The accrual basis of accounting requires that all revenues be recorded as they are earned and that expenses recorded as they are incurred. That is, there is a proper matching of revenues and expenses only if the income statement for the period includes all of the revenues and expenses applicable to the accounting period without regard to the timing of either the receipt or the disbursement of cash. At the end of any accounting period, there will usually be certain transactions that are still in the process of completion or that have occurred but that have not been recorded in the accounts. These transactions require adjusting entries to record revenues and expenses and to allocate them to the proper period or periods. All adjusting entries will involve either an expense or a revenue. In general, the types of transactions that require end-of-period adjusting entries fall into the following groups:
- Allocation of prepaid expenses to the proper periods
- Recognition of unrecorded (accrued) expenses
- Allocation of a portion of the recorded cost of property, plant and equipment to the accounting periods that benefit from their use (depreciation)
- Allocation of unearned revenue to the proper periods
- Recognition of unrecorded (accrued) revenues
Classification of Adjusting Entries
Entries to Adjust Expenses:
- Prepaid Expenses
Purpose: Allocate prepaid assets to expense as they are used
Example: Time passing on a multi-period insurance policy - Accrued Expenses
Purpose: Record expenses incurred, but not yet recorded
Example: Wages owed to employees, but not yet paid
- Depreciation Expense
Purpose: Spread assets cost over period that benefit
Example: A year's depreciation for a company vehicle
Entries to Adjust Revenues:
- Unearned Revenues
Purpose: Record the earning of a portion of unearned revenues
Example: Completed a job (or service) that had been paid for in advance - Accrued Revenues
Purpose: Record revenues earned, but not yet recorded
Example: Interest earned, but not yet received