Topic 5 - Accrual Accounting Adjustments

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This article is a topic within the subject Accounting 1A.

Contents

Required Reading

Trotman, K. & Gibbins, M., 2009 Financial Accounting: An Integrated Approach, 4th edition, Melbourne: Thomson Nelson ITP pp. 201-241.

Foundations of Accrual Accounting

[1]

In accrual accounting (different to cash accounting), events, estimates and judgements are crucial to the measurement of financial position and financial performance. A downside of this is that accrual accounting can be manipulated.

Revenues and expenses can be recognised:

  • Before cash changes hand (credit sale)
  • at the same time as cash changes hand (cash sale) or,
  • after cash changes hand (unearned revenues or prepayments)

Expiration of Assets

When a company pays expenses in advance of recognising the expense it is known as an "expiration of asset" adjustment. This is because the 'prepayment' of cash means the company is entitled to future economic benefits.

  • For example, if a firm pays 12 months of insurance in advance, it does not recognise the full cash amount initially, but rather 1/12th of it each month. Initially the firm will debit a prepaid insurance account (increase it), and credit cash. After each month, the firm will debit insurance expense (1/12th of the total cash paid) and credit prepaid insurance (as it must be decreased as the benefits are used up)

The journal entry for this adjustment is DR Prepaid 'Insurance/Rent/whatever', CR Cash, as the asset is used up, we DR 'Insurance/Rent' Expense, CR Prepaid 'Insurance/Rent',

It is important to note that in this case expense recognition occurs AFTER cash flow

Unearned Revenues

  • Arise when cash is received before the recognition of revenue (possibly because the goods have not been provided/made/rendered)
    • E.g. if a customer were to pay for a 12 month magazine subscription in advance of actually receiving all 12 magazines

The unearned revenue is a 'liability' account as we still owe the customer the goods or services he or she paid for in advance.

The journal entry for this adjustment is DR Cash, CR Unearned Revenues.

It is important to note that in this case revenue recognition occurs AFTER cash flow.

Accrual of Unrecorded Expenses

  • Accrued Expenses are those expenses that have been incurred during the current period but will not be paid until the following period
    • E.g. electricity bill has been received but will not be paid in the period.

The journal entry for this adjustment is DR 'Expense', CR Accrued Expenses

  • E.g. DR Wage Expense, CR Wages Payable (or Accrued Wages)
    • The following period, the mistiming of cash flows and expenses will be corrected - DR Wages Payable, CR Cash

It is important to note that in this case expense recognition occurs BEFORE cash flow

Accrual of Unrecorded Revenues

  • Accrued Revenues: When a G/S has been rendered & cash will not be received until the following period
    • E.g. Interest Receivables (when interest is paid at end of the loan) $300,000 @ 10% For 1 year, At 4 Months would have $10,000 interest revenue accrued
      • DR Receivables/Accrued Revenues, CR Revenue (Than CR Receivables DR Cash)

The journal entry for this adjustment is DR 'Receivable', CR Revenue and later we CR Receivable, DR Cash (as receivables/owed money is received as cash)

It is important to note that in this case revenue recognition occurs BEFORE cash flow.

Contra Accounts

[2]

Nearly all accounts are known as 'control' accounts. This means that the amount recorded is what should be found (e.g. the amount of cash and inventory held should be equal to what is recorded in the control account).

Contra accounts serve in important function in that they allow for expenses and related value changes whilst maintaining the 'control' account for control purposes.

Accumulated Depreciation

Accumulated depreciation is a contra account associated with property, plant and equipment. It always has a credit balance.

  • It allows the user to know how long the asset has been in service as well as knowing the original cost that management paid for it

The journal entry is DR Depreciation Expense, CR Accumulated Depreciation

Accounts Receivable

  • Accounts receivable represents recognised revenue that is yet to be collected.
  • It is stated at the lower of cost (original transaction value + other charges)
    • Net Realisable Value = Accounts Receivable - Allowance for Doubtful Debts

The Allowance for Doubtful Debts account is the contra account associated with accounts receivable that reduces the net realisable value in anticipation of bad debts. THis is because their is a risk that the customer will be unable to pay.

  • To recognise bad debt expenses we DR Bad Debts Expense, CR Allowance for Doubtful Debts
    • The amount expensed is usually determined by past experience

By using the contra asset and not reducing the accounts receivable control account, the firm is able to know how much it is still legally owed.

  • If the company writes off the account (gives up on collection) the journal entry is:
    • DR Allowance for Doubtful Debts, CR Accounts Receivable

Full Accounting Cycle Example

This example (summarised) can be found in chapter 5.7 in the prescribed textbook [3] with the adjusting entries treated as normal entries meaning that an adjusted trial balance is not necessary in this case.

Journal Entries

JE5.7.jpg

Ledger, Trial Balance And Closing Entries

TB5.7.jpg

Post Closing Trial Balance And Financial Statements

BS5.7.jpg

End

This is the end of this topic. Click Accounting 1A to go back to the main subject page for Accounting 1A

References

Textbook refers to Trotman, K. & Gibbins, M., 2009 Financial Accounting: An Integrated Approach, 4th edition, Melbourne: Thomson Nelson ITP

  1. Trotman, K. and M. Gibbins. Financial Accounting: An Integrated Approach, Thomas Nelson, Fourth Edition 2009
  2. Trotman, K. and M. Gibbins. Financial Accounting: An Integrated Approach, Thomas Nelson, Fourth Edition 2009
  3. Trotman, K. and M. Gibbins. Financial Accounting: An Integrated Approach, Thomas Nelson, Fourth Edition 2009
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