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The Adjustment Process

 

The Adjustment Process

 

Accountants use adjusting entries to apply accrual accounting to transactions that span more than one accounting period. Adjusting entries have at least one balance sheet (or permanent) account entry and at least one income statement (or temporary) account entry. Adjusting entries never involve the Cash account. They are needed when deferrals or accruals exist. A deferral is the postponement of the recognition of an expense already paid or incurred or of a revenue already received. Deferrals are used in two instances:

  1. Costs have been recorded that must be apportioned between two or more accounting periods. Examples are the cost of a building, prepaid insurance, and supplies. The adjusting entry in this case involves an asset account and an expense account.
  2. Revenue have been recorded that must be apportioned between two or more accounting periods. An example is payments collected for services yet to be rendered. The adjusting entry involves a liability account and a revenue account.

An accrual is the recognition of a revenue or expense that has arisen but has not yet been recorded. Accruals are required in these two cases:

  1. There are unrecorded revenues. An example is fees earned but not yet collected or billed to customers.
  2. There are unrecorded expenses. Example are the wages earned by employees in the current accounting period but after the last pay period. The adjusting entry involves an expense account and a liability account.

Example:

 

Apportioning Recorded Expenses Between Two or More Accounting Periods (Deferral Expenses)

 

Transaction: Expiration of one month’s rent.

 

Analysis: Assets decrease. Owner’s equity decreases.

 

Rules: Decreases in assets are recorded by credits. Decreases in owner’s equity are recorded by debits.

 

Entries: The decrease in owner’s equity is recorded by a debit to Rent Expense. The decrease in assets is recorded by a credit to Prepaid Rent.

 

rent expense transaction

The Prepaid Rent account now has a balance of $400, which represents on month’s rent in advance. The Rent Expense account reflects the $400 expense for the month of January.