4 Accrual Accounting and Adjusting Entries

When to recognize revenue and expenses

Accrual-basis accounting records transactions in the periods when the related economic activity occurs, not simply when cash changes hands. It gives a fuller picture of a period’s performance and of the assets and liabilities at its end. Cash-basis accounting, by contrast, generally records revenue when cash is received and expenses when cash is paid.

Under accrual accounting, revenue is recognized when earned, typically as the business satisfies its promise to provide goods or services. Expenses are recognized when incurred, such as when resources are used or an obligation arises. Recognizing related costs in the same period as the revenue they help generate is useful, but it does not mean every expense must be directly matched to a particular sale.

For example, a consulting firm that completes $\$900$ of work in December and receives payment in January records December revenue and a receivable. A company that receives a December electricity bill in January records the expense in December, when the electricity was used.

Why period-end adjustments are needed

At period-end, some earned revenues and incurred expenses may not yet be recorded. Conversely, amounts already recorded as assets or liabilities may have been partly earned or used. Adjusting entries update the accounts so revenue and expenses appear in the appropriate period and balance-sheet accounts reflect what remains. They generally involve at least one income-statement account and one balance-sheet account, and they do not record a new cash receipt or payment.

Adjustments fall into two broad categories:

• Deferral: Cash was received or paid before the related revenue was earned or expense incurred. Common examples are unearned revenue and prepaid expenses.

• Accrual: Revenue was earned or expense incurred before cash was received or paid, and the transaction has not yet been recorded. Common examples are accrued revenue and accrued expense.

Adjusting deferrals

A prepaid expense begins as an asset because the business has paid for a future benefit. As the benefit is used, the used portion becomes an expense.

Suppose a business pays $\$1{,}200$ on January $1$ for six months of insurance and initially records Prepaid Insurance. At January $31$, one month has expired. The adjustment is:

• Debit Insurance Expense: $\$200$

• Credit Prepaid Insurance: $\$200$

This recognizes January’s insurance cost and leaves $\$1{,}000$ as an asset for the remaining coverage.

Cash received before goods or services are provided is recorded as a liability. The business still owes the customer performance or a refund, depending on the arrangement. As the business earns the revenue, it reduces the liability and recognizes revenue.

For example, a business receives $\$2{,}400$ in advance for four months of service and records Unearned Revenue. After providing one month of service, it records:

• Debit Unearned Revenue: $\$600$

• Credit Service Revenue: $\$600$

The remaining $\$1{,}800$ is still a liability because the service has not yet been provided.

Adjusting accruals

Revenue earned but not yet billed or collected is recorded with a receivable and revenue. If a business has completed $\$900$ of work by period-end but has not billed the customer, it records:

• Debit Accounts Receivable: $\$900$

• Credit Service Revenue: $\$900$

When the customer later pays, the business records cash and reduces Accounts Receivable. It does not recognize the same revenue a second time.

An expense incurred but not yet paid or recorded is recognized with an expense and a liability. If employees have earned $\$600$ of wages by period-end that will be paid later, the business records:

• Debit Wages Expense: $\$600$

• Credit Wages Payable: $\$600$

When the wages are paid, the business reduces Wages Payable and credits Cash. The expense was already recognized in the period employees did the work.

A practical adjustment process

To analyze an adjustment:

1. Identify what has been earned, used, incurred, or remains owed by the reporting date.

2. Compare that amount with what the accounts already show.

3. Adjust only the difference, debiting and crediting equal amounts.

4. Check that the adjustment updates both the appropriate income-statement account and balance-sheet account.

The central question is when revenue was earned or an expense was incurred, not when cash moved. Deferrals move amounts from a balance-sheet account into revenue or expense as they are earned or used. Accruals record revenue or expense, along with the related receivable or payable, before the cash transaction occurs.

In summary, accrual accounting reports revenues when earned and expenses when incurred, independently of cash timing. Period-end adjustments bring accounts up to date: deferrals recognize previously paid or received amounts as they are used or earned, while accruals recognize earned revenue or incurred expense not yet recorded. Each adjustment helps present the correct period’s performance and the related assets or liabilities.