Accounting for business can be done on either an accrual or cash basis. The latter indicates that economic events are recorded when cash is received or paid-out. Under accrual basis accounting, economic events are recorded in the accounting time period in which the economic event happens. Most accrual method tips involve adjustments, which are amendments to records used to ensure that economic events are placed in the proper time period.
The revenue recognition principle is an element of accrual basis accounting that helps accountants record revenue in the correct time period. This principle dictates that revenue must be recorded when it is earned. For example, a customer may purchase a product in one accounting time period, but pay for it in another. Using the revenue recognition principle, the profit from the product should be recorded when the customer buys the product instead of when the payment is received.
Adjustments to records help keep accrual basis accounting accurate. Accountants usually adjust records at the end of accounting time periods, which may be a week, a month, a quarter, or a year. Some economic events, such as the use of office supplies, are not recorded on a daily basis because it would be inefficient to constantly note these dates. Instead, these events are added up and recorded as an adjustment at the end of the accounting time period.
Other types of adjustments are not initially recorded because the economic event happens with the passage of time. These may include rent, equipment charges, and insurance. Some adjustments are simply oversights of economic events that should have been recorded previously.
Accountants usually keep ledgers of daily economic events and transactions. When it is time to make adjustments for accrual basis accounting, accountants make trial closing balances that report the temporary amount in each account. Then the accountant may begin to adjust for accruals by adding accumulated and unrecorded economic events.
Deferrals and accruals are two types of adjustments used in accrual basis accounting. Accruals include accrued revenues, which are those that have been earned, but not received. Accrued expenses are another kind of accrual adjustment. These expenses are incurred, but not yet paid.
Prepaid expenses are a type of deferral. Adjustments for prepaid expenses involve payments for assets that haven’t been consumed during the accounting time period. Another type of deferral, called unearned revenue, involves adjusting for cash payments received before the company has earned the money.