Businesses go through a series of financial transactions that occur on a continuous basis within an accounting period. This sequence of transactions is referred to as an operating cycle and it goes like this:
- At the beginning of the period, the entity has a certain amount of cash
- This cash is used to purchase supplies and pay for expenses
- Revenue is earned that either results in a cash transaction or an account receivable
- Finally, cash is collected on accounts receivable
Revenue Recognition and the Matching Principle
Due to the continuous nature of these events, figuring out the exact balance in any account affected by the operating cycle for a specific period is challenging. It would be nice if all the accounts receivable generated in a month were also collected within that month, but that is not realistic. Neither is buying just enough supplies to generate revenue for a specific month. This is the basis of accrual accounting – not every transaction can be completely accounted for within the period the transaction occurs.
There will always be some overlap in the accounts related to the operating cycle. These overlaps occur in two main categories of transactions:
1. Recording revenue: transactions involving revenue generation and identifying at what point the revenue is “earned”
2. Recording expenses: transactions involving payments and expenses incurred to generate those revenues.
The GAAP principles that explain why these types of transactions are not straightforward nor are they easily accounted for include the Revenue Recognition principle and the Matching principle
Revenue recognition establishes the point at which revenue is actually earned – it is not necessarily earned when cash changes hands. GAAP says that revenue is earned when the service is completed or the goods are sold. In practice, this means that revenue is recognized when an invoice has been sent. The accounting issue that arises from this convenience is how to record revenue when an advance payment or deposit is received.
In this situation, the money is received but the revenue has not been “earned.” If the service is expected to be complete by the end of the accounting period then the receipt is recorded as revenue.
On July 1, Paul’s Computing receives a $250 advance payment for a network installation project expected to be complete by the end of the month.
DR Cash $250
CR Revenue $250
In the case where money is received for services that are NOT expected to be complete before the end of the accounting period, the receipt is recorded as a liability. The liability account involved is titled Unearned Revenue.
On July 1, Paul’s Computing enters into a 6-month network service contract totaling $2400 and receives an $800 advance payment.
DR Cash $800
CR Unearned Revenue $800
Recording Cost Outlays and Expenses
When a company purchases something (on account or with cash), that item can be recorded as either an Asset or an Expense. Some of these are obvious: the purchase of a truck is an Asset and the payment of the utility bill is an expense, however, others are a mixture of the two. Consider the purchase of office supplies. They can be considered an asset or an expense. The asset portion is the amount of supplies left after the accounting period and the expense portion is the amount used up during the accounting period. Items like insurance, rent or taxes are considered assets because they are pre-paid and thus their usefulness has not been used up yet. The rule is as follows:
- If the cost is used to purchase something that will help to produce revenue in future accounting periods it is an Asset.
- If the cost is used to purchase something that will be used up in the current accounting period it is an Expense.
On February 1, Phil’s Photography purchases a one-year insurance policy for $1200.
That purchase would be considered an Asset purchase. The insurance policy will be used up over the course of the year but at the time of purchase, that $1200 represents an asset of the company.
DR Prepaid-Insurance $1200
CR Cash $1200
Accrual Accounting and Matching
Accrual accounting matches revenues with expenses for a particular period and this is the basis of the matching principle. Accrual accounting demands that expenses be matched with the revenue that was generated from those expenses. The expenses for a period, therefore, must include the portion of assets that was used up during the period. This matching is done so that the net income reported is as accurate as possible. With accrual accounting there are two different categories of expenses:
1. Cost of goods (services provided or items sold) that are directly aligned to the revenue of the period i.e. the cost of repair supplies for a repair service business.
2. The cost of assets partially consumed during the period i.e. the amount of the supply inventory used in one month.
To make sure that the expenses of an accounting period are matched with the revenues, entries are made at the end of an accounting period to “adjust” the account balances accordingly. There are two types of adjusting entries:
1. The amount of an asset that is used up during the accounting period is transferred to a corresponding expense account.
2. The amount of a liability that has been earned during the accounting period is transferred to the corresponding revenue account.
The accounts that are affected by adjusting entries are called mixed accounts. That means that these accounts have both a balance sheet portion and an income statement portion. To report net income accurately, the income statement portion must be removed by an adjusting entry.
Example: Transfer an Asset to an Expense
Previously we learned that on February 1 Phil’s Photography purchased a one-year insurance policy for $1200. The journal entry on Feb. 1 was:
DR Prepaid-Insurance $1200
CR Cash $1200
At the end of February, one month’s insurance has been used. The monthly portion of insurance is $100, therefore $100 must be removed from the asset account Pre-paid Insurance and transferred to the expense account Insurance Expense. This adjusting entry will match the expenses incurred in February with the revenues received in February.
DR Insurance Expense $100
CR Pre-Paid Insurance $100
To record insurance expense for February.
The balance in the Pre-paid Insurance account is now $1100 and each month another $100 will be removed until it is time to purchase next year’s policy.
Example: Transfer a Liability to a Revenue
When on July 1 Paul’s Computing entered into a 6-month network service contract for $2400 and received an $800 advance payment the following journal entry was made:
DR Cash $800
CR Unearned Revenue $800
At the end of July 1 month of revenue from that contract was earned. Each month Paul’s Computing earns $400 from the contract, therefore $400 must be removed from the liability account of Unearned Revenue and transferred to “earned” Revenue account.
DR Unearned Revenue $400
CR Revenue $400
The balance in the Unearned Revenue account is now $400. At the end of August, the remaining $400 will be transferred and future payments for the contracted service can be recorded directly into the Revenue account.
The adjusting entries require additional steps in the Accounting Process:
- Analyze the account balances and prepare adjusting entries
- Post the Adjusting entries to the Ledger accounts
- Prepare an Adjusted Trial Balance to prove that the Debits and Credits still match
For a teaching lesson plan for this lesson see:
Accrual Accounting And Adjusting Entries Lesson Plan