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4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries

Why Adjusting Entries Are Necessary​

Adjusting entries are journal entries made at the end of an accounting period to update accounts before financial statements are prepared. They ensure that revenues and expenses are recorded in the correct period according to the accrual basis of accounting.

The Need for Adjustments​

Most business transactions are recorded when they occur. However, some events that affect the business are not captured by regular transactions:

Examples:

  • Time passes (depreciation, rent expiration, interest accrual)
  • Services are provided but not yet billed (accrued revenue)
  • Expenses are incurred but not yet paid (accrued expenses)
  • Cash is received before services are provided (unearned revenue)
  • Expenses are paid before they are incurred (prepaid expenses)

These situations require adjusting entries to ensure accurate financial reporting.

Accrual Basis vs. Cash Basis​

Accrual Basis Accounting (Required in Luxembourg):

  • Revenues recorded when earned (not when cash received)
  • Expenses recorded when incurred (not when cash paid)
  • Requires adjusting entries

Cash Basis Accounting (Generally not allowed in Luxembourg):

  • Revenues recorded when cash received
  • Expenses recorded when cash paid
  • No adjusting entries needed (but not compliant with PCN)

Luxembourg Requirement: All businesses subject to PCN must use accrual basis accounting, which requires adjusting entries.

The Time Period Concept​

The time period concept (also called the periodicity assumption) divides business activities into specific time periods for reporting purposes (months, quarters, years).

Implications:

  • Financial statements cover specific periods
  • Revenues and expenses must be matched to the correct period
  • Adjusting entries allocate revenues and expenses to the correct period

Example: Marie's restaurant prepares monthly financial statements. Adjusting entries ensure that November's expenses are recorded in November, even if paid in December.

The Matching Principle​

The matching principle requires that expenses be recorded in the same period as the revenues they helped generate.

Why it matters:

  • Provides accurate measure of profitability
  • Shows true performance for each period
  • Required for accurate financial statements

Example: Marie purchases ingredients in November that are used to prepare meals sold in November. The cost should be recorded as an expense in November, matching the revenue from those meals.

Revenue Recognition Principle​

The revenue recognition principle requires that revenue be recorded when it is earned, not necessarily when cash is received.

Why it matters:

  • Accurately reflects performance
  • Matches revenue with the period it was earned
  • Required for accrual accounting

Example: Marie provides catering services in November but doesn't receive payment until December. Revenue should be recorded in November when the service was provided.

When Adjusting Entries Are Made​

Adjusting entries are made:

  • At the end of each accounting period (monthly, quarterly, or annually)
  • After all regular transactions are recorded
  • Before financial statements are prepared

Timing:

  1. Record all regular transactions for the period
  2. Prepare unadjusted trial balance
  3. Make adjusting entries
  4. Prepare adjusted trial balance
  5. Prepare financial statements

Characteristics of Adjusting Entries​

Key Characteristics:

  1. Always involve at least one income statement account (revenue or expense)
  2. Always involve at least one balance sheet account (asset or liability)
  3. Never involve cash (cash transactions are recorded as regular transactions)
  4. Made at period end (not during the period)

Why no cash? Adjusting entries allocate revenues and expenses to periods. Cash transactions are already recorded. Adjusting entries update accounts to reflect the accrual basis.

Luxembourg Compliance Note​

In Luxembourg, adjusting entries must:

  • Follow accrual basis accounting (required by PCN)
  • Use proper PCN account classifications
  • Be supported by calculations and documentation
  • Be made before filing financial statements with RCS
  • Be retained for 10 years (as part of accounting records)

Think It Through​

Why are adjusting entries necessary even if all cash transactions have been properly recorded? Give an example of a situation that would require an adjusting entry even though no cash changed hands.