2) What is the purpose of adjusting entries? Discuss the effect of not preparing adjusting entries on various accounts.
In views of the financial results of the organization during the reporting period the separation of revenues and expenses between reporting periods is conducted. Revenues and expenses related to given reporting period are reflected in the accounts of current accounting of revenues and expenses and are involved in determining the financial result for the reporting period. Directly in the international standards, the accrual accounting and business continuity are considered as underlying assumptions of financial accounting (International Financial Reporting Standards). According to the correspondence principle, revenues should be reported only in those periods when they are earned, and expenses should be recorded in those periods when they happened for getting those revenues.
In order to reflect the time difference between the moments of recognition of income and expenditure and cash flows, adjusting entries are performed at the end of the reporting period (Slater, 2006). Adjusting entries are made in order to provide:
– The reflection of incomes in the period in which they are earned and the recognition of expenses in the period in which they were incurred;
– The principle of revenue recognition and the principle of correspondence.
Adjusting entries can be categorized either as (Slater, 2006): advance payment (prepaid expenses or income received in future periods), or as accruals (accrued revenues or accrued expenses). There are the following types of adjusting entries: accrued expenses; accrued revenues; deferred expenses; deferred revenues (Albrecht, 2007). While carrying out the adjusting entries incomes and expenses that have occurred in this time period should be attributed to this period and the balance is deferred to the future period.
Adjusting entries are made at the end of the accounting period in order to see the changes of the status of the accounts for the intervening period or at the end of the period. It must be remembered that the duty of an accountant is to identify time periods between making adjusting entries. Unlike all the other entries on the log, there are no documents being left confirming that the adjusting entries were made (Weygandt, 2009).
Thus, adjusting entries are needed when (Slater, 2006; Albrecht, 2007): the costs incurred are divided between 2 or more reporting periods; earned revenues are divided among 2 or more reporting periods; there are unaccrued costs; there are unaccrued incomes. It should be noted that transformation helps accountants provide accounting information necessary for making management decisions; helps measure financial results and determine the financial position of a firm; ensures comparability of financial statements for various periods.
All the adjusting entries have their own operation code and concrete balance accounts. Due to the peculiarities of their origin, some of expenses and revenues cannot be assessed in advance, and their account is implemented on a cash basis, i.e. the amount of such income or expense becomes known only at the real receipt or writing off of funds (Weygandt, 2009). If the entry/withdrawal is made after the end of the reporting period to which they belong, the adjusting entries on the accounts of expenditure/income are made in correspondence with the assessed income/expenses. Closing of occurred account balances should be implemented through an ordinary, not an adjusting entry in correspondence with correspondent accounts, cash accounts, current accounts of counterparties of the bank, etc. (Albrecht, 2007).
Enormous uncertainty in the attribution of incomes and expenditures to the future periods, as well as providing organizations the opportunity to determine the order of allocation and write-off of future period incomes/expenses leads to disruption of uniformity in accounting. It requires the development of guidelines or recommendations for accounting, classification and order of cancellation of revenues and expenses in future periods, as well as the development of the methods of transition of this type of articles to international standards of accounting and financial reporting (IFRS).
Albrecht, W. S., Stice, J.D., & Stice, E. K. (2007). Accounting: Concepts and Applications. Cengage Learning.
International Financial Reporting Standards Website. http://www.ifrs.org/
Slater, J. (2006). College Accounting: A Practical Approach (10th edn.). Prentice Hall.
Weygandt, J. J. (2009). Financial Accounting. John Wiley and Sons.