When preparing its complete financial statements, a company will review its operations in order to determine whether any accruals or adjustments are needed. This allows for allocation of revenue and expense items into the proper accounting period.
The Need for Accruals and Valuation Adjustments
The process of translating business transactions into the accounting system is relatively straightforward. Challenges are, however, presented whenever cash receipts or disbursements occur in periods which differ from the related revenue or expense, or when the reportable values of assets vary. This necessitates accruals or valuation adjustments.
Based on accrual accounting, revenue must be recorded when earned and expenses recorded when incurred, irrespective of whenever the cash movement takes place. This allows for revenue and expenses to be reported in their proper accounting periods.
There are four types of accrual entries that may be required, each of which requires an originating entry and at least one adjusting entry at a later date:
- Unearned revenue (or deferred revenue): This arises whenever a company receives cash prior to earning the related revenue. The originating entry will be the recording of cash received and a corresponding liability, while subsequent adjusting entries will reduce the liability and record revenue.
- Accrued revenue (or unbilled revenue): This arises whenever a company earns revenue prior to receiving cash but has not yet recognized the revenue at the end of an accounting period. The accounting treatment will involve an originating entry to record the revenue earned and a related receivable. When payment is received, an adjusting entry will eliminate the receivable.
- Prepaid expense: This arises whenever a company makes cash payments prior to recognizing the expenses. An originating entry records the payment of cash and a prepaid asset which reflects future benefits. Subsequent adjusting entries record the expense and eliminate the prepaid asset.
- Accrued expense: This arises whenever a company incurs expenses that are unpaid as at the end of the accounting period. An originating entry records the expense and corresponding liability, while future adjusting entries eliminate the liability when cash is paid.
Valuation adjustments are made to a company’s assets or liabilities in order for the accounting records to reflect the current market value of the asset or liability rather than the historical cost.
An increase in assets will be accompanied by a gain on the income statement or an increase in other comprehensive income. Conversely, a decrease in assets will be accompanied by a loss on the income statement or a decrease in other comprehensive income.
If at the end of an accounting period, cash was received, but no revenue was earned, the accounting treatment will affect:
A. Accrued revenue and an asset
B. Prepaid expense and an asset
C. Accrued revenue and a liability
The correct answer is C.
The originating entry will be the recording of cash received and a corresponding liability which is reduced while revenue is earned.
Reading 22 LOS22e:
Describe the need for accruals and valuation adjustments in preparing financial statements