Accrual Basis and Inventory Adjustments (The Heart of Financial Accounting)
Accrual Basis and Adjusting Entries: The Heart of Financial Accounting
Imagine it’s the end of December. You paid the rent for the next six months in advance, and you also finished a large project for a customer who will pay you in February. If you record only what you “touched” in cash, your profits for this year will be completely wrong! This is why the Accrual Basis and Adjusting Entries exist. In this guide, we provide a comprehensive explanation of how to adjust your records before period closing to ensure your financial statements reflect the real economic truth of your business.
- A clear definition of the Accrual Basis and how it differs from the Cash Basis.
- What are Adjusting Entries and why are they recorded at year-end?
- Detailed classification of adjustments: Prepayments, Accruals, and Estimates.
- Visual model (SVG) of the data flow during period closing.
- Practical journal entries for common cases (Rent, Salaries, Unearned Revenue).
- A downloadable “Closing Roadmap” to ensure no entry is forgotten.
1) What is the Accrual Basis?
The Accrual Basis is the standard for professional accounting. It states that:
- Revenues are recorded when earned (service provided), regardless of when cash is received.
- Expenses are recorded when incurred (service used), regardless of when cash is paid.
2) Accrual vs. Cash Basis Comparison
| Feature | Accrual Basis | Cash Basis |
|---|---|---|
| Trigger | Economic Event (Service/Goods) | Cash Movement (Safe/Bank) |
| Goal | Measuring Profit & Performance | Measuring Liquidity |
| Report Utility | Required for IFRS/GAAP | Mainly for taxes or micro-businesses |
| Complexity | Higher (requires Adjusting Entries) | Simpler |
3) Why do we need Adjusting Entries?
At the end of any period, some ledger accounts are not up to date. Adjusting Entries bridge the gap between daily recording and final reporting. Without them:
- Asset value would be overstated (e.g., used supplies still listed as full inventory).
- Liabilities would be understated (e.g., unpaid utilities not recorded).
- Profit would be misleading and wouldn’t match the period effort.
5) Visual Logic: The Closing Flow
6) Prepaid Expenses: “Cash first, Use later”
You pay $12,000 for a one-year insurance policy in July. At year-end (December), only 6 months have been used.
Stock Movement Register - Excel Template
7) Accrued Expenses: “Use first, Cash later”
Employees worked in the last week of December, earning $5,000, but salaries will be paid in January.
11) Closing Roadmap & Checklist
Use this table to manage your month-end/year-end adjustment process:
| Step | Description | Evidence/Output | Status |
|---|---|---|---|
| 1 | Confirm Cut-off date & period lock | Closing Policy + Approvals | |
| 2 | Review Accruals (Exp/Rev) | Accrual List + Documents | |
| 3 | Review Deferrals (Prepayments) | Amortization Schedules | |
| 4 | Post Depreciation & Provisions | Fixed Asset Register | |
| 5 | Re-evaluate FX for foreign balances | FX Rate Table |
12) Frequently Asked Questions
Does every company have to use the accrual basis?
Almost all commercial companies aiming for international standards (IFRS) must use it. It is the only way to accurately show profits.
Do I need adjusting entries every month?
Ideally, yes. Monthly adjustments provide management with accurate reports for decision-making rather than waiting until the end of the year.
13) Conclusion
The summary is simple: Adjusting Entries turn your accounting from a simple “Cash Tracker” into a powerful “Profit Engine.” By mastering accruals, prepayments, and non-cash adjustments, you ensure that your Financial Statements tell the true story of your company’s success and health.