ACFI1002 Lecture Notes - Lecture 2: Book Value, Creative Accounting, Deferral
29 Jun 2018
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The Adjusting Process: Week 2.
LO1: Differentiate between accrual and cash-basis accounting.
Accrual Accounting: records effect of each transaction as it occurs. Most use this.
Cash-basis Accounting: records only cash receipts and cash payments, ignores receivables,
payables etc. Only very small businesses use the cash basis of accounting.
For example, if a business were to buy supplies on credit:
Accrual based accounting would record an increase in office supplies, and its effect on
accounts payable.
Cash based accounting would ignore this transaction, as no cash was paid.
The Accrual based accounting method is the normal way to do accounting and is required by
Australian Accounting Standards. It provides more complete information than cash-basis accounting.
LO2: Explain criteria for revenue recognition and expense recognition.
Revenue recognition principle:
Revenue is recognised when it is deemed ‘earned’. Recognition of revenue and cash receipts do not
necessarily occur at the same time. The amount of revenue to record is equal to the value of goods
or services transferred to the customer.
Expense recognition principle:
Relates inputs and outputs of goods and services to one another. The costs of inputs are treated as
expenses, and subtracted from the revenues associated with outputs in calculating profit for a
period. Thus, expenses should be recorded when the benefit from the expense is received (when
cost is incurred to produce revenue).
LO3: Explain why adjusting entries are needed.
At the end of the period, the accountant prepares the financial statements. The unadjusted trial
balance lists the revenues and expenses, but these amounts are incomplete due to omitting various
transactions. This is why the trial balance must be adjusted. Accrual accounting requires adjustment
of entries at the end of the period to ensure balances are correct for the financial statements.
Adjusting entries assign revenues to a period where they are earned and expenses to a period where
they are incurred. Adjusting entries also update the assets and liability accounts. Adjustments are
needed to properly measure:
1. Profit (loss) in the income statement, and
2. Assets and liabilities in the balance sheet.
Adjusting entries never includes the cash account, and essentially will either increase revenue
earned, or increase an expense.
There are two categories of adjusting entries:
1. Prepaid adjustments: advance payments of expenses- ie. rent, insurance and supplies
(sometimes). These prepaid expenses are considered assets rather than expenses. When
prepayment is used up, the used portion of the asset becomes an expense via adjusting
journal entry.
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2. Accrued adjustments: business often incur expenses before paying for them. The term
accrued expense refers to an expense of this type. An accrued expense hasn’t been paid for
yet- for example, an employee’s salary- it grows as the employee works (it accrues). Another
accrued expense is an interest expense on a loan payable. An accrued expense always
creates a liability. Companies don’t usually make weekly journal entries for accrued
expenses, waiting till the end of the accounting period to make adjusting entries to bring
each expense up to date for the financial statements. See salary adjustment in the next dot
point. Ultimately, this also includes revenue.
LO4: Journalise and post adjusting entries.
Prepaid Rent (Prepaid adjustment):
Entry recorded as:
Jun 1: Prepaid rent ($1000 x 3) 3000
Cash 3000
Paid rent in advance
The trial balance at 30 June 2016 lists prepaid rent with a debit balance of 3 000. But this will not be
the amount for the balance sheet at the end of the month, as now we are only 2 months prepaid,
with the expense of rent for one month realised. The adjusting entry would be:
Jun 30: Rent Expense ($3000 x 1/3) 1000
Prepaid Rent 1000
To record rent expense
And would be entered into the T accounts to add 1000 to the right side of the Prepaid Rent T-
account, and 1000 to the left side of the Rent Expense T-Account.
The same method can be used for supplies.
Depreciation:
Property, plant and equipment assets are long-term, tangible assets used in the operation of the
business. As they are used, their value and usefulness decline. This is an expense. It is similarly
accounted for in the same way as prepaid expenses. For example:
Furniture purchased for $18 000.
Jun 3: Furniture 18 000
Cash 18 000
Purchased furniture
After posting, the furniture T account would have 18 000 on the left side, and the cash account
would have 18 000 on the right side. To account for the accumulation of depreciation each month,
we can divide the costs of the asset over its useful life, and then open an accumulated depreciation
account.
Jun 30: Depreciation expense- furniture 300
Accumulated depreciation- furniture 300
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find more resources at oneclass.com
Document Summary
Accrual accounting: records effect of each transaction as it occurs. Cash-basis accounting: records only cash receipts and cash payments, ignores receivables, payables etc. Only very small businesses use the cash basis of accounting. For example, if a business were to buy supplies on credit: Accrual based accounting would record an increase in office supplies, and its effect on accounts payable. Cash based accounting would ignore this transaction, as no cash was paid. The accrual based accounting method is the normal way to do accounting and is required by. It provides more complete information than cash-basis accounting. Lo2: explain criteria for revenue recognition and expense recognition. Revenue is recognised when it is deemed earned". Recognition of revenue and cash receipts do not necessarily occur at the same time. The amount of revenue to record is equal to the value of goods or services transferred to the customer. Relates inputs and outputs of goods and services to one another.
