The Adjusting Process

 

The Adjusting Process
Companies choose between accrual based accounting and cash based accounting. • Cash based accounting – only records transactions when cash changes hands• Accrual based accounting- records transactions when revenue is earned or expenses are incurred.
Accrual accounting is required for publicly traded companies and companies with over $5 million in sales. Companies not required to use often choose to use accrual
accounting because it presents a fairer picture of the profitability of the company’s activities. Just because cash has not changed hands does not mean that the
company has not earned a profit.
Some differences between cash accounting and accrual accounting…• If a company provides service and bills customers for that service, the revenue from that service is recorded when the service is performed under accrual
accounting. There would be no entry under cash accounting.• If a company purchased materials on account to use during the month and will not pay for those materials until the following month, the company records that
expense under accrual accounting. There would be no entry under cash accounting.
Accrual accounting communicates the activities of the business during the timeframe being reported. This allows investors, creditors and others to see the performance
of the company.
As an extreme example, suppose a company sells everything to its customers on account and purchases everything on credit. Under cash accounting, the company may report
nothing because all of its sales were on credit and it received no payments and because it purchased everything on credit and paid nothing during the month. The
appearance is that this company did nothing that period. Accrual accounting would report the money earned and the expenses incurred to determine the profitability of
that period.
Consider also the ability of companies to manipulate the numbers using cash accounting. If the company wants to project a higher net income, it simply forgoes paying
its expenses in the current month. These expenses will not be reported since no cash exchanged hands.

Adjusting Process
Accrual accounting requires an adjustment process to occur at the end of each period. The adjusting process consists of reviewing each account to determine if
adjusting entries need to be made.
Adjusting entries are journal entries made to bring account balances current as of the end of the accounting period.
Adjusting entries are required in four types of accounts.• Prepaid Expense (Deferred Expense) – These are items the company purchases in advance of using them. Examples include prepaid insurance or prepaid rent.• Accrued Expense – These are items that the company uses before paying for them. Examples include Salaries Payable or Utilities Payable.• Unearned Revenue (Deferred Revenue) – These are items the company receives in advance of earning them. Examples include Unearned Rent Revenue or Unearned Fees.• Accrued Revenue – These are items that the company earns before receiving payment. These include Interest Income or unbilled Accounts Receivable.

Depreciation refers to the loss in value of assets over time. Companies depreciate assets through an adjusting entry at the end of the month. This entry uses the
contra asset account called Accumulated Depreciation. Land is never depreciated.
The entry to record depreciation is written as follows:

Date Account Description Debit Credit01/31 Depreciation Expense 10,000Accumulated Depreciation 10,000Ecamples of typical adjusting entries include:• A landlord who collects a year’s worth of rent in advance needs to record the revenue associated with that rent each month.o Original entry includes:• Debit to Cash • Credit toUnearned Rent Revenueo Each monthly entry includes:• Debit to Unearned Rent Revenue• Credit to Rent Revenue• The dollar amount is calculated by dividing the total amount for the year and dividing by the number of months.• A company who pays wages weekly finds that the last day of the month falls on a Wednesday.o The adjusting entry includes:• Debit to Wages Expense• Credit to Wages Payable• The dollar amount is calculated by dividing the total weekly payroll amount and dividing by the number of days to determine a daily rate. This rate is
multiplied by the number of days in the week which apply to the month.• A company purchases supplies at the beginning of the month. At the end of the month, the company determines how much of the supplies are remaining on hand and
have not been used.o Original entry includes:• Debit to Supplies • Credit toCash (or Accounts Payable)o The adjusting entry includes:• Debit to Supplies Expense• Credit to Supplies• The dollar amount is calculated by taking the total amount of supplies purchased and subtracting the remaining balance. The difference is the amount used
during the period.• A company purchases a six month insurance policy at the beginning of the first month of coverage. The company needs to record the expiration of each month of
insurance coverage and the associated expense.o Original entry includes:• Debit to Prepaid Insurance • Credit toCash (or Accounts Payable)o The adjusting entry includes:• Debit to Insurance Expense• Credit to Prepaid Insurance• The dollar amount is calculated by dividing the total amount of the policy and dividing by the number of months.

Additional Resources:
http://www.accountingcoach.com/online-accounting-course/08Xpg01.html
http://accountinginfo.com/study/accrual-101.htm
Bonus Questions (email me the answers to all three questions for three extra beans) :
1. What type of account is Prepaid Insurance?2. What is the journal entry to record a $3,000 advance received from a customer to provide service for three months?3. What is the adjusting journal entry used to record

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