Lecture: Accrual Accounting and Adjusting Entries
Lecture script · about 15–20 minutes spoken · Week 4
Opening
Picture three places. A gym sells a membership that runs for a full year, and the member pays the whole price on the first visit. A small software firm pays for a year of cloud service before it has used a single hour. And our bicycle shop reaches the last day of its first month with a stack of numbers that are almost right. In all three places, the cash moved on one day and the real work happens across many days. This lecture is about putting each dollar in the month it belongs to.
Let me remind you where we are. In Week 1 you met the people who read financial statements and the FASB, the group that sets GAAP. In Week 2 you walked the shop's 12 Month 1 transactions through the accounting equation. In Week 3 you journalized them, posted them, and proved the unadjusted trial balance at $36,800 on each side. That trial balance balances. But it does not yet tell the truth about the month, and in this lecture you'll see why.
Here's the plan. We'll compare two ways of counting, cash and accrual. We'll take the FASB's five steps for deciding when revenue is earned, then the rule for expenses. We'll sort the kinds of adjustment, work the shop's six adjustments one by one, and check the adjusted trial balance. We'll finish with what makes the numbers useful to a reader. Next week, in Completing the Accounting Cycle, those adjusted numbers become the statements.
1. Cash basis versus accrual basis
Start with a feeling you already have. If a friend pays you up front to help them move house next month, did you earn that money the day they paid? Most people say no. You were paid that day. You'll earn it when you carry the boxes.
Accountants have two ways to handle that gap. Under the cash basis, revenues are recorded only when cash is received and expenses only when cash is paid. Under the accrual basis, revenues are recorded when earned and expenses when incurred, regardless of when cash moves. GAAP requires accrual-basis statements. The cash basis is easier to keep, but it lets a month look strong because a customer paid early, or weak because a bill arrived.
Accrual accounting leans on one more idea. The time period assumption says a business's life is divided into periods such as months, quarters, and years so it can report on each. Once you draw a line at the end of Month 1, every event that crosses that line has to be split at the line. That's where adjusting entries come from.
Here's the shop's example. On Day 6, a cycling club paid the shop $1,200 for a season of group tune-ups the shop had not yet performed. On the accrual basis, the shop recorded that $1,200 as Cash and as Unearned Revenue, a liability. It owes the club the tune-ups.
Pause and try this. Under the cash basis, how much Month 1 revenue would the shop record on Day 6 for the club's payment?
Take a moment and say your figure out loud.
Here's the answer. The cash basis would record all $1,200 as revenue on Day 6, because that's the day the cash arrived. The accrual basis records none of it as revenue that day, because the shop hadn't done any tune-ups yet.
Hold on to that contrast. Revenue is not earned when the cash arrives. It's earned when the work is done.
2. Revenue recognition in five steps
So when exactly is the work done? Think about that gym again. The member paid for a year, and every month the gym opens its doors, keeps the treadmills running, and runs its classes. The gym earns its revenue a month at a time, as it delivers.
The FASB wrote that common-sense idea down in its Accounting Standards Update No. 2014-09, issued in May 2014. Revenue recognition is recording revenue in the period it is earned, through five steps. I'll say them in the standard's own words. First, "identify the contract(s) with a customer". Second, "identify the performance obligations in the contract". Third, "determine the transaction price". Fourth, "allocate the transaction price to the performance obligations in the contract". And fifth, "recognize revenue when (or as) the entity satisfies a performance obligation".
Two terms in there deserve a plain gloss. A performance obligation is a promise in a contract to provide a good or a service to a customer. The transaction price is the amount the business expects to receive from a customer in exchange for what a contract promises.
Let's walk the club through all five. The contract is the club's agreement for a season of group tune-ups. The performance obligation is that one service, the season of tune-ups. The transaction price is $1,200. With only one performance obligation, all $1,200 is allocated to it. And the shop recognizes revenue as it performs the tune-ups.
By the end of Month 1, the shop has performed one quarter of them.
