The Importance of Adjusting
- Accounting Period is basic concept of accounting representing that to prepare financial statements, accountant must be assuming that the economic life of the business can be divided into time periods
- Using the accounting period concept, accountants must determine in which period the revenues and expenses of the business should be reported
- To determine the appropriate period, accountants will use either (1) the cash basis of accounting or (2) the accrual basis of accounting
Under cash basis, revenues and expenses are reported in the income statement in the period in which cash is received or paid
The Accrual Basis
- Under the accrual basis, revenues are reported in the income statement in the period in which they are earned
- Revenue is reported when the services are provided to customers. Cash may or may not be received from customers during this period
- The concept that supports this reporting of revenues is called the revenue recognition concept
- Expenses are reported in the same period as the revenues to which the relate
- Generally accepted accounting principles require the use of the accrual basis
- Small service businesses may use the cash basis because they have few receivables and payables
- For small service businesses, cash basis will yield financial statements similar to those prepared under the accrual basis
- For most large businesses, the cash basis will not provide accurate financial statements for user needs
- The accrual basis and its related matching concept require an analysis and updating of some accounts when financial statements are prepared
Nature of The Adjusting Process
- At the end of an accounting the period, many of the balances of accounts in the ledger can be reported in the financial statement
- To show the actual financial condition of the firm, It’s required updating to some accounts
- The journal entries that bring the accounts up to date at the end of the accounting period are called adjusting entries
- All adjusting entries affect at least one income statement account and one balance sheet account
- An adjusting entry will always involve a revenue or an expense account and asset or liability account
- There are 4 (four) basic items require adjusting entry:
a. The first two items are deferrals. They are consisted of: (1) deferred expenses or prepaid expenses, and (2) deferred revenues or unearned revenues
b. The second two items are accruals. They are consisted of: (1) accrued expenses or accrued liabilities, and (2) accrued revenues or accrued assets
- The following pictures is the illustrtion of deferrals and accruals (Illustration 2)
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