Understanding accrual accounting requires understanding adjusting entries. The purpose of these entries is to properly adjust the accounting statements for accrual-basis accounting. Adjusting entries typically have an impact on the income statement and balance sheet. The cash flow statement is typically not affected.
The American accounting system is based on the generally accepted accounting principles (GAAP). The GAAP system is an accrual-based system, which means that revenues are recognized when they are earned and expenses are recognized when they are incurred. This creates a gap between cash and accrual accounting. Because a cash transaction does not have to occur for revenue or expenses to be recognized, this creates the need for adjusting entries.
Adjusting entries are made at the end of the accounting period to allocate revenues and expenditures to the right time periods. They are used very often, as companies often have expenses and revenues that do not match up with the cash inflows and outlays. Examples of accounts that often need adjusting entries are prepaid assets and unearned revenue. However, other accounts also need to be adjusted on a regular basis. Fixed assets that are subject to depreciation are subject to adjusting entries even though no cash transactions occur.
Prepaid Asset Example
On Jan. 1, a company pays rent for the whole year of $12,000, or $1,000 a month. The only transaction on the books at the point is the cash outflow of $12,000 and the prepaid rent asset of $12,000, but there is nothing on the income statement. At the end of January, the company has to recognize $1,000 of rent expense on its income statement and lower prepaid rent asset by $1,000. No cash expense or transaction occurs.
Unearned Revenue Example
On Jan. 1, a company receives $1 million in cash for products and services to be delivered in February. On Jan. 1, that is booked as $1 million in unearned revenue and no revenue is recognized on the income statement. A cash flow of $1 million occurs also. At the end of February, after the obligation is satisfied, the company has to recognize $1 million to revenue on its income statement and decrease $1 million of unearned revenue. Revenue is recognized without there being a cash outflow.