can be prepared regularly. A fiscal year is any twelve consecutive months; it need not coincide with the calendar year.
• Revenue recognition principle. Revenue is recorded when it is earned, using a five-step process: (1) identify the contract with the customer; (2) identify the performance obligations (distinct promised goods or services); (3) determine the transaction price; (4) allocate the price to the performance obligations; (5) recognise revenue when (or as) each obligation is satisfied, that is, when the customer obtains control of the good or service.
• Matching principle. Expenses are recorded in the period in which they are incurred and matched against the revenues of that period, so that net income for the period is accurate.

Adjusting entries

At the end of a period, the unadjusted trial balance is incomplete: some revenues have been earned and some expenses incurred without any transaction being recorded. Adjusting entries are made at the end of the period to assign revenues to the period in which they are earned and expenses to the period in which they occur. They also update the related asset and liability accounts, so both net income and the balance sheet are measured correctly. An adjusting entry never involves cash.

Deferrals postpone recognition: the cash came first, the expense or revenue follows. Accruals record the expense or revenue before the cash moves.

Deferred expenses

Prepaid rent. On 1 December Smart Touch Learning prepays three months' rent of $3,000 ($1,000 a month). On 31 December one month is used up:

Prepaid rent now shows $2,000, the two months still to come.

Office supplies. The company bought $500 of supplies and at 31 December $100 is still on hand. Supplies used = 500 − 100 = $400: Dr Supplies expense 400, Cr Office supplies 400. With a beginning balance the formula is: supplies used = beginning balance + purchases − ending balance on hand.

Depreciation

Property, plant and equipment (land, buildings, equipment, furniture) are long-lived tangible assets. Allocating their cost over their useful life is depreciation; it works like a long-term prepaid expense. Land is never depreciated. The residual value is the expected value at the end of the useful life. The simplest method is straight-line:

The furniture of $18,000 has a five-year life and no residual value: 18,000 / 5 = $3,600 a year, or $300 a month. The December adjusting entry:

The cost is not credited directly. Instead the credit goes to accumulated depreciation, a contra asset account: it is listed directly after its related asset and has the opposite normal balance (credit). The book value of the asset is cost minus accumulated depreciation, here 18,000 − 300 = $17,700. For the building bought on 1 December, monthly depreciation of $250 is recorded the same way.

Deferred revenues

A law firm paid $600 on 21 December for 30 days of e-learning service. That was recorded as unearned revenue (a liability). By 31 December ten days, one third, has been delivered:

Accrued expenses

The company pays an employee $2,400 a month, half on the 15th and half on the 1st of the next month. The second half of December is paid on 1 January, but it was earned in December, so on 31 December:

When the salary is paid on 1 January, the entry is Dr Salaries payable 1,200, Cr Cash 1,200: no expense in January. Interest that has built up on a loan but has not been paid is accrued the same way (Dr Interest expense, Cr Interest payable).

Accrued revenues

Smart Touch Learning was hired to perform services from 16 December for $1,600 a month, payable on 15 January. On 31 December half a month has been earned:

On 15 January the company collects $1,600: Dr Cash 1,600, Cr Accounts receivable 800, Cr Service revenue 800 (the January half).

The adjusted trial balance and the effect of forgetting adjustments

After journalizing and posting the adjusting entries, the accountant prepares the adjusted trial balance: all accounts with their adjusted balances. It confirms that debits still equal credits and is the source for the financial statements. Failing to record an adjusting entry gives wrong statements. For example, forgetting to accrue salaries understates expenses and liabilities and overstates net income and equity; forgetting to record earned unearned revenue understates revenue and overstates liabilities.

Case: Lucy's lemonade stand

Ten-year-old Lucy needs €90 for a concert ticket and has seven Saturdays to earn it. She starts with €30 of savings. On Friday she buys ingredients for €11; her father delivers a wooden stand and will collect the €21 materials cost on Sunday; cousin Joris pays €2 in advance for four cups he will drink on Saturday. On Saturday she sells 60 cups at €0.50 (including Joris's four) and gives her father €15 for ingredients for next Saturday. On Sunday she pays her brother €2 for helping on Saturday and pays her father the €21.

Lucy's own (cash) view: Friday +30 − 11 + 2 = +€21, Saturday +28 − 15 = +€13, Sunday −2 − 21 = −€23. Her weekend "earnings" are €11, and seven weekends give €77: not enough. But this cash view mixes up things that are not performance at all.

Accrual view:

The stand is used for seven Saturdays, so depreciation is 21 / 7 = €3 per weekend. Accrual profit = revenue 30 − cost of goods sold 11 − salary 2 − depreciation 3 = €14 per weekend, or €98 over seven weekends: Lucy can buy the ticket. The trial balance totals €63 on both sides (cash 11, inventory 15, stand 21, expenses 16 on the debit side; accumulated depreciation 3, equity 30, revenue 30 on the credit side).

The main differences: the €30 owner contribution is financing, not earnings, and will not repeat; the €15 of ingredients for next week is inventory (an asset), not a cost of this weekend; the stand serves seven weekends, so only one seventh of its cost belongs to each weekend; Joris's advance payment is earned only when he gets his lemonade. Cash accounting remains useful for liquidity (can you pay your bills?), and cash returns in the statement of cash flows, but accrual accounting measures performance.