Adjustments for Financial Reporting

Summary :

This chapter distinguishes the cash basis from the accrual basis of accounting and explains why adjusting entries are necessary at the end of a period. It identifies the classes and types of adjusting entries, shows how to prepare them, and examines the effect on financial statements if they are omitted.

Cash basis versus accrual basis

Under the cash basis, revenue and expenses are recorded only when cash actually changes hands. Under the accrual basis, revenue is recorded when it is earned and expenses when they are incurred, regardless of when cash moves. Accrual accounting gives a more complete picture of a period's financial performance, which is exactly why adjustments for financial reporting are needed to bring the accounts up to date before statements are finally prepared.

Why and when adjusting entries are made

Adjusting entries are needed because some transactions span more than one accounting period, or because certain events, such as the earning of interest or the gradual using up of supplies, occur continuously without triggering a matching daily journal entry on their own. Without these entries, revenues and expenses would be misstated and would not reflect the period in which they genuinely occurred, distorting the resulting financial statements.

Classes of adjusting entries

Adjusting entries generally fall into a small number of recurring types: apportioning previously recorded assets and liabilities between periods, and recording previously unrecorded revenues and expenses that have already accrued. The chapter works through preparing each type in turn and shows, with a worked example, exactly how omitting them would distort a company's reported income and its year-end account balances.