Accountants use journal entries to adjust the books, and a wide variety of reasons justify these adjust- ments. For example, they may be used to fix previ- ous account coding errors; to set up transactions made in this period that do properly apply later;
and to report liabilities that have not yet been paid.
The big problem with the complexity of ac- counting procedures is that it invites abuse. There
are good reasons to make journal entries, as described in the following list; but this also means that the legitimate reasons to make adjustments can easily lead to manipulation and misrepresentation of operating re- sults. Listed here are typical reasons for journal entries followed by exam- ples of how these have been abused in the past and how you can protect yourself by recognizing questionable adjustments. The common types of journal entry adjustments include:
1. Reporting income earned but not yet received. The typical account- ing system depends on the accrual of noncash transactions. An accrual is a journal entry made to book income that has been earned in the current period but not yet received, or costs and ex- penses incurred but not yet paid. When something is placed into
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journal entries
adjustments made to the books and records to correct errors, report transactions that belong in the current period but that have not yet occurred, to move transactions to later periods when they occur too soon, and to record noncash transactions.
Accounting is complex and requires expertise to manage. The problem is not merely in its complexity, but in the degree to which its na- ture invites abuse.
Key Point
the books to report it in the current period, it is called recognition in the accounting business. The transaction is “recognized” and thus reflected so that the current period books are accurate.
A corporation may report a large sale near the end of the year. However, the customer has not yet paid the bill for the goods that were deliv- ered; payment is expected to occur within 30 days, which will place the cash transaction in the follow- ing year. To ignore this earned income would be unrealistic, because it was earned in the current year. So a journal entry is prepared to recognize the income in the current year. Because cash will not be received until later, the offsetting entry is made to accounts receivable, a current asset. Later, when cash is received, the balance of accounts re- ceivable will be reduced. The net effect is that in- come is booked in the proper period; cash is booked when received; and accounts receivable has one entry going in and an offsetting entry coming back out.
2. Reporting expenses not yet paid. Just as income may be earned in advance of cash receipt, costs and expenses can be incurred. For example, a corporation orders supplies this month, but is not in- voiced until later. To accurately recognize the expense in the cur- rent month, it needs to make a journal entry. The appropriate cost or expense category has an entry made, offset by an equal amount to the current liability account, accounts payable. Later,
accrual a system in ac- counting of book- ing revenues, costs, and ex- penses prior to cash exchanging hands; the pur- pose is to book these in the proper accounting period. It often occurs that cash transacts later than the period income is earned or expenses are incurred.
recognition in accounting the process of book- ing revenues and costs and expenses in the proper period, even when cash has not yet traded hands. The pur- pose of recogniz- ing items early is to make the re- ported books accurate in order to include not only cash but earned income and incurred costs and expenses.
It is the timing of recognition—the year in which revenues and costs and expenses are booked—that determines overall profitability.
Because accountants make these decisions, they have the power to manipulate; and that power is sometimes abused.
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when payment is made, an offsetting entry is made to remove the liability and to show a reduction in the cash account. The total of these accrued expenses reflects the cur- rently owed amounts.
The procedure for entering accruals of income, costs, and expenses is done by way of journal entry. A debit and a credit are en- tered for each and every transaction in the double-entry bookkeeping system in every in- stance; the sum of all debits and all credits is always zero, meaning the books are in balance. It is not accurate to think of a debit as a plus and a credit as a minus; the use of “plus” and “minus” values is done as a control feature, and both sides of every entry are equally important.
A summary of accruals and the debit and credit entries involved for income, costs, and expenses is shown in Figure 5.1.
Note in the figure that the entries are designed to show all operating entries (in- come and costs and expenses) in the cur- rent period, while cash is received or paid later. So the accounts receivable and ac- counts payable values are always entered and then reversed. This system enables ac- countants to accurately reflect the earned income and incurred costs and expenses in the proper period, while cash transactions often occur later.
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The purpose of accruals is to ensure that all earned income and incurred costs and ex- penses are reported in the proper period—but this is not always how accruals are used.
Key Point
earned income revenues earned in one period and properly reported in that period even if actual payment will not occur until later; to report income accurately, earned income is entered by way of a journal entry, offset by an addi- tion to the current asset, accounts receivable.
accounts receivable a current asset consisting of balances due from customers, used to report earned income in the proper ac- counting period even when cash will not be re- ceived until later.
accounts payable a current liability reflecting all of the currently owed costs and expenses; the account is used to recognize costs and expenses in a current period even though they will not be paid until later.
