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Year end accounting.

Revenue and expenses may be accounted for on a cash basis or on an accrual basis of accounting. When the cash basis is used, revenues are earned when cash is received and expenses are recorded when cash is paid. This basis works well for some small businesses and individuals, but it is not adequate for most businesses. Revenue is frequently earned in a period other than when cash is received and expenses are incurred in a period other than when cash is paid. The accrual basis of accounting provides a more accurate and comparable measure of net income. Revenues are then recorded in the period earned and expenses are matched to the cost of earning that revenue.

In order to accomplish this matching of revenue and expense, some year end adjustments are necessary. In many cases, transactions span the year end cut-off date and only that portion related to the current year can be considered in income or expense. One type of adjusting entry is a deferral. A deferral is the postponement of expense already paid or of revenue already received. Expenditures that benefit more than one accounting period are debited to an asset account, usually as a current asset called prepaid expense, and at the end of the period, the appropriate amount is transferred to the expense account. Long-term prepayments that are chargeable to several years are presented on the balance sheet as deferred charges. Typical examples are prepaid rent, prepaid insurance, and supplies. Prepaid rent and insurance are prorated based on the term of the lease or of the insurance policy and the amount of time expired during the year. The adjustment for supplies is generally determined by taking a physical inventory of supplies on hand at year end and adjusting the asset account to match that amount.

Another, although somewhat different type of a deferral is depreciation expense. When a company purchases a fixed asset such as a building, equipment or furniture, it is really prepaying for the use of that asset over a period of years. Correct accounting would therefore require the allocation of the cost of the asset over its useful life. The entry made to record depreciation is similar to recording other adjustments for prepaid expense. The only difference is that the balance sheet adjustment is made to a "contra" account rather than the original asset account. It is common practice to report both the original cost of the fixed asset and the amount of accumulated depreciation on the balance sheet. This procedure preserves the amount of original cost and still shows how much of the asset is left to be depreciated. It also recognizes that the depreciation is really only an estimate of the actual decline in value.

An additional deferral is the postponement of revenues for which cash has been received, but which have not been earned as yet. Typical examples of unearned revenue are magazine subscriptions, insurance premiums, school tuition, or a retainer fee received by an architect or other service professional. Generally when the payment is received in advance, it is credited to a liability account. At the end of the accounting period, the income account will be credited for any portion of the goods or services which has been delivered.

A second type of year end adjustment is an accrual. This is the recognition of an expense or revenue that has occurred but has not been recorded. Amounts for accrued expenses are generally payable within one year and are shown on the balance sheet as current liabilities. The most common of the unrecorded expenses is employee wages. When the year end falls in the middle of a pay period, the amount of wages earned but not paid at that time must be accrued. Accounts payable is always adjusted at year end to include any amounts for goods or services acquired during the year but not paid.

Deferred revenues are shown on the balance sheet as a current liability. If a period of time longer than the annual accounting cycle is involved, they are listed separately on the balance sheet as deferred credits. An excellent example of an unearned revenue is interest payable on a note receivable. Let's assume you had a customer note on which the principal and interest is payable quarterly. The note was signed on November 1, 1990, and the first payment is due on February 1, 1991. The amount of interest accrued for the months of November and December should be recorded as a current asset, Interest Receivable, on the balance sheet and as interest income for the fiscal year. Table I summarizes these year end adjusting entries.

Sometimes total revenue receipts or total expenditures will be posted to the applicable income or expense accounts during the year. In this case, at year end the adjustments would be a reverse of those shown on Table 1 [omitted]. The amount of deferred or accrued revenue or expense would be carried to the balance sheet and the income statement accounts would be reduced accordingly.

Two additional year end adjustments, are inventory and bad debts. Each of these will be discussed separately in later columns.

Adjusting entries are the final step in accrual accounting. They complete the preparation of a financial statement and enable the user to see the whole picture. Revenues and expenses have been matched, allowing management to determine just how much the company has earned in a given period and what the assets and liabilities are on a specified date. Adjusting entries provide for the comparability of financial statements from one period to the next. If year end adjustments were not made, income could be overstated in one period and understated in the following period such that nothing would be learned from comparing the two statements. The final important point to remember is that adjusting entries, as with all transactions, must be verifiable. Estimates are used, but they can be supported by objective evidence such as pas experience or by reference to other similar businesses.
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Title Annotation:business accounting procedures
Author:Schwartz, Marlyn A.
Publication:The National Public Accountant
Date:Jan 1, 1991
Previous Article:Answers!
Next Article:Franchising -- the future of small business.

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