balance day adjustments – Financial Memos

In dealing with accrual accounting systems, end-of-period adjustments must account for material items not yet recorded at the balance date. In this article, we will be looking at the accrued rent journal entry from both the landlord's and tenant's perspectives. This should provide you with a good overview of all the transactions that need to be account for. For those here for the quick answer, you would record a journal entry like below if you are the landlord. You need to recognise a credit to a rental revenue account and then a debit to increase a debtors asset account. DateAccount NameDebitCredit4 JuneDebtors$300Rental Income$300 If you are a tenant, you will record a journal entry like the following—a debit entry to a rental expense account and a credit entry to a creditors account. DateAccount NameDebitCredit4 JuneRental Expense$300Creditors$300 And remember, you will need to reverse the adjustment at the beginning of the next reporting period so you do not end up double counting. Please read on if you want to know more about why accrual transactions are made and when and work through a few examples. What Does Accrued Mean in Accounting? Merriam-webster defines the word "accrued" as the process of something being "accumulated over a period of time". And when it comes to accounting, it means the same thing when dealing with revenue and expenses. In the case of rent, the revenue, or the expense, is being built up but has yet to be received or paid. As we mentioned in the introduction, we'll be looking at both sides of the transaction. When Do We Record Accrued Rent? Accrued rent is recorded at the end of a reporting period and when you are using an accrual accounting system. The type of system and balance day adjustments are further explained below. Cash v Accrual Systems Cash Accounting System The cash system does what it says on the side of the tin. It records transactions when cash moves. When a business receives cash or pays for something in cash, that transaction is recorded. When we use the word "cash" in accounting, we don't necessarily mean notes and coins. What we mean is when currency moves, which is normally electronic these days. I use the word currency here rather than money because they mean very different things. This isn't the point of today's article, so skip this part if you like. But for those interested, currency refers to the "legal tender" in a given country. So in the United States, it is, of course, the US dollar (USD). In India, it is the Rupee (INR). And in the United Kingdom, it is the British Pound (GBP). Whereas "money" can be anything two or more people decide they wish to use and agree has a value. Over the centuries, this has varied from salt, beads, gems, precious metals, paper, and nowadays crypto like Bitcoin (BTC). Coming back to where I should be, we are only interested in recording transactions when currency moves under a cash system. How do you know you are using a cash system? The easiest way to tell is when you issue an invoice or send a customer a bill, does your accounting record this? If it records this transaction as a debtor, you have an accrual system, not a cash system. Accrual Accounting Systems So if an accounting system records more than just when cash moves, it is an accrual system. This means it will record the economic flows of a business, i.e. the changes in the economic benefits and obligations of a business. The term economic benefit comes from the work conducted on accounting conceptual frameworks. I like to use the International Financial Reporting Standards (IFRS) Conceptual Framework and its definitions. IFRS defines economic benefits as cash inflows, control over resources, the extinguishment of debt, etc. In other words, we are talking about changes in assets. It goes onto talk about economic obligations. Unsurprisingly, this is just the opposite side of the coin, as we are talking about cash outflows, giving up control of resources, gaining debt, etc. So as you can see, accrual systems tend to be much more complex because they account for a much broader range of transactions than pure cash. But remember, under either system, the basics of the accounting equation still apply. All the debits must still equal all of the credits. The graphic below puts it better. And why is the accounting equation useful? Because it helps explain how double-entry accounting works. All of the things that cash can be spent on, including itself, are on the left; these are debit accounts. While on the right are all the ways cash can come into the business, being debt, revenue or money from owners. And these are all credit accounts. The genius of its invention is in its simplicity to break down the complexity of the real world into simple increases and decreases across an equation. What Are Balance Day Adjustments? At the end of a reporting period, which might be anything from weekly to annually, adjustments are required to be made at that balance day. Sometimes these adjustments are called end-of-period adjustments. It all means the same thing. These adjustments update the accounting records for economic flows that have yet to be recorded but could have a material impact upon the user of the information. Whether information being omitted or included would be material depends very much on the audience. Internal reporting, say on the weekly or monthly reporting, has a different purpose and audience when compared to the annual external reporting. Accrued rent is the example of a balance day adjustment we are looking at today. From the landlord's point of view, we would be recording the revenue as an accrual because either the tenant hasn't been invoiced/billed or the money hasn't been received. If the tenant had been billed, then this would appear in the debtor and credit sales journal. And if the landlord had received the cash, this would have appeared in the cash receipts journal. As neither of these has happened (the examples below will