One type of adjusting entry results from the need to “accrue” certain revenues and expenses in order to compute net income of a business on the accrual basis. The accrual method, as distinguished from the cash receipts and disbursements method of accounting, reports revenues when they are earned even though no cash may have been received and reports expenses when they have been incurred even though no payment of cash has been made in connection with such expenses. The recording of the sales revenue and the related accounts receivable illustrated in section C. above is one example of the use of accrual accounting. Revenue is recognized when a sale is made, not when the cash is collected.
“Accrued revenues and expenses” are examples of the use of the accrual method of accounting that also necessitate adjusting entries. The accrual of a revenue or expense at the end of an accounting period is the recognition of a revenue or expense even though there has been no receipt or payment and no prior recording of the transaction. The recognition of sales revenue and a related receivable (asset) at the time of a sale is an accrual of revenue that is recorded during the accounting period at the time of a transaction. However, the use of the term accrual is usually applied to revenues and expenses that are not normally recognized in the financial books until the end of the accounting period.
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a. Accrued Revenues
To illustrate the accrual of revenue, assume that Company J holds a $50,000 note receivable (an asset) bearing interest at a rate of ten per cent per annum payable
annually. The note is dated July 1, 201x, and interest is payable on each July 1 during the term of the note. The business maintains its books on a calendar year basis. At December 31, 201x, no interest has been received on the note. However, as of that date, Company J has earned interest of approximately $2,500, one half of the $5,000 interest payment that will be made on July 1 of the following year. Therefore, Company J will “accrue”
$2,500 of interest revenue on December 31, 201x, to reflect the revenue that has been earned but not yet received. This interest revenue is accrued revenue. The adjusting entry that would be made on December 31, 201x, would be as follows:
Accrued Interest Receivable $2,500
Interest Revenue $2,500
This entry “adjusts” the financial records to recognize the accrued interest revenue and create a corresponding asset. Similar accruals of revenue may be necessary for such things as rent and other types of revenue that are earned with the passage of time.
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b. Accrued Expenses
Certain expenses are incurred with the passage of time even though such expenses have not yet been paid. These expenses must be recognized as they are incurred. The recognition of these expenses that have been incurred but not yet paid involves the accrual of the expense and typically the creation of a related liability.
Assume that a business pays its employees every other Friday. On December 31, 201x, the employees have worked one of the two weeks in their current payroll period. If the total payroll that will be paid on the next payday is $25,000, then the business should accrue compensation expense on December 31 in the amount of $12,500. That is, the business should recognize the compensation expense that has been earned by its employees on December 31 even though that compensation is not payable until the next Friday. (Note that payroll taxes and similar items related to payroll would be accrued as well but this illustration will be limited to the basic payroll.) The necessary adjusting entry to record the accrued compensation would be as follows:
Compensation Expense $12,500
Accrued Salaries & Wages Payable
$12,500
The debit entry records the appropriate amount of the accrued expense and the credit entry increases a corresponding liability account for the amount
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that will be paid. Other types of expenses for which accrual-type adjusting entries are often made include interest expense, rent expense, certain taxes (property taxes that
accrue over time and income taxes that must be accrued as of year-end even though they are not payable for several months), and estimated liabilities (for example, the estimated exposure on outstanding warranties of businesses that extend warranties in connection with the sale of products).
c. Accounting for Actual Receipt of Payment
The adjusting entries that are illustrated above must be kept in mind when the actual receipt of cash or payment of cash later occurs in order to avoid misstating the relevant revenues or expenses. For example, when the interest payment on the note receivable discussed above is received, the full $5,000 will not be reported as revenue. Rather, the entry to record the receipt of the interest would be as follows (assuming no further accrual of interest revenue on the note has occurred during the current year):
Cash $5,000
Accrued Interest Receivable $2,500
Interest Revenue $2,500
The total interest revenue earned for the first full year of the note ($5,000) now has been recognized but through the use of the adjusting entry to accrue
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interest revenue in 201x, the revenue has been appropriately allocated between the two years.
Similarly, when the payroll discussed above is paid in the subsequent year, the correct entry would be as follows:
Compensation Expense $12,500
Accrued Salaries & Wages Payable $12,500
Cash $25,000
As in the case of the interest revenue, the total compensation expense associated with the payroll has been appropriately allocated to 201x and the following year through the use of the adjusting entry at the end of 201x.
d. Reversing Entries
In actual practice, many businesses employ an additional procedure known as a
“reversing entry” to simplify the accounting for an actual cash receipt or payment after an adjusting entry has been made to accrue revenue or expense. This process makes it much simpler for the appropriate accounting personnel who handle the routine transaction recording to ignore the adjusting entry process. To illustrate, assume that the books for 201x have been closed (a process that will be described below) and it is now the first day of business in the following year. For many of the adjusting entries that were made at the end of 201x, “reversing entries” will be made to
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eliminate the accrued revenue or expense and the related asset or liability.
Thus, for the interest revenue that was accrued in 201x, a reversing entry would be recorded in the next year as follows:
Interest Revenue $2,500
Accrued Interest Receivable $2,500
This eliminates the interest receivable (asset) account. Immediately after this entry, interest revenue for the new year will actually show a negative (debit) balance of $2,500.
When the interest payment is actually received on July 1, the appropriate accounting clerk can record the normal entry for receipt of interest as follows:
Cash $5,000
Interest Revenue $5,000
When the $5,000 credit entry is made to the interest revenue account, the balance in the account immediately following the cash receipt will be $2,500, the $5,000 credit less the $2,500 that was debited to the account in the reversing entry process. A similar procedure could be followed for the accrual of compensation expense and for other accrued revenues and expenses.
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