Adjusting Entries for Accruals As we discovered in the Adjusting Entries – Part I presentation, adjusting entries are made in order to adjust incorrect account balances, and correct them. The adjusting entries are made at the end of the accounting period, before the financial statements are prepared. They are necessary because some of the events that did change the account balances were not recorded during the period, simply because it was not convenient or feasible to do so. Now, at the end of the period, we must make these entries. If we do not, the account balances and the financial statements will not be correct.
Which Accounts Need Adjustment? We left our company at the end of the first presentation with the following trial balance. Accounts highlighted in green are deferred revenue and expense items that we previously adjusted. We must now adjust those in yellow – the accrued revenue and expense items.
Accrued Expenses We previously examined adjusting entries for deferrals. Adjusting entries for accruals are a different type of adjustment. As we know, accrual basis accounting rules require that expenses be recorded when they are incurred, whether they have been paid or not. In the case of deferrals, cash is paid for things such as supplies or equipment first, and then the expense is incurred later when these assets are used up. In the case of accruals, the expense is incurred first, before the cash is paid. Wages, for example, or telephone bills, behave this way. They are paid after the expense is incurred. We must be careful, then, and be sure to record these kinds of expenses if they have been incurred. It is easy to omit them. After all, the December telephone bill wont even be received until January, and the wages wont be calculated until payday!
Accrued Expenses, Continued When something accrues it accumulates. An accrued expense, then, is one that has accumulated and will be paid, but not until the payment is due. Since the expense has been incurred, the company is legally obligated to make the payment. All adjusting entries for accrued expenses require a debit to an expense account and a credit to a liability account.
Utilities and Telephone Expense In the last frame, Accounts Payable was used in the illustration for the accrued expense entries. Typically, separate liability accounts are used for accrued expenses. Accounts Payable is reserved for amounts owed to the companys suppliers. If our company estimates that $150 of Utilities Expense and $100 of Wages Expense has accrued, the adjusting entries would be:
Payment of Accrued Expenses When the payment due date is finally reached in the following period, the accounts will be paid. Note that the cash paid may be greater than the liability account balance if additional expense is incurred in the following period. Suppose that the utility bill is $150 and it is paid on January 10, but that the wages, paid the same day, amount to $500. The additional amount represents $400 of wages expense that was incurred during January.
Accrued Revenues Revenues also accrue if work is being done for a customer who will pay after the job is finished. It will be necessary to determine how much revenue has been earned by the end of the period, and record it. All adjusting entries for accrued revenue require a debit to Accounts Receivable and a credit to the Revenue account.
Accrued Revenues, Continued Suppose our company has begun providing services for a customer. By December 31, $300 of services have been performed. The job will be finished in January, and the customer will be billed for $500 at that time. The adjusting entry to record the accrued revenue is:
Collection of Accrued Revenues When payment is received from the customer in the following period, it will be necessary to debit Cash and credit Accounts Receivable. Note that the cash received may be greater than the Account Receivable balance if additional revenue is earned in the following period. When the customer pays the $500 bill in January, the additional $200 represents revenue earned during January.
Effects of the Adjusting Entries The adjustments for accrued revenue and expense items have affected many of the accounts on the trial balance. The highlighted accounts are those that have changed.
Conclusion We have just seen that many of the account balances have been affected by adjusting entries for accrued revenue and expense items. It is important that we make them! Had the adjustments not been made, several errors would have occurred in the financial statements. The table below summarizes them.