As a recap, we explained yesterday that after recoding and posting of transactions into various accounts, there may be need to adjust such entries to give a true view of a company’s financials. There are however some basic principles and or assumptions that we must know. We explained some of them: time assumption and accrual or cash basis accounting.
Now let us further our discussion.
More principles in adjusting entries
Revenue recognition principle: This principle requires that revenue be recognized in the books in the period it was earned. You earn revenue in the period service is rendered, or goods are supplied. For instance, In December 2021 your company supplied goods to company B, though company B didn’t pay for the goods until later in January 2022, the sales will be recognized in December 2021.
Expenses recognition principle: Here expenses are recognized as incurred in the period they relate to. For instance, the expenses incurred to supply those goods to company B above will be recognized in December too. This follows a concept called matching concept; that is, you tie expenses to the revenue they generate. So, if in our earlier example, you engaged a transportation company to move those goods to company B, it does not matter when you pay for the transportation, transport expense has already been incurred in December 2021 and must be treated as such in the books.
From our example, remember that the revenue and associated expenses were treated in December 2021; what will now happen in the books when company B pays for the goods in January 2022? This is where adjustments come in.
Types of adjustment entries
Adjusting entries can either be deferrals or accruals.
Deferrals are instances where money exchanged hand before the transaction itself takes place. It can be either income or expenses. For income, it is unearned revenue and for expenses it is prepaid or prepayment.
Accruals on the other hand is where the transaction has already happened, but money is yet to exchange hand. For income, it is accrued income and for expenses it is accrued expenses.
So, let me ask, what category of adjustment is the example we have been using?
Did I hear you say ‘accruals?’ Whao, you are right. You recall that the transaction had already happened before money was paid.
Therefore, the clear distinction is that deferrals is payment in advance and accruals is payment in arrears.
Example of prepayment entry adjustment
Examples of prepaid expenses are rent, insurance etc. You pay for a year’s rent, it would be sheer waste of time entering each day’s rent in the book, instead, at the time of preparing the financial statement, you can adjust for the amount of rent used for the period.
For a clearer picture, let us assume you paid N3,000,000.00 for your office rent on January 1st 2022; the sum paid is for a period of two years effective from January 1 2022. On the date of payment, you debit rent prepayment account (an asset) and credit cash account. You observe that rent expense account is not affected now, because the expense is yet to be incurred.
You can record the expense monthly or at the point of preparing the financial statement. So, assuming that you are preparing statement for the first quarter of 2022; all you need to do is debit rent expense account and credit prepaid rent account by N375,000.00; amount of rent used for the quarter. (rent per month is N125,000.00 and a quarter will be N375,000.00).
As usual time has gone so swiftly, let us stop here for today. When we meet again next week, we will continue with explanation of accruals and then do a detailed example. Assuring you of my best wishes, good night.
UNDERSTANDING FINANCIAL STATEMENTS