explain more), and the amount is material, accrued rent would need to be recorded. Accrued Rent Journal Entry - Landlord Now on with the fun part. If someone don't like the debits and credits, they probably shouldn't be an account. As I'm fond of saying about pilots, you probably shouldn't be a pilot if you don't like the taking-off and landing bits. But on the journal entries. First off, we'll look at accrued rent from the landlord's point of view. So we will be dealing with revenue and debtors. Our trusty example company, ABC Ltd, has been doing well in the construction, landscaping and retail business. A few years back, it got into the commercial rental market with a few small shops, one of which is a cafe. On May 15, ABC signed a two-year shop lease with Watercress Cafe, charging them $1,000 per calendar month. We'll keep the exercise simple and not be worrying about other costs, bonds, etc. ABC's accounts team has a month-end management report to prepare each month on a full accrual basis, including all material transactions. Its commercial rental operation, although small, is deemed material for this reporting. End of Month Balance Day Adjustment ABC's accounts team would prepare the following entry for the accrued rent from its lease with Watercress for the month ending June 30: June 30 - June 15 = 15 days (12 months x $1,000) / 365 days x 15 days = $493 accrued rent DateAccount NameDebitCreditJune 30Debtors$493Rental Income$493 The debit entry to the Debtors account increases the assets side of the accounting equation by $493. The asset increase reflects the inflow of economic benefits to ABC Ltd, which is generated through the credit to the Rental Income account. In the accounting equation, you would see the following entries: End of Month Balance Day Reversal Because these end of period journals are adjustments for reporting, they need to be reversed at the beginning of the next reporting. So in this example, the ABC accounts team would prepare the following journal. In many computerised systems, this process is automated rather than manual entries being prepared. However, like a lot of accounting, you need to understand the manual processes, so you know what the automated processes are up. DateAccount NameDebitCreditAugust 1Rental Income$493Debtors$493 The reversal entry for any end-of-period adjustment journal will always be just the opposite of what you prepared before. Just swap the debits and credits around the other way. The accounting equation would now look like the following: Rent Received Not part of the accrued rent journal entry we are looking at, but for completeness, when Watercress pay on August 15, ABC would see the following journal flow through their accounts: DateAccount NameDebitCreditAugust 15Bank$1,000Rental Income$1,000 The debit to the Bank account this time increases assets because of the cash ABC has received. And the credit to the Rental Income account reflects the inflow of economic benefits (i.e. rental receipts). With the balance day adjustment reversal on August 1, you avoid the over-inflation of assets and revenue. If we didn't reverse the adjustment entry from June 30, you would now have an increase in assets and revenue of $1,493 - which, of course, is not what has happened in the contract. As you can see in the accounting equation below, the amount of $1,000 in assets and revenue is what the accounting system is recording. Accrued Rent Journal Entry - Tenant Now we move onto the tenant's side of the transaction. So we will be looking at the accounting entries that Watercress Cafe is making in their books, which should look like a mirror image of what we saw for ABC Ltd. This is assuming, of course, that being a small cafe, Watercress would bother with a full accrual system - including month-end balance day adjustments. This is not very realistic for a small operation. For tax purposes, if they were reporting on an accrual basis, Watercress would make adjustments like rent. However, in all likelihood, these entries below would not be done every month by a small cafe. End of Month Balance Day Adjustment Using the same calculation as we did with ABC Ltd, Watercress Cafe will be making an end-of-period adjustment of $493 for the rent expense for the month-end. This time the debt is to the Rental Expense account. At the same time, the credit is to creditors. DateAccount NameDebitCreditJune 30Rental Expense$493Creditors$493 And in the accounting equation below, you can see how it remains in balance by increasing both sides of the equation. End of Month Balance Day Reversal As ABC did in its books, Watercress would reverse the adjustment to ensure the system does not overstate its creditors and expenses. Their accountant would prepare the following journal entry: DateAccount NameDebitCreditAugust 1Creditors$493Rental Expense$493 We can now update the accounting equation and show the second transaction, keeping the equation in balance. Rent Paid The final entry for us to look at is when Watercress pays its monthly rent. In the journal below, we see the reduction in the Bank account and an increase in the Rental Expense. DateAccount NameDebitCreditAugust 15Rental Expense$1,000Bank$1,000 We know that these are both natural debit accounts, so the decrease and increase keep the whole equation in balance, as you see in the table below. Additional Reading If you would like to read more on accrued rent and some different examples, we have a few more articles that may help. Some of them go into the conceptual frameworks more or focus more on the income or expense side of the accrual. You can find a list of these articles by following this category link. Conclusion We trust this article, part of our accounting tutorial series, has helped you understand accrued rent and the required journal entries. Like all balance day adjustments, accrued rent is trying to reflect the economic flows of the reporting entity. And of course, these adjustments will only show up in an accrual accounting system,