Accrual accounting and adjusting entries

Learning goals

• Explain why profit and cash flow differ under accrual accounting.
• Prepare deferral, accrual, and depreciation adjustments.
• Calculate an adjusted account balance and avoid double counting.
• Trace each adjustment to profit, equity, and the statement of financial position.
• Use documents and estimates to build a period-end adjustment schedule.

Prerequisite check

1. A company pays $12,000 for a future twelve-month service. Why might the full cash payment not be this month's expense?
2. A customer deposit has a credit balance. What must happen before it becomes revenue?

Vocabulary

• Accrual basis: recognizes economic effects in the periods in which they occur, not only when cash moves.
• Deferral: cash occurs before recognition of revenue or expense.
• Accrual: recognition occurs before the related cash receipt or payment.
• Adjusting entry: period-end entry that updates accounts before statements.
• Prepaid expense: an asset representing service or benefit not yet consumed.
• Unearned revenue: a liability for goods or services still owed.
• Depreciation: systematic allocation of a depreciable asset's amount over its useful life; not a valuation forecast.
• Contra asset: account with a credit balance that reduces a related asset, such as Accumulated Depreciation.

Core idea

An unadjusted trial balance contains recorded cash and credit transactions, but time has passed and some economic activity has no routine document yet. Period-end adjustments ask:

• What asset benefit has been consumed?
• What liability obligation has been satisfied?
• What revenue has been earned but not billed?
• What expense has been incurred but not recorded?
• What long-lived asset cost belongs to this period?

Adjustments normally involve one income-statement account and one statement-of- financial-position account. They normally do not debit or credit Cash.

Why this treatment makes sense

Without adjustments, a company could choose profit simply by accelerating collections or delaying payments. Accrual accounting instead reports resources, obligations, and performance in the period to which they relate. Some amounts are estimates; a documented reasonable estimate can faithfully represent more than waiting for a perfectly precise number that arrives too late.

A repeatable method

Use SCAN–TARGET–CHANGE–ENTRY–RECHECK:

1. Scan contracts, counts, payroll cut-off, invoices, asset records, and later receipts/payments.
2. Set the correct ending target balance for the asset or liability.
3. Compute the change: target minus the current ledger balance.
4. Build the entry and explain the income effect.
5. Recheck that no cash is used, the direction makes sense, and the adjusted balance equals the target.

Worked example

At December 31, Harbour Media's unadjusted records and evidence show:

1. Prepaid Insurance is $3,600 for 12 months beginning October 1.
2. Supplies is $2,700; a physical count finds $800 unused.
3. Equipment cost $24,000, residual value is estimated at $0, useful life five years, straight-line, and it has been available for three months.
4. Unearned Revenue is $6,000; two-thirds of the promised work is complete.
5. Employees have earned $1,500 to be paid in January.
6. $2,200 of December service is complete but not yet billed.

Adjustments:

Net profit effect: revenue +$6,200; expenses +$5,500; therefore profit and equity increase $700 relative to the unadjusted records.

Journal, ledger, and statement connection

Posting changes the ledger targets: Prepaid Insurance $2,700 Dr; Supplies $800 Dr; Accumulated Depreciation $1,200 Cr; Unearned Revenue $2,000 Cr; Wages Payable $1,500 Cr; and A/R $2,200 higher. These adjusted balances—not the unadjusted ones—feed the statements. When January wages are paid, debit Wages Payable for the accrued portion so January does not expense it again.

Common mistakes

• Adjusting by the desired ending balance instead of by the required change.
• Expensing supplies remaining rather than supplies used.
• Crediting Equipment for ordinary depreciation instead of using Accumulated Depreciation.
• Recording January cash in the December adjusting entry.
• Recognizing all unearned revenue because cash is non-refundable; the performance facts still matter.
• Treating an estimate as permission to invent. Document method, evidence, assumptions, and review.
• Forgetting that “available for use,” not purchase order date, normally starts depreciation.

Guided practice

At March 31:

1. Prepaid Rent has $8,000 from a four-month payment made February 1.
2. Supplies before adjustment are $1,950; count is $620.
3. Unearned Lesson Revenue is $4,500; 40% remains unearned.
4. Staff earned $780 not yet recorded.
5. Equipment costing $18,000, $3,000 residual, five-year life, has been available for six months; use straight-line.

Prepare and explain each entry.

Independent practice

At June 30, Blue Canoe Analytics has these unadjusted balances: Prepaid Insurance $6,000; Supplies $3,400; Unearned Revenue $9,600. Evidence shows: insurance was a ten-month policy beginning April 1; supplies on hand are $900; 75% of the customer work has been delivered; consultants have earned $2,300 not yet paid; and $1,700 service is complete but unbilled. Prepare an adjustment schedule, entries, ending balance of each related asset/liability, and net effect on profit. State one evidence source for each estimate.

Self-check and solutions

Guided: Rent Expense Dr $4,000 / Prepaid Rent Cr $4,000 (two months used); Supplies Expense Dr $1,330 / Supplies Cr $1,330; Unearned Revenue Dr $2,700 / Lesson Revenue Cr $2,700, leaving $1,800; Wages Expense Dr $780 / Wages Payable Cr $780; Depreciation Expense Dr $1,500 / Accumulated Depreciation Cr $1,500 because ($18,000 − $3,000) ÷ 60 × 6.

Independent: Insurance Expense $1,800 and Prepaid Insurance ending $4,200; Supplies Expense $2,500 and Supplies ending $900; debit Unearned Revenue and credit Revenue $7,200, leaving liability $2,400; Wages Expense/Payable $2,300; A/R/Revenue $1,700. Revenue rises $8,900 and expenses rise $6,600, so profit rises $2,300 versus unadjusted profit.

Evidence: policy and coverage dates; signed count sheet; contract/milestones and acceptance; approved time records; work log and customer contract. A strong answer explains why evidence supports the percentage, not merely the arithmetic.

Retrieval practice

1. Contrast an accrued expense and a prepaid expense.
2. Why do ordinary adjusting entries usually exclude Cash?
3. Write the formula for straight-line depreciation.
4. What target-balance question prevents supplies and unearned-revenue errors?

Exam-style application

Unearned Revenue has a $14,000 credit before adjustment. Review shows $9,500 remains unearned. A student debits Unearned Revenue $9,500 and credits Revenue $9,500. Diagnose the error, prepare the correct entry, and quantify the profit overstatement.

Target: Earned amount is $14,000 − $9,500 = $4,500. Dr Unearned Revenue $4,500 / Cr Revenue $4,500. The student's revenue and profit are overstated by $5,000, and the liability is understated by $5,000.

Lesson summary

Accrual adjustments update assets and liabilities to evidence-based ending balances and place revenue and expenses in the proper period. Compute the target, record the change, then trace the effect through profit and equity.