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Accounting Systems

Introduction

Preparation of financial statements and accounting procedures are ruled by Generally Accepted Accounting Principles (GAAP). According to GAAP, financial statements should be prepared on the accrual basis. Accrual accounting recognizes economic events at the moment when the economic transaction occurs, regardless of associated cash transaction; this approach provides a more accurate overview of the company’s financial position (Needles & Powers, 2010). However, this method of accounting is based on the principles of matching and revenue recognition (matches revenues in the period when they are earned against associated expenses) and thus is more difficult to implement than cash accounting. For the transactions which have not fully transpired during the accounting period adjustment of entries in the end of the period is required. The purpose of this assignment is to discuss the types of adjusting entries, consider issues related to entry adjustment in computerized accounting systems and to discuss possible ethical issues related to the adjustment of entries.

Purpose of adjusting entries

In general, the accounting cycle includes two types of steps. The steps done during the accounting period are: identification of transactions, analysis of transaction, making journal entries and posting to ledger. In the end of the accounting period the following steps of the cycle are done: preparation of trial balance, adjusting entries, preparing the adjusted trial balance, making financial statements, closing entries and trial balance (Needles & Powers, 2010).

Adjusting entries is required to match the revenues and expenses in the period when they are applicable. Common scenarios which require adjustment are the situations when either nothing has been reflected in the accounting records regarding certain transactions, or when the accounting records are present, but the sums in them have to be divided between several accounting periods. Adjustment of entries always affects balance sheet accounts and cash flow statement accounts (Warren & Reeve & Duchac, 2008).

Types of adjusting entries

Scenarios of adjusting entries provide the information about the future or past cash flows and can thus be divided into two classes: accruals – take place for the expenses and revenues matched to dates prior to recording the transaction, and deferrals – which take place for the revenues and expenses matched to dates after the registration of the transaction. Consequently, there are 4 types of adjusting entries (Needles & Powers, 2010):

  • Prepaid expenses
  • Unearned revenues
  • Accrued expenses
  • Accrued revenues

Prepaid expenses

Companies can pay for certain goods and services in advance. By the end of the period, these goods or services will be used, and associated adjustment entry should increase the expense in this period, and reduce the asset for the same amount (the cost of prepaid expenses). For example, a manufacturing company on January 1, 2011 has rented a new assembly shop, and paid in advance the rent for three months equal to $21,000. As a result, the company has received a new asset, holding its right to use the assembly shop. By the end of the month, one third of this asset became an expense. Adjustment entry for this situation should be the following:

Entry (Jan. 31) Dr. Cr.
Prepaid rent $7,000
Rent expense $7,000
The accounts will undergo the following transformations:

Assets

Liabilities and owner’s equity
Prepaid rent Rent expense
Dr. Cr. Dr. Cr.
Jan. 1 $21,000 Jan. 31 $7,000 Jan. 31 $7,000
Bal. $14,000 Bal. $7,000

Unearned revenues

Companies can also receive the revenues in advance, which results in the company’s obligation to provide goods or services. For example, the manufacturing company on April 20, 2011 received the payment ($18,000) for items, some of which were already shipped (worth of $10,000) and some will be assembled and shipped in May (worth of $8,000). These actions will require adjustment of unearned revenue (debit) and revenue (credit) accounts equal to $10,000.

Journal:
Entry (Apr. 30) Dr. Cr.
Unearned revenue $10,000
Revenue $10,000
Accounts:
Assets Liabilities and Owner’s equity
Unearned revenue
Dr. Cr. Dr. Cr.
Apr. 30 $10,000 Apr. 20 $18,000
Bal. $8,000
Revenue
Apr. 30 $10,000
Bal. $10,000

Accrued expenses

At the end of the months additional expenses might emerge, which were not reflected in the accounts. Examples of such expenses are borrowings, interest rate payments and unrecorded wages (Needles & Powers, 2010). For example, let us suggest that at the assembly shop of the manufacturing plant workers get paid on a per day basis, $125 per working day, and are paid twice a month, on the 14th and on the 28th of every month. By the end of March 2011, a group of workers have worked from 29th to 31st of March, and their unrecorded wages should be adjusted. To make the adjustment, it is necessary to increase the accounts “wages expense” (debit) and “wages payable” (credit) to the sum of unrecorded wages (10*$125*3=$3,750).

Journal entry:
Entry (March 31) Dr. Cr.
Wages payable $3,750
Wages expense $3,750
Accounts:
Assets Liabilities and Owner’s equity
Prepaid rent Wages expense
Dr. Cr. Dr. Cr.
March 14 $12,500
March 28 $12,500
March 31 $3,750
Bal. $28,750
Wages payable
$3,750
Bal. $3,750

Accrued revenues

Revenues which were earned but not recorded in the accounts, are called accrued revenues, and in the end of the period adjustment for these revenues should be done, through debiting assets and crediting revenue (Needles & Powers, 2010). For example, a manufacturing company has received an order for 10,000 items worth $15 each, and has managed to assemble and ship 500 of these items until the end of April 2011. The whole transaction will be recorded in May when the total order is fulfilled, and the bill to the customer is sent. However, the recent “sale” worth of $7,500 should be recorded as accrued revenue. The transaction will affect accounts receivable (debit) and revenue (credit).
Journal:
Entry (April 30) Dr. Cr.
Accounts receivable $7,500
Revenue $7,500
Accounts:
Assets Liabilities and owner’s equity
Accounts receivable Revenue
Dr. Cr. Dr. Cr.
April 30 $7,500 April 30 $7,500
Bal. $7,500 Bal. $7,500

Recording of entries in a computerized accounting system

In case of using a computerized accounting system, manual adjustment of entries is generally not required. Such systems allow to avoid mathematical errors, and allow to make timely and easy changes in the accounts. Trial balance is often not necessary for the computerized accounting procedure, since accounting software can do the balancing automatically.

In addition to this, quality accounting software can do certain adjustments (e.g. rent payments or interest payments) automatically in the end of the period, and can be programmed to do the other adjustments required for a given company (Warren & Reeve & Duchac, 2008). Analysis and consideration of financial results is still required, and certain adjustments (e.g. unexpected or unrecorded revenues or expenses) can produce adjustments, but everything can be done on the spot, with transaction log showing the changes and the date of the changes.

Ethical issues

There are certain ethical issues related to the adjustment of entries. Since the accountant makes the decisions on the adjustments, there is plenty of space for manipulating the figures in order to achieve a certain financial result which does not correspond to the real situation. For example, in the case with unrecorded revenues, if the company needed to reach a positive dynamics in its financial statements during the current period compared to the previous period, the accountant might be tempted to wait a little with closing the statements (e.g. if the next 5,000 items will be shipped on May 2, 2011) and include this transaction as part of April adjustment. However, this approach is unethical since the accounting figures not only show the current financial position of the company, but also provide information for managerial decision, and have to be absolutely accurate (Warren & Reeve & Duchac, 2008). The accountant should adhere to the code of honesty and reliability, and should not manipulate financial data in the process of adjusting entries.

 

References

Needles, B.E. & Powers, M. (2010). Principles of Financial Accounting. Cengage Learning.
Warren, C.S. & Reeve, J.M. & Duchac, J. (2008). Financial and Managerial Accounting. Cengage Learning.