The adjusted trial balance and ethics of accruals
After adjusting, accountants prepare the adjusted trial balance and financial statements. Accrual judgements must be made honestly.
The adjusted trial balance
After recording adjusting entries, accountants prepare an adjusted trial balance listing all accounts with their updated balances. It confirms that debits still equal credits and provides the figures used to prepare the financial statements.
Preparing statements in order
Statements are typically prepared in order: the income statement (revenues and expenses give net income), then the statement of retained earnings or owner's equity (using net income), then the balance sheet (using ending equity), and finally the statement of cash flows.
Reversing entries
Some businesses make optional reversing entries at the start of the next period, reversing certain accrual adjustments such as accrued wages. This simplifies recording when the cash is later paid, because the full payment can be recorded as an expense without splitting it.
Estimates and judgement
Accrual accounting requires estimates: useful lives and residual values for depreciation, the amount of receivables that will not be collected, warranty costs, and the portion of long contracts completed. Reasonable estimates are necessary but create room for error or manipulation.
Earnings management
Earnings management uses accounting choices and timing to make results look smoother or better, such as delaying expenses or recognising revenue early. Some is legal but aggressive; crossing into fraud, such as recording fictitious revenue, is illegal. Notable cases include WorldCom, which improperly capitalised billions of dollars of expenses before collapsing in 2002.
The conservatism tradition and materiality
Accountants have traditionally applied prudence (conservatism): when in doubt, avoid overstating assets and income. Materiality means information is material if omitting or misstating it could influence users' decisions; immaterial items can be handled more simply, such as expensing a cheap stapler rather than depreciating it.
Internal controls and audits
Internal controls, such as segregation of duties, authorisation, reconciliations, and documentation, help prevent errors and fraud. External auditors examine financial statements and issue opinions on whether they are fairly presented. The Sarbanes-Oxley Act (2002) requires US public company management to assess internal controls over financial reporting.
Worked example
A company's unadjusted trial balance shows Service Revenue of 80,000 dollars and Unearned Revenue of 10,000. Adjustments: 4,000 of unearned revenue has been earned; wages of 2,000 are accrued; depreciation is 3,000. Adjusted revenue is 84,000; wages and depreciation expenses rise by 5,000 in total. Net income changes by 4,000 - 5,000 = -1,000 compared with the unadjusted figures.
Key takeaways
The adjusted trial balance provides figures for the statements, prepared in order: income statement, equity statement, balance sheet, and cash flows. Reversing entries are optional simplifications. Accruals require estimates, creating room for earnings management, which becomes fraud when results are falsified, as at WorldCom. Prudence and materiality guide judgement. Internal controls and audits, reinforced by Sarbanes-Oxley, protect reliability.
Flashcard
Balances after adjustments
Check your understanding
Why is a cheap stapler usually expensed immediately rather than depreciated over several years?