Financial Accounting: In an Economic Context

PERIODIC ADJUSTMENTS

Up to now the discussion has focused on the financial statement effects of exchange transactions—transactions backed by documented evidence, in which assets and/or liabilities are transferred between parties. Assets and liabilities, however, are often created or discharged without the occurrence of a visible, document-driven exchange transaction. They sometimes build up or expire as time passes. Interest, for example, is earned continually on bank savings accounts, and machinery depreciates as it is used in a company's operations. Such phenomena are not evidenced by exchange transactions, but they can be very important to a company's performance and financial condition.

Net income for a particular period is measured by (1) recognizing revenues when the earning process is complete and (2) matching against those revenues the expenses incurred to generate them. Under this view of performance, called the accrual system of accounting, revenues are booked when assets are created (or liabilities are discharged) and expenses are recorded when liabilities arise (or assets are reduced). In other words, revenues and expenses can be recognized either before or after the related cash is received or paid. The accrual system requires that periodic adjustments be made to the financial statements so that net income for a given period of time will be the result of a proper matching of the revenues and expenses within that period.

Periodic adjustments take one of three forms: ...