Chapter Summary

The purpose of adjusting entries is to allocate revenue and expenses among accounting periods in accordance with the realization and matching principles. These end-of-period entries are necessary because revenue may be earned and expenses incurred in periods other than the one in which the related transactions are recorded.

The four basic types of adjusting entries are made to (1) convert assets to expenses, (2) convert liabilities to revenue, (3) accrue unpaid expenses, and (4) accrue unrecorded revenue. Often a transaction affects the revenue or expenses of two or more accounting periods. The related cash inflow or outflow does not always coincide with the period in which these revenue or expense items are recorded. Thus, the need for adjusting entries results from timing differences between the receipt or disbursement of cash and the recording of revenue or expenses.

When an expenditure is made that will benefit more than one accounting period, an asset account is debited and cash is credited. The asset account is used to defer (or postpone) expense recognition until a later date. At the end of each period benefiting from this expenditure, an adjusting entry is made to transfer an appropriate amount from the asset account to an expense account. This adjustment reflects the fact that part of the asset's cost has been matched against revenue in the measurement of income for the current period.

Customers sometimes pay in advance for services to be rendered in later accounting periods. For accounting purposes, the cash received does not represent revenue until it has been earned. Thus, the recognition of revenue must be deferred until it is earned. Advance collections from customers are recorded by debiting Cash and by crediting a liability account for unearned revenue. This liability is sometimes called Customer Deposits, Advance Sales, or Deferred Revenue. As unearned revenue becomes earned, an adjusting entry is made at the end of each period to transfer an appropriate amount from the liability account to a revenue account. This adjustment reflects the fact that all or part of the company's obligation to its customers has been fulfilled and that revenue has been realized.

Some expenses accumulate (or accrue) in the current period but are not paid until a future period. These accrued expenses are recorded as part of the adjusting process at the end of each period by debiting the appropriate expense (e.g., Salary Expense, Interest Expense, and Income Taxes Expense), and by crediting a liability account (e.g., Salaries Payable, Interest Payable, and Income Taxes Payable). In future periods, as cash is disbursed in settlement of these liabilities, the appropriate liability account is debited and Cash is credited. Note: Recording the accrued expense in the current period is the adjusting entry. Recording the disbursement of cash in a future period is not considered an adjusting entry.

Some revenues are earned (or accrued) in the current period but are not collected until a future period. These revenues are normally recorded as part of the adjusting process at the end of each period by debiting an asset account called Accounts Receivable, and by crediting the appropriate revenue account. In future periods, as cash is collected in settlement of outstanding receivables, Cash is debited and Accounts Receivable is credited. Note: Recording the accrued revenue in the current period is the adjusting entry. Recording the receipt of cash in a future period is not considered an adjusting entry.

Adjusting entries are the tools by which accountants apply the realization and matching principles. Through these entries, revenues are recognized as they are earned, and expenses are recognized as resources are used or consumed in producing the related revenue.

The concept of materiality allows accountants to use estimated amounts and even to ignore other accounting principles if these actions will not have a material effect on financial statements. A material effect is one that might reasonably be expected to influence the decisions made by users of financial statements. Thus accountants may count for immaterial items and events in the easiest and most convenient manner.

The adjusted trial balance reports all of the balances in the general ledger after the end-of-period adjusting entries have been made and posted. Generally, all of a company's balance sheet accounts are listed, followed by the statement of retained earnings accounts, and finally, the income statement accounts. The amounts shown in the adjusted trial balance are carried forward directly to the financial statements. The adjusted trial balance is not considered one of the four general purposes financial statements introduced in Chapter 2. Rather, it is simply a schedule (or tool) used in preparing the financial statements.

In this chapter we have examined adjusting entries made for the accrual and deferral of expenses and revenue. In Chapter 5, we complete the remaining steps of the accounting cycle by illustrating the preparation of financial statements, the end-of-period closing process, and the after-closing trial balance.