Read the following scenario to answer the questions in below.
As the book-keeper for your company you are required to create quarterly financial statements (Income Statement, Statement of Owner's Equity Balance Sheet and Statement of Cash Flows) in order to report on the financial activities of the company for the quarter (three months).
It is now March 29th, and in preparation for creating the 1st quarter's financial statements (as of 3/31), you have called a meeting with the Dept. Managers for Accounts Receivable and Accounts Payable to confirm deadlines that have to be met for recording March-related transactions. As the meeting starts the owner walks in - she sits quietly as you explain the deadlines, but as soon as you have finished she says "Well, for this quarter, if we have not paid March invoices by March 31, there is no need to record them in March. We can record/expense those invoices when we pay them in April or May."
Questions:
1. Do you agree with the owner, or, do you feel that an adjusting entry is necessary in the situation described? If so - which type of adjusting entry is needed?
2. Discuss the impact (understated or overstated) on the accounts affected if the adjustment is not made and explain how the adjustment affects the appropriate financial statements

1. I do not agree with the owner that expenses not paid for in March should not be accrued in March but recorded in April or May when actual payment is made.  Such practise violates the accrual concept and matching principle of accounting.  They require expenses to be matched to the period's income.

The adjusting entry needed to record the expenses is accrual adjustment, which requires the expense account to be debited and the expense payable account credited as a liability (unpaid financail obligation).

2.  If the adjustment is not made, the particular expense account will be understated.  This will also result in the overstatement of the net income.

The adjustment affects the Income Statement and the Balance Sheet.  The income statement is affected because it is there that expenses are deducted from the gross profit to arrive at income before tax.  The carryover effect is that the Retained Earnings, which adjust the net income after tax is also overstated.

Explanation:

Adjusting entries are journal entries used to recognize income or expenses that occurred but are not accurately displayed in the records.  Adjusting journal entries are created at the end of an accounting period to balance debits and credits and match expenses to the income for the period in accordance with the accrual concept and matching principle of generally accepted accounting principles.

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