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The Adjusting Process

Accounting can be done on either a cash or accrual basis. A cash-basis means transactions are recorded when cash actually changes hands. An accrual basis means that transactions are recorded as they occur, even if no cash is received or paid out. Company's use an accrual basis for accounting because it gives us a better current snapshot of a firm's financial picture. For example, if a firm makes a sale on account, we record the accounts receivable as an asset on the balance sheet and the sale as revenue. If we waited until cash actually changed hands to record the transaction, we would be understating assets and sales in the meantime.

However, because we use an accrual basis, some accounts need to be reconciled at the end of the period. These accounting adjustments fall into three basic categories: deferrals, depreciation and accruals. At the end of the period, we make these adjusting entries in the general journal, post these entries to the ledger and then prepare an adjusted trial balance. We often use a worksheet for the preparation of the adjusted trial balance. The adjusted trial balance is then used to prepare the income statement, the statement of retained earnings and the balance sheet.

(1) Deferrals: Unearned Revenue and Prepaid Expenses

A deferral is an adjustments for which the business paid or received cash in advance. For example, a company typical purchases office supplies over the period. These are kept on the balance sheet as an asset. At the end of the period, we determine how how much supplies we have left. The decrease in supplies is then recorded as an office supplies expense. Deferrals include, for example, unearned revenue, cost of goods sold (under a periodic inventory system) office supplies, prepaid rent, and prepaid insurance. These adjusting entries may look like this:


(2) Depreciation 

When we buy a capital asset, an asset that will last a long time, we do not expense it right away. We expense a portion of the asset every year we use it over its useful life. We call the portion of the asset that we expense depreciation, and we calculate the amount of depreciation for the period at the end of the period. We use a contra asset account called accumulated depreciation, and an expense account called depreciation expense to record depreciation.  The amount of the capital asset less its accumulated depreciation is called that asset's carrying amount; this is the book value of the asset, or the net amount that the asset is still worth based on its historical cost. 


(3) Accruals: Accrued Revenue and Accrued Expenses

Over time, businesses accrue revenues and expenses that have yet to be received or paid. For example, your phone company accrues revenue over the month, and sends you a bill at the end of the month. On your end, you accrue a phone expense over the month, which becomes an account payable. At the end of the period, the phone company must make an adjustments for this earned revenue, even if the bill hasn't been mailed. At the same time, even if you haven't received the invoice, you know that you've incurred some phone expense based on your contract (maybe its $100/month all inclusive). 



We typically use a worksheet to help us prepare the trial balance from the adjusting entries. Below is an example of a worksheet. We started with the unadjusted trial balance we used before (see: Trial Balance) and added two columns for our adjusting entries. Adjusting entries (a) through (e) are the five types of entries from above. We also included entries for accrued salaries (f), building depreciation (g) and accrued taxes (h). We also added two more columns for our adjusted trial balance. We simply add the adjusting entries in the middle to columns to the balances in the first two columns to get the balances of the adjusted trial balance. 


*Note: in our examples above, two different companies were used to show how accrued revenue for one company is an accrued expense for another. In our worksheet, we wanted to show both of these entries (since all companies accrue both revenues and expenses). To simplify things, we pretended our accrued phone expense was for ABC company as well, and included it on the worksheet. 

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