Financial Accounting Basics: Part 1 – Getting Started
Financial Accounting Basics: Part 2 – Double Entry Accounting
Financial Accounting Basics: Part 3 – Post to the General Ledger
Financial Accounting Basics: Part 4 – Unadjusted Trial Balance
Financial Accounting Basics: Part 5 – Posting Adjusting Entries
Financial Accounting Basics: Part 6 – Adjusted Trial Balance
Financial Accounting Basics: Part 7 – Creating Financial Statements
Financial Accounting Basics: Part 8 – Post Closing Entries
This article is an introduction to the Posting of Adjusting Entries and The Accrual Method of Accounting.
In Part 4 we created an unadjusted trial balance as a test to check that your debits and credits are in balance, but we will now have to make some adjustments by posting some adjusting entries because you have ended a financial year.
“Adjusting Entries,” are journal entries posted at the end of an accounting period that bring your books in line with something called “The Accrual Method of Accounting.”
To understand you really need to know about the accounting rule books. Yes, there are rule books, and all accountants must follow them. But the rules change depending on where you are based. International Financial Reporting Standards (IFRS) or a variation of Generally Accepted Accounting Principles (GAAP) make sure that your financial statements reflect a true and fair view of your business which is important because a lot of people rely on financial statements, particularly those who have lent you money or invested in your business. There is one thing in common with the IFRS and GAAP, they both want you to follow the “Accrual Method of Accounting,” revenue is recognized as it is earned, expenses are recorded as they are incurred. This is the most accurate way to calculate your profit.
So here is the thing, BIG News hasn’t been playing by the rules. In February we ran a promotion on annual subscriptions starting on March 1st. We collected $30,000 in cash and posted a journal to recognize that whole amount as revenue on February 28th.
This is called cash accounting and it is not the same as accrual accounting. In “Cash Accounting,” you recognize your revenue as you receive cash and record your expenses as you pay it out. But receiving cash is not the same as earning revenue.
You received the cash amount of $30,000 during February but you actually earn that revenue over the next twelve months, because of the subscription payments. This is when you do the work and release each issue of BIG News. So today as things stand on December 31st you have recognized twelve months of income this financial year but you haven’t earned two months of it yet, and you won’t until the end of February of next year. This is what adjusting entries are for. They also can be used to account for depreciation of assets which is a decrease in value. These are the journal entries that you post to bring your books in line.
With the accrual method we can fix this situation by reversing two out of the twelve months of your subscription revenue which is $5,000, and temporarily holding it as a liability in an account called deferred revenue or unearned revenue. This is a liability account because you still have an obligation at the end of the year to provide your customers with BIG News from January to February. Let’s post this one to your general ledger and then we can run a new adjusted trial balance.
For the next step in the process, join us for Part 6 as we create the adjusted trial balance so we can begin making our financial statements.