Question

In developing an accounting information system, it is vital to establish processes whereby all transactions that affect the components of the accounting equation are recorded. Why then, is it often necessary to adjust the accounts before financial statements are prepared even in a properly designed accounting system? Identify the major types of adjustments that are frequently made and give a specific example of each.

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Answer 1

Account adjustments, also known as adjusting entries, are entries that are made in the general journal at the end of an accounting period to bring account balances up-to-date. Unlike entries made to the general journal that are a result of business transactions, account adjustments are a result of internal events.

There are four types of account adjustments found in the accounting industry under 2 broad categories – accrual basis & deferred basis.

ACCRUAL BASIS

There are two types of accrual basis adjusting entries:

ACCRUED REVENUE: An accrued revenue is one that occurs when a sale is made or services are performed in one accounting period but payment is not received until a later period.

ACCRUED EXPENSE: An accrued expense is an expense that has occurred in one accounting period but won't be paid until another period.

Examples of such accounting adjustments are:

• Altering the amount in a reserve account, such as the allowance for doubtful accounts or the inventory obsolescence reserve.
• Recognizing revenue that has not yet been billed.
• Deferring the recognition of revenue that has been billed but has not yet been earned.
• Recognizing expenses for supplier invoices that have not yet been received.
• Deferring the recognition of expenses that have been billed to the company, but for which the company has not yet expended the asset.
• Recognizing prepaid expenses as expenses.

DEFERRED BASIS

There are two types of deferred based entries:

DEFERRED REVENUE: A deferred revenue is money that has been paid in advance for a service that will be performed later.

Situational Examples:

• Gift cards
• Airline miles
• Subscriptions to newspaper and magazines

Adjustment Journal Entry:

XYZ Company delivered services in September for an $800 payment that was made three months ago.

DR Unearned Revenue      800

CR Sales Revenue            800

DEFERRED EXPENSE: A deferred expense is an expense that has been paid in advance and will be expensed out at a later date.

Situational Examples:

• Prepayment of advertising, insurance, or rent becomes used up over time

Adjustment Journal Entry:

One month of XYZ Company’s insurance expired in June. The original payment of $800 covers June through September.

DR Insurance Expense       200

CR Prepaid Insurance           200