3. Adjusting current books for income received in ad- vance. The most common occurrence requiring accruals is when revenues earned this period will not be paid until later. The reverse can oc- cur as well. In some cases a customer may make payment before the period the income is earned. Any revenue received in advance of the period when it is earned is properly classified as deferred income. A corporation, for example, re- ceives an order for goods to be shipped in two months; however, the customer advances a par- tial payment. In this case the payment is a de- posit, perhaps made to secure the order. It should be treated as being earned in a future pe- riod; an entry is made involving a debit to the cash account and a credit in the liability section of the balance sheet. Although the receipt is not technically a liability, it is entered there as a de- ferred credit. Conceivably, if the order were to be cancelled, the deposit may be returned to the customer. It would be inaccurate, however, to book prepaid revenues as being earned in the current period.
Current Period Future Period
Income Earned Debit Accounts Receivable Credit Revenue
Debit Cost or Expense Credit Accounts Payable
Debit Accounts Payable Credit Cash Costs and Expenses
Incurred
Debit Cash Credit Accounts
Receivable
FIGURE 5.1 Accrual Entries
debit a left-sided entry and part of equal debits and credits in all instances as part of a double- entry bookkeeping system; the pur- pose of debits and credits is to ensure that the books are always in balance.
accrued expenses those expenses that are payable but not yet paid, representing currently incurred obligations that will be billed by invoice or state- ment in the fu- ture, usually in the following month.
4. Adjusting current books for expenses paid in advance. The need to make adjustments for expenses paid in advance is quite common.
Remember, the purpose to making journal entries is to reflect current revenues and costs and expenses in the proper period.
When prepaid expenses occur, a portion has to be set up as an asset. Each month, a por- tion is moved from the asset account to the expense account—this is a process called amortization.
It is common practice, for example, to prepay insurance policies. A premium for a full year may be payable in advance two- thirds of the way through a fiscal year of a company. In this case one-third is applica- ble to the current year and two-thirds to the following year. So two-thirds of the payment will be set up as a prepaid expense and reversed in the following year.
5. Adjusting current books to anticipate future losses. Another type of journal entry is one made to set up reserves for future estimated losses. For example, the current asset called
accounts receivable is the total of money due from customers;
some portion of accounts receivable will become bad debts in the future and will not be collectible. Each year the total of accounts receivable is reduced to set up an entry to a reserve for bad debts.
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credit
a right-sided entry and part of equal debits and credits in all instances as part of a double- entry bookkeep- ing system; the purpose of debits and credits is to ensure that the books are always in balance.
double-entry bookkeeping the system of entering transac- tions in the books and records of a company, whether consisting of cash or accruals; all entries consist of a left-sided debit and a right-sided credit. The two sides always con- tain equal value, so that the control feature is
designed to guar- antee mathemati- cal accuracy. The sum of all debits and all credits should always be zero.
Relatively simple concepts like management of prepaid assets often lead to mischief among corporate accounting departments. It is accu- rate to say that problems begin with minor de- cisions, and that the devil is in the details.
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This appears as a reduction of the current asset.
It is appropriate because, even though it is an estimate, the effort has to be made to recognize these bad debts in approximately the same year they are established to make the books as accu- rate as possible. An entry is made to debit the bad debt expense account and to credit the re- serve for bad debts; each year, the estimate is ad- justed based on actual experience.
6. Adjustments for noncash expenses. Most transac- tions of a company eventually end up in cash form. Even a large volume of accruals are made to manage timing differences; those current as- set and liability account entries are normally reversed the following year. However, some journal entries are made for items that will not occur in the form of cash. For example, if an expense is assigned to the wrong account, a journal entry is used to make a correction. Var- ious adjustments may be required from time to time to adjust errors such as these. One major expense occurs without any cash exchanging hands. Capital assets are set up on the balance sheet, and periodic expenses for depreciation are entered. This is a periodic write-off of a portion of the asset. For example, automobiles are depreciated in only a few years, while build- ings take three decades. Land cannot be depre- ciated at all. So various rules govern how depreciation is calculated. An entry is made in each accounting period (month, quarter, or year) to show the expense (a debit) and an off- setting reduction in the long-term asset (a credit called accumulated depreciation). Even- tually, at the end of the depreciable period, the total of accumulated depreciation will equal the original depreciable base of the asset (usu- ally the original cost).
deferred income any income re- ceived in the current period but not earned until a future period; this is properly set up as a deferred credit in the liabil- ity section of the balance sheet, to be reversed later when the revenue becomes earned (for example, when goods are shipped to the customer).
prepaid expenses those expenses paid in advance and set up as prepaid assets to be amortized over a period of months; the result is to reflect the expense in the proper periods.
amortization writing down an account over a period of time—
such as when a prepaid asset is gradually amor- tized so that the expense is re- ported in the applicable month and year.