Problem 19 - Accounting

Question

At the end of the current year, \(\$ 11,500\) of fees have been earned but have not been billed to clients. a. Journalize the adjusting entry to record the accrued fees. b. If the cash basis rather than the accrual basis had been used, would an adjusting entry have been necessary? Explain.

Step-by-Step Solution

Answer

Accrual entry: Debit Accounts Receivable $11,500; Credit Service Revenue $11,500. No entry needed under cash basis.

Step 1: Identify the Need for Adjusting Entry

Determine that the company has earned fees of $11,500 that have not yet been billed, which indicates revenue has been earned but not recorded in the books. This requires an adjusting journal entry to recognize this revenue in the current period as per accrual accounting principles.

Step 2: Prepare the Journal Entry

Revenue needs to be recorded in the accounting period it is earned, following the accrual basis of accounting. The entry is made by debiting 'Accounts Receivable' and crediting 'Service Revenue' to record the income that the company expects to receive in the future. The journal entry is: Debit: Accounts Receivable $11,500 Credit: Service Revenue $11,500

Step 3: Analyze Cash Basis Accounting

Explain that under the cash basis accounting, revenue is only recognized when cash is received. Thus, since no cash has been received yet, no adjusting entry would be made under the cash basis accounting to record accrued fees.

Key Concepts

Adjusting Entry

In accounting, adjusting entries are critical for ensuring that all revenues and expenses are recorded in the correct accounting period. Imagine you're running a business, and you delivered a service worth $11,500, but you haven't yet billed your client. This is precisely the scenario where adjusting entries come into play. To recognize the revenue earned but not yet recorded, you make an adjustment in the journal. In this case, you'd create a journal entry by debiting 'Accounts Receivable' and crediting 'Service Revenue' for $11,500.

• Debit: Accounts Receivable $11,500
• Credit: Service Revenue $11,500

This entry ensures that the revenue is recognized in the period it was earned, in line with the accrual accounting principles. By doing so, the financial statements accurately reflect the company's financial performance over the specified period.

Accounts Receivable

Accounts receivable represents the money owed to a business by its customers for goods or services provided on credit. In our scenario, when a service is provided worth $11,500 but not yet billed, this amount is recorded as accounts receivable. Accounts receivable allows businesses to maintain the record of expected future payments, balancing the revenue recognized with the matching principle of accrual accounting.

• Short-term Asset: It's recorded as a current asset on the balance sheet because it's typically expected to be converted into cash within a year.
• Credit Sales: It arises from making sales on credit, where customers promise to pay in the future.

The proper management of accounts receivable is vital, as it affects cash flow. Companies aim to collect these payments efficiently to maintain liquidity.

Cash Basis Accounting

Cash basis accounting is a simpler alternative to accrual accounting, primarily used by small businesses. Under this method, transactions are recorded only when cash changes hands. So, if you've provided services worth $11,500 but haven't received payment, you'd not record this revenue till you receive the cash. This means no adjusting entries are made for income not received, creating a different picture of financial performance.

• Revenues and expenses are only recognized when cash is received or paid.
• It doesn't adhere to the matching principle, potentially underreporting earnings during the period of service delivery.

While simpler, cash basis accounting can lead to misleading financial statements, as it might not accurately portray the financial health on a specific period basis.