Nature of Adjusting Process

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Learn all about the nature of the adjusting process in just a few minutes! Fabio Ambrosio, CPA, instructor of accounting at the Central Washington University, introduces accrual basis accounting and how it utilizes revenue recognition, the matching principle, and the time period concept, which, in turn, contextualizes how and why the adjusting process is utilized.

Overview of Accrual Basis and Cash Basis Accounting

Accrual basis accounting is required by GAAP and uses the matching principle in the adjusting process. Cash basis accounting is a simpler method, as it recognizes revenue or expenses when cash is received or paid, and is not subject to GAAP.

Generally accepted accounting principles, or GAAP, require the use of accrual basis accounting, which draws on the principles of revenue recognition, matching, and time period. Accrual basis accounting recognizes revenue when earned and recording expenses when incurred regardless of the cash received or paid. At the end of each accounting period, which is the time period covered by financial statements—monthly, quarterly, semiannually, or annually—certain accounts will need to be brought to the proper amounts for reporting purposes by means of the adjusting process. The adjusting process is the process of recording adjusting entries at period end where required. Adjusting entries are entries made at the end of the accounting period to adjust and bring the asset, liability, revenue, and expense accounts to their proper balances using accrual basis accounting.

The Accounting Period

The reporting of a business's activity is divided into specific time periods, such as by months, known as accounting periods. A business may prepare statements each month-end for an accounting period. In this case, the accounting periods are July 1-31 and August 1-31.

Cash basis accounting recognizes revenues or expenses when cash is received or paid and is not consistent with GAAP. For example, a customer books a flight from Toronto, Canada, to Reykjavík, Iceland, in January and pays $2,000 to Global Air. The departure date is in May, four months away. If Global Air were to use cash basis accounting, it would recognize the $2,000 revenue in January when the cash is received or paid. Smaller businesses and sole proprietors may use cash basis accounting. It is a simpler method and reflects the amount of cash on hand. There may be a tax advantage to using this method, if allowed by the tax authority, in that the business does not have to claim that income during a year when the revenue is not actually received.

If a business such as Global Air were to use accrual basis accounting, it would recognize the revenue in May, when the flight actually takes place and the services are rendered to the customer. By recognizing the flight revenue in May, Global Air follows the revenue recognition principle under GAAP, which is the principle on which the adjusting process is based. It recognizes or records revenue in the time period when earned, regardless of when cash is received.

Global Air receives $2,000 in January for a flight to take place in May.

Matching Expense with Revenue

	January	May	Timing Difference
Cash basis	Revenue recognized = cash received $2,000	$0 revenue recognized	Does not follow GAAP, as revenue is recognized in the incorrect accounting period (January, instead of May)
Accrual basis	Cash received $2,000; $0 revenue, carried as unearned revenue (liability)	Revenue recognized when earned; $2,000	Under the revenue recognition principle, revenue is recognized in the correct accounting period to follow GAAP rules (May).
Result if cash basis is used	Revenue overstated for the month, not necessarily for the period	Revenue understated

To apply accrual basis accounting further, Global Air purchases and uses $500 in fuel to fly the aircraft from Toronto to Reykjavík in May and pays the invoice in June. Global Air will use the matching principle, which is applied in the adjusting process to report or match expenses in the same accounting period as the revenue earned. Global Air reports or matches expenses, such as fuel expense, in the same accounting period as the flight revenue they helped to generate, namely, in the month of May, even though the payment does not occur until June. The business income for Global Air reported for the month of May would then be correct by matching the expense with the revenue that the expense helped to generate, again using the accrual basis accounting.

Global Air orders and uses $500 in fuel for the May flight but pays for the fuel in June.

Matching Expense with Revenue Generated by Expense

	May	June	Timing Difference
Cash basis	$0 fuel expense	Fuel expense = cash payment $500	Does not follow GAAP, as the expense is recognized in the incorrect accounting period (June, instead of May)
Accrual basis	Fuel expense recognized to match the revenue earned; $500	$0 fuel expense; cash payment $500	Under the matching principle, the expense is recognized in the correct accounting period (May).
Result if cash basis is used	Expense understated	Expense overstated

There is a financial impact for the month of May using accrual basis accounting and cash basis accounting.

Accrual Basis versus Cash Basis

Global Air: Transaction Impact	Accrual Basis Accounting			Cash Basis Accounting
	January	May	June	January	May	June
Revenue	--	$2,000	--	$2,000	--	--
Expense	--	($500)	--	--	--	($500)
Business income	--	$1,500	--	$2,000	$0	($500)

The Adjusting Process

Adjusting entries are important for accurately reporting the transactions and results of a business for a certain time period.

Using accrual basis accounting, adjusting entries are required to properly account for revenue and expense recognition in accordance with GAAP. Accrual basis accounting is based on the principles of revenue recognition, the matching principle, and the time period concept, which is the division of a business's activities into specific time periods, such as a month, quarter, or year. The matching principle requires reporting or matching expenses in the same accounting period as when the revenue was earned. Adjusting entries are made for unearned revenue, which is a liability, a payment (cash) received before the goods or services are provided. Adjusting entries are also made for a prepaid expense, which is an expense that has been paid for in advance of receiving goods or services purchased.

At the end of each accounting period, or specific time period, certain accounts will need to be adjusted to bring an asset or liability account balance to an accurate amount. In doing so, revenues or expenses will also be impacted. Therefore, every adjusting entry affects both an income statement account (revenue or expense) and a balance sheet account (asset or liability). Adjusting entries are recorded at the period end, typically, at month-end or at year-end. This is the adjusting process.

For example, the adjusting process plays a part in the proper reporting of financial results for an airline company, Global Air. Using the accrual basis accounting method, adjusting entries are recorded at the company's period end, which is month-end July 31. Global Air receives $5,000 cash in ticket sales on July 1 as unearned or deferred revenue. Half of the company's flights then occur in July, and the other half occur in August. Thus, the required adjusting entry on July 31 (month-end) is half of the cash, $2,500. Also, Global Air pays $6,000 as a prepaid expense for insurance coverage for 6 months (July through December) on July 1. At the end of the month, July 31, the adjusting entry for the prepaid expense will be for one month's insurance.

Using the accrual basis accounting method, adjusting entries are recorded at the end of a period, which can be month-end or at the end of another period, such as a year.

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