Most organizations use accrual basis accounting. With the use of accounting software and computers, many transactions are no longer manually recorded. There are far fewer manual accrual entries for revenues and expenses than there once were. However, learning the related concepts is still important, as it is necessary to understand what expenses and revenues should be recorded and when, what entries a computerized accounting system is recording, and if they are recorded correctly. In addition, real-time entry of transactions is not always possible, making it necessary to know how to record adjusting entries for revenue and expenses. Adjusting entries, completed at the end of the period, ensure that revenues are matched with the appropriate expenses in the correct accounting period.
As illustrated by the following example, even with the use of computers and accounting software, some adjusting entries must be manually entered at the end of the accounting cycle. Global Air is now a small business owned by two pilots. It provides a private flight to a New Year's Eve event for a wealthy customer and charges a fee of $5,000 on December 31. The pilots do not return in time to enter the flight into their billing system, and so they have to manually accrue the revenue. Global Air "earned" $5,000 in flight revenue, as the services were rendered. Global Air should report the $5,000 as revenue on the income statement in December. Thus, even though the invoice was not generated in the accounting system to record the revenues for Global Air in December, the business will record $5,000 in revenue under the revenue recognition principle on the income statement.
Also, at the end of December, the customer owes Global Air for the flight. Accounts receivable for this customer must be adjusted to bring this asset account balance to its proper amount on the balance sheet. The adjusting entry affects both an income statement account and a balance sheet account.
Accrual of Revenue by Global Air
|Situation||Adjusting Entry Required on December 31||Adjusting Entry: Revenue|
|Global Air has "earned" $5,000 in flight revenue, as the services have been rendered.||Global Air has rendered the service but has yet to invoice the customer.||Debit Accounts Receivable $5,000 (increase asset)
Credit Revenue $5,000 (increase revenue)
Adjusting entries may also be needed to properly account for expense recognition in accordance with GAAP in accrual basis accounting. These entries may affect preparation of financial statements.
For example, regarding accrued expense, Global Air hires an outside company to perform maintenance on its aircraft during December totaling $1,000. At the end of December, when it is time to close the period and prepare financial statements, Global Air has not yet received an invoice for the maintenance.
The $1,000 of maintenance service provided by the outside company for Global Air has not been received, but it is an expense incurred for Global Air in December. An adjusting entry is needed to increase expense (debit Maintenance Expense) and increase liability (credit Accounts Payable). The adjusting entry affects both an income statement account and a balance sheet account.
Accrual of Expense by Global Air
|Situation||Adjusting Entry Required on December 31||Adjusting Entry: Expense|
|Global Air owes for maintenance service.||Global Air has received the maintenance service and has incurred an expense but has yet to receive the invoice.||Debit Maintenance Expense $1,000 (increase expense)
Credit Accounts Payable $1,000 (increase liability)