Under strict cash basis accounting
, revenue is recorded only when cash is received and expenses are recorded only when cash is paid. Net income is cash revenue minus cash expenses. The matching principle is ignored here, resulting inconformity with generally accepted accounting principles.
Most companies use accrual basis accounting
, recognizing revenue when it is earned (the goods are sold or the services performed) and recognizing expenses in the period incurred without regard to the time of receipt or payment of cash. Net income is revenue earned minus expenses incurred.
Although operating a business is a continuous process, there must be a cut-off point for periodic reports. Reports are prepared at the end of an accounting period.
- A balance sheet must list all assets and liabilities at the end of the accounting period.
- An income statement must list all revenues and expenses applicable to the accounting period.
Some transactions span more than one accounting period and they require adjustments. Adjustments are necessary for determining key profitability performance measures because they affect net income, assets, and liabilities. Adjustments, however, never affect the cash account in the current period. They provide information about future cash flow. For example, accounts receivable indicates expected future cash inflows.
The four basic types of adjusting entries are:
- Unearned revenues are revenues that are received in cash before delivery of goods/services. These "revenues" are not earned yet and thus should be recorded as liabilities. An adjusting entry should be: a debit to a liability account (e.g., unearned revenue) and a credit to a revenue account (e.g., revenue). Examples are magazine subscription fees and customer deposits for services.
- Accrued revenues are revenues that are earned but not yet received or recorded. They are also called unrecorded revenues. An adjusting entry should be: a debit to an asset account (e.g., accounts receivable) and a credit to a revenue account (e.g., interest revenue). Examples include interest revenues, rent revenues, etc. Such revenues accumulate with the passing of time, but the company may have not received payment or billed the client.
- Deferred expenses are expenses that benefit more than one period. When these assets are consumed, expenses should be recognized: a debit to an expense account and a credit to an asset account. For example, prepaid expenses (e.g., prepaid insurance, rent, etc.) are expenses paid in advance and recorded as assets before they are used or consumed. Another example is depreciation. The cost of a long-term asset is allocated as an expense over its useful life. At the end of each period, a depreciation expense is recorded through an adjusting entry: a debit to a depreciation expense account and a credit to an accumulated depreciation account (a contra account used to total past depreciation expenses on specific long-term assets).
- Accrued expenses are expenses that are incurred but not yet paid or recorded. At the end of the accounting period, the accrued expense is recorded through an adjusting entry: a debit to an expense account (e.g., salaries expense) and a credit to a liability account (e.g., salaries payable). Examples are employee salaries and interest on borrowed money.
In some cases valuation adjustments entries are required for assets. For example, trading securities are always recorded at their current market value, which can change from time to time.
- If the value of an asset has increased, then there should be a gain on the income statement or an increase to other comprehensive income.
- If the value of an asset has decreased, then there should be a loss on the income statement or a decrease to other comprehensive income.