Adjusting accounting entries is our new topic. We concluded accounting entries and recording last week. You know doubt feel like an accountant by now. You are able to take transaction from the scratch – journalize, enter the accounts, prepare the trial balance and financial statements. I congratulate you on that. However, it might interest you to know that it’s just the foundation. Things are not straight forward like that in real life. For instance, there are times you buy things and make payment later; sometimes your customer may pay you in advance for a job you are yet to do. For an equipment you brought two years ago, how do you tell the value it contributed to your business this year? How do you determine your exact profit for a period?
We will be discussing accounting adjustments and how to do same. But first, why do we adjust accounts? We will learn some basic terms and principles; their application and how to prepare adjusted trial balance and preparing the financial statements afterward.
Let us start.
Why adjusting entries?
Adjusting entries are needed to accurately tell the value or financial strength of a business at any given time. Adjusting helps to know and account for the exact revenue earned; the exact expenses incurred and thus helps to know the exact profit made.
In the past, there were some sharp practices; where companies moved revenue not yet earned to the current year just to boost profit; they may delay recognition of expenses to later year. Thus, giving misleading financial information. This abuse of financial reporting emphasizes the need to have some basic standards and the need for adjustments.
Let us now talk on some basic assumptions and principles.
Time period assumption:
Time period assumption: This is the division of the economic life of a business into artificial time periods. We do not wait until a business die before we account for the revenue or profit it earned; during its lifetime or the total expenses it incurred. Business owners require this information from time to time for several reasons.
Financial statements are prepared in accounting time periods; to be able to access a company’s financial result of operation within such periods. These periods can be a monthly, quarterly, or yearly. Where an accounting time period is not up to a year, we say it is an Interim period; and where it is up to a year, it’s called fiscal year. Note however, that a fiscal year is not same as calendar year. A calendar year starts 1st January and ends 31st December; while, a fiscal year starts on 1st of a month and ends on the last day of the next 12 months.
Basis of accounting
- Accrual basis accounting: In accrual basis of accounting, transactions are recorded in the period they occur. That is, revenues are recorded in the year they are earned; and expenses are incurred as they occur, you don’t wait until money exchange hands before recognizing the transaction. For example, If your customer pay you for a work you are yet to do; you will recognize only the value relating to the work you have done for the period.
- Cash basis accounting on the other hand, recognize a transaction only when money exchange hands. For example, you supplied a customer in November 2021, the customer did not pay you until February 2022. Cash basis accounting will recognize this revenue in February 2022 even though it has occurred since 2021.
NOTE: Cash basis accounting is not in line with generally accepted accounting principles, hence most companies use the accrual basis.
My eyes are heavy with sleep, let us continue tomorrow. Bye.
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