Define The Accrual Basis Of Accounting And Why It Is General

Define the accrual basis of accounting, and why it is generally preferred over the cash basis

The accrual basis of accounting is a method that records financial transactions when they occur, regardless of when cash is received or paid. Under this system, revenues are recognized when earned, and expenses are recognized when incurred, aligning income and expenses with the actual economic activities of the business. This approach adheres to the revenue recognition and matching principles of accounting, providing a more accurate picture of a company’s financial position and operational performance.

In contrast, the cash basis of accounting records transactions only when cash is exchanged. Revenues are recognized only when cash is received, and expenses are recognized when paid. While the cash basis is simpler and easier to manage, it often fails to reflect the true financial health of a business because it ignores outstanding receivables and payables. For example, a company may perform services in one month but not receive payment until the next, leading to distorted income figures.

The accrual basis is generally preferred over the cash basis because it provides a more comprehensive and precise view of a company's financial status. It allows stakeholders, such as investors and creditors, to assess the company’s profitability and financial stability more accurately and facilitates better decision-making. Moreover, accrual accounting complies with Generally Accepted Accounting Principles (GAAP), which necessitate the recognition of economic events in the period they occur, improving comparability across firms and periods.

Describe the two main types of adjusting entries ( deferrals and accruals ), and give at least 1 example of EACH of THE 2 types

Adjusting entries are journal entries made at the end of an accounting period to update account balances before financial statements are prepared. They ensure that revenues and expenses are recorded in the period they occur, adhering to the accrual accounting principle. The two primary types of adjusting entries are deferrals and accruals.

Deferrals

Deferrals involve postponing the recognition of income or expense to a future period. These entries are needed when cash is received or paid before the related revenue or expense is recognized. An example of a deferral is the receipt of a prepaid expense.

For example, a company pays $6,000 for six months of insurance coverage in advance. Initially, the entire amount is recorded as a prepaid asset. At the end of each month, an adjusting entry is made to move the appropriate portion of the prepaid insurance to insurance expense:

Debit: Insurance Expense $1,000
Credit: Prepaid Insurance $1,000

This entry recognizes the insurance expense incurred during the month.

Accruals

Accruals involve recording revenues earned or expenses incurred that have not yet been documented through cash transactions. They are used to recognize income or expenses in the period they happen, even if cash has not yet been received or paid.

An example of an accrual is accrued wages. Suppose employees have earned $3,000 in wages by the end of the period, but the wages will not be paid until the next period. An adjusting entry is made to recognize wages expense and wages payable:

Debit: Wages Expense $3,000
Credit: Wages Payable $3,000

This ensures wages expense is properly matched to the period in which they were earned.

Explain what an Unadjusted Trial Balance is, and the relationship between the Unadjusted Trial Balance, adjusting journal entries, and the Adjusted Trial Balance

An Unadjusted Trial Balance is a list of all general ledger account balances before any adjusting entries are made, showing the debit and credit totals to verify ledger accuracy. It provides a preliminary snapshot of the company's financial records at the end of an accounting period.

The unadjusted trial balance often contains temporarily unrecorded transactions or estimates that need correction through adjusting journal entries. These entries modify account balances to reflect accrued revenues, expenses, deferrals, and impairments that weren’t initially recorded or fully recognized. After these adjustments are posted, the adjusted trial balance is prepared, which includes the updated account balances.

The adjusted trial balance then serves as the primary source for preparing financial statements such as the income statement, balance sheet, and statement of cash flows. It ensures the accuracy and completeness of reported financial results by incorporating all necessary adjustments.

Finally, what do we do with the Trial Balance, and what statements is it used to produce?

The trial balance, particularly the adjusted trial balance, forms the foundation for preparing the core financial statements. The primary use of the trial balance is to facilitate the creation of the income statement, which reports revenues and expenses to determine net income or loss. It also supports the development of the balance sheet, which presents a snapshot of assets, liabilities, and owner’s equity.

By verifying that total debits equal total credits in the trial balance, accountants can ensure the ledger is balanced before generating these financial reports. Financial statements derived from the trial balance are essential tools for internal management, investors, creditors, and regulatory agencies to evaluate a company’s financial health and operational performance.

References

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• AccountingTools. (2022). Adjusting Entries. https://www.accountingtools.com/articles/adjusting-entries.html
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