Pause and try this. How much of the club's $1,200 has the shop earned by the end of Month 1, and how much does it still owe?
Work it out before I go on.
Here's the answer. One quarter of $1,200 is $300, so the shop has earned $300 and still owes the club $900 of tune-ups. That $900 stays in unearned revenue, which is cash a customer has paid for work the business has not done yet, which the business owes until it does the work.
Notice the trap in that name. Unearned revenue sounds like revenue, but it's a liability. The name tells you what it will become, not what it is now.
3. Matching each expense to its month
Expenses follow the same logic from the other side. Think about a crew that mows lawns all week and gets paid the week after. Their hours on the last days of the month helped produce that month's revenue, even though payday comes later.
Expense recognition is recording an expense in the period in which the business uses the resources to produce that period's revenues. It's often called matching, because each expense is matched to the revenue it helped earn.
Here's the shop's case. The part-time mechanic worked the last days of Month 1 and earned $400 the shop hasn't paid yet. Those hours helped earn Month 1's repair revenue. So that $400 is a Month 1 expense, even though the cash leaves in Month 2. The other half of the entry is Wages Payable, a liability, because the shop owes the mechanic.
The software firm from the opening shows the mirror image. It paid for a year of cloud service up front, so most of that cost isn't an expense yet. It becomes an expense one month at a time, as the firm uses the service.
Pause and try this. The shop pays the mechanic's $400 in Month 2. In which month does that $400 belong as an expense, and why?
Give yourself a few seconds on the why.
Here's the answer. It belongs in Month 1, because the mechanic's work happened in Month 1 and helped earn Month 1's revenue. The payment in Month 2 settles the liability; it doesn't create a new expense.
4. Deferrals and accruals: sorting the adjustments
Every adjustment you'll ever make fits one of two timing shapes. In one, the money moves first and the work comes later. In the other, the work comes first and the money moves later. Once you know the shape, you know the entry.
An adjusting entry is an entry made at the end of a period so that revenues and expenses land in the period they belong to. Deferrals are the adjustments where cash moved first: a prepaid expense, which is a cost paid in advance for something the business will use later, and an unearned revenue. Accruals are the adjustments where cash moves later: an accrued revenue, earned but not yet billed or collected, and an accrued expense, incurred but not yet paid.
Depreciation fits the deferral shape too. The shop paid $12,000 for its equipment on Day 2, and it will use that equipment for years. Depreciation is the allocation of a long-lived asset's cost to the periods that use the asset. It is not a measure of market value, and it uses no cash. The credit goes to Accumulated Depreciation, a contra asset account with a credit balance. It sits with the assets and reduces Equipment. It is never a liability.
Here's the rule that checks every adjustment. An accrual or deferral adjusting entry affects one income statement account and one balance sheet account, and never Cash. The cash already moved, or it hasn't moved yet. Either way, the adjustment is about the other account.
Pause and try this. The mechanic's unpaid $400 and the club's $300 of tune-ups: which one is a deferral and which one is an accrual?
Think about which came first, the cash or the work.
Here's the answer. The club's $300 is a deferral, because the cash arrived first and the work came after. The mechanic's $400 is an accrual, because the work came first and the cash comes later.
5. The six month-end adjustments
Now let's put the whole toolkit to work on the bicycle shop, which is illustrative. There are six adjustments, labelled (a) through (f). For each one, I'll say what happened, which accounts change, the debit and the credit, and the effect.
Adjustment (a) is supplies. The shop bought $900 of supplies, and a count on Day 31 finds $350 still on the shelf. So $550 was used. Debit Supplies Expense $550, credit Supplies $550. That's a prepaid expense, a deferral.
Adjustment (b) is insurance. The 12-month policy cost $2,400, so one month is $200. Debit Insurance Expense $200, credit Prepaid Insurance $200. Prepaid Insurance drops to $2,200.
