I was tempted to believe that corporate financial accounting started and ended with the basic accounting equation. That would have been cool but there is so much more about statements of account.
Time period accounting
Timing is very crucial in financial reporting. Since managers can not wait for annual reports before they know the state of a business, it became imperative for businesses to generate periodic reports such as monthly, quarterly, or bi-annual reports. The process of generating time period reports is based on time period assumptions. In order to properly demarcate the time periods, we need to understand the difference between fiscal and calendar years. The fiscal year refers to an accounting time period that is one year in length. The start date will be the first day on any month of the year while the last day will be 12 months later. While calendar year refers to a time period that starts January 1st and ends December 31st.
As a result of a need for interim reports, account adjustments became necessary. Many business transaction affect more than one of these arbitrary time periods. For example, an asset purchased can have a five year economic lifespan, we must be able to ascertain the contribution of the asset to each year. To help achieve the adjustment of accounts, understanding of two accounting practice is required. One is accrual basis accounting and cash basis accounting. Accrual accounting refers to accounting practice where any transaction affecting the financial statement of a company is recorded as it happens. However, cash basis accounting practice recorded transactions when cash is received. Small companies are allowed by regulators to use cash basis accounting because they have very small account receivables and payables but medium and large companies must use accrual basis accounting.
Deferral & Accrual
Adjusting entries are classified as either deferrals or accruals. Deferrals are cost or revenues that are recognized at a date later than the point when cash was exchanged. Deferral entries adjusts two types of account and they are: Prepaid expense accounts and unearned revenue accounts. In the case of prepayments also referred to as prepaid expense, adjustment happens by reducing the asset account (credit side) then increase (debit side) the respective expense account. Example of prepayments include: rent expense or insurance expense. While in the case for unearned revenue, account managers record revenue before they are earned or service rendered. Increasing entry is made into liability account know as unearned revenue then adjustment is achieved by decreasing it (debit side) when service has been rendered.
The second adjusting entries, accruals adjust accrued revenue accounts and accrued expense accounts. Accrued revenue include interest revenue. These are unrecorded because the earning does not involve day to day transaction. They also include service rendered yet paid. An adjusting entry for accrued revenue results in an increase to an asset account and an increase to a revenue account. Accrued expenses are expenses incurred but not yet paid. These include: taxes and salaries. An adjusting entry for accrued expenses results in an increase to an expense account and an increase to a liability account