Cash basis, accrual basis and modifications of those bases are the most common accounting bases used in the present. Cash basis accounting records transactions when cash and cash equivalents either are received or paid out. In contrast, accrual basis accounting records most transactions at the times of their occurrence. Adjusting entries are entries made prior to the end of the period to update the organization's financial circumstances in accordance with accrual basis accounting. Although multiple generally accepted accounting principles contribute to the existence of such entries in accrual basis accounting, the matching principle and the time period assumption are the most relevant.
Recognition Under Accrual Basis Accounting
Recognition refers to the set of rules used to determine when to record transactions. In general under accrual basis accounting, transactions are recorded at the times of their occurrence so long as the transactions are complete and the values exchanged determinable. For example, a business can record its utilities expense at the end of the month even if the bill has yet to arrive because it can reasonably estimate the sum in question.
Adjusting entries are made at the end of each period to update the organization's financial circumstances in accordance with the rules of accrual basis accounting. Such adjustments can include accrued revenues, accrued expenses and adjustments to assets and liabilities. One example of an adjusting entry is recording interest revenue accruing on a bond that the organization is holding onto.
The matching principle is the main GAAP behind adjusting entries. Said principle states that costs should be recorded in the same periods as the revenues that their occurrence helped to produce and vice versa. As such, one of the reasons that adjusting entries are made is to place revenues and expenses in the appropriate periods. For example, a business can record its utilities expense before the bill arrives because the expense was incurred for the period of its operation rather than the period during which the bill arrived.
Time Period Assumption
The time period assumption is one of the core rules behind accounting and even more important in regard to adjusting entries than it is to most other accounting procedures. Time period assumption is the rule that divides the activities of the organization into distinct and measurable periods so that those activities can be better reported in financial statements. Most organizations use both months and years. Time period assumption is important to adjusting entries because said entries are reliant on the concept of accounting time periods.
Alan Li started writing in 2008 and has seen his work published in newsletters written for the Cecil Street Community Centre in Toronto. He is a graduate of the finance program at the University of Toronto with a Bachelor of Commerce and has additional accreditation from the Canadian Securities Institute.