In this lecture, we’re going to dive into the process of recording and adjusting transactions related to accounts receivable. Our focus will be on understanding the journal entry on the left-hand side and how it’s reflected in the trial balance on the right-hand side. The trial balance format highlights assets in green, liabilities in orange, equity in light blue, and the income statement in a deeper shade of blue, encompassing both revenue and expenses.
Adjusting entries carry a unique characteristic that sets them apart from regular journal entries. While they involve two accounts just like standard entries, they also encompass one income statement account below the blue line and one balance sheet account above the blue line – the light blue line that separates owner’s equity. This means that one account is situated above owner’s equity and another below it.
Considering this concept and the trial balance, we can swiftly identify the accounts associated with accounts receivable. For instance, “Accounts Receivable” itself is an obvious candidate for the balance sheet account. On the income statement, the account correlated with accounts receivable is typically “Revenue.” By recognizing it as an adjusting entry and linking it to accounts receivable, we deduce the accounts involved and the direction of their changes.
Given that revenue is an income statement account, its balance only ascends – it increases with credits. Since revenue has a credit balance (indicated by the right side of the T-account), to elevate it further, we perform a credit entry. Consequently, we credit “Revenue.” The counterpart is “Accounts Receivable,” the account above owner’s equity. Since accounts receivable is a balance sheet account, its increase involves a debit entry. Thus, we debit “Accounts Receivable.”
This deduction stems from the understanding that the adjusting entry pertains to accounts receivable. However, let’s delve deeper into the rationale behind this entry.
What might seem puzzling about this adjusting entry is its apparent similarity to a typical transaction – specifically, when we make a sale on account. Ordinarily, we record a journal entry upon invoicing the client: debiting accounts receivable and crediting sales. Then, why hasn’t the accounting department executed this entry? Shouldn’t this be part of their responsibilities?
The discrepancy arises from timing differences, a common feature of adjusting entries. Analogously, consider a legal or CPA office where billable hours of various professionals are consolidated to generate an invoice. This process takes time before issuing the invoice, which could occur in January of the following year despite the work being performed in December. Consequently, even though the work transpired in December, the invoicing took place in January. Cash collection typically occurs sometime thereafter.
Here, the accounting department’s actions are justified; they’ve adhered to the workflow. The delay between performing the work and billing necessitates an adjusting entry to recognize revenue in compliance with the revenue recognition principle. This principle mandates acknowledging revenue once it’s earned, regardless of the billing date.
Now, let’s consider a numerical example – let’s assume the amount is $4,900. In this scenario, the invoice for this sum was dispatched the following month, not within the current accounting period. To prevent double-counting, we must reverse this entry in the subsequent month.
Therefore, to accurately reflect the financial statements for the current cutoff date, we debit “Accounts Receivable” by $4,900 and simultaneously credit “Revenue” by the same amount. This operation increases the balance of “Accounts Receivable” from $32,000 to $36,900 and escalates “Revenue” from $327,350 to $332,250.
As we consider the accounting equation, assets climb due to the increase in “Accounts Receivable,” an asset account. Orange liability accounts remain unchanged. Consequently, equity sees an elevation – an outcome of the surge in income. Isolating net income reveals that it climbed from $86,180 (net of credits minus debits) to $91,080, attributable to the $4,900 entry.
In summary, the process of recording and adjusting transactions involving accounts receivable brings to light the nuances of timing differences and the significance of adhering to the revenue recognition principle. While the entry might mirror regular transactions, the temporal aspect necessitates adjustments. Understanding the intricacies of these adjustments ensures accurate financial reporting and compliance with accounting principles.