Adjustment (c) is depreciation. The $12,000 of equipment should last 5 years, which is 60 months, with no residual value. That's $200 a month. Debit Depreciation Expense $200, credit Accumulated Depreciation $200. The equipment's book value becomes $11,800.
Adjustment (d) is the club. One quarter of the tune-ups are done, so $300 is earned. Debit Unearned Revenue $300, credit Service Revenue $300. Unearned Revenue falls to $900.
Adjustment (e) is the mechanic. Debit Wages Expense $400, credit Wages Payable $400. Wages Expense rises from $1,600 to $2,000.
Adjustment (f) is unbilled work. The shop finished $250 of repairs for the delivery company and hasn't billed them yet. Debit Accounts Receivable $250, credit Service Revenue $250. Accounts Receivable rises from $800 to $1,050, and Service Revenue reaches $5,850.
Pause and try this. Look back over all six entries in your head. How many of them touch the Cash account?
Run down the list from (a) to (f) before you answer.
Here's the answer. None of them touch Cash, and Cash stays at $17,100. Each entry pairs one income statement account with one balance sheet account. If you ever find Cash in an accrual or deferral adjustment, stop and look again.
6. The adjusted trial balance
After the six entries are posted, you list every account balance again. The adjusted trial balance is a list of every ledger account and its balance after the adjusting entries are posted, checking that total debits still equal total credits. The statements come from it.
For the shop, the adjusted trial balance shows $37,650 on each side. Where did the extra come from, compared with the unadjusted $36,800? Three adjustments, (c), (e), and (f), each open a new amount on both sides: $200, $400, and $250. Add those to $36,800 and you land on $37,650. The other three, (a), (b), and (d), move amounts between accounts on the same side, so they don't change either total.
If you build it in a free spreadsheet, type each balance once and let a sum formula total each column. Then add one cell that subtracts the credits from the debits. That cell should read zero.
Pause and try this. Suppose you forgot adjustment (e) entirely. Would the adjusted trial balance still balance?
Think back to the warning from Week 3.
Here's the answer. Yes, it would still balance, with both sides $400 smaller. Leaving out a whole entry removes the same amount from each column. A balanced trial balance shows that debits equal credits, not that every adjustment was made.
7. What makes the numbers useful
Finally, picture a lender deciding whether to lend the shop money. That lender needs numbers that matter to the decision and that tell the truth about the month. The FASB's conceptual framework, Concepts Statement No. 8, names those qualities.
The qualitative characteristics are the qualities that make financial information useful. Two are fundamental: relevance, meaning the information can make a difference to its readers' decisions, and faithful representation, meaning it shows what it says it shows, completely, neutrally, and free from error. Four are enhancing: comparability, verifiability, timeliness, and understandability.
Here's the link back to the shop. Without the six adjustments, its Month 1 numbers would leave out $550 of revenue it earned and $1,350 of expenses it incurred. Those numbers would be fast and tidy, and they would not be faithful.
Pause and try this. Which group, fundamental or enhancing, does timeliness belong to?
Say the group, then say why it matters.
Here's the answer. Timeliness is an enhancing characteristic. A fast report helps only when the information is already relevant and faithful, so speed can't rescue numbers that leave out six adjustments.
Closing
Let me pull it together in the order we built it. The accrual basis records revenue when earned and expenses when incurred, and GAAP requires it. Revenue follows the FASB's five steps, so the club's payment became revenue only as the shop did the tune-ups. Each expense belongs in the month whose revenue it helped earn. Adjustments come in two shapes, deferrals and accruals, with depreciation as the deferral of an asset's cost. The shop's six adjustments each touched one income statement account and one balance sheet account, never Cash. The adjusted trial balance still balances at $37,650 on each side, and those six adjustments are what make the month's numbers faithful.
Next in this module, read the Readings & Resources page, then work the lecture tutorial and the practice set before the quiz, the discussion, and the assignment. Next week, in Completing the Accounting Cycle, you'll turn this adjusted trial balance into the shop's financial statements and close the books.
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