To illustrate, let's assume that New Corp begins its business on December 1 and uses Sales Rep Company for calling on customers. For this service, New Corp agrees to pay commissions of 5% of sales with payment made 10 days after the month ends. If December's sales are $100,000 New Corp will be incurring a commissions expense of $5,000 and a liability of $5,000. However, the payment will actually occur on January 10. Without an accrual adjusting entry as of December 31 New Corp's financial statements will have the following problems:
- Its December income statement will report $0 commissions expense in getting December's sales of $100,000
- Its January income statement will report $5,000 in commissions expense that were actually incurred in order to get December's sales
- Its December 31 balance sheet will not be reporting its $5,000 liability to Sales Rep Company
In order for New Corp's December's income statement to match the $5,000 of expense with December's sales of $100,000, and for New Corp's December 31 balance sheet to report the liability of $5,000 the following accrual adjusting entry is needed as of December 31: debit Commissions Expense for $5,000; credit Commissions Payable for $5,000.
Over at Sales Rep Company, for its financial statements to comply with the accrual method of accounting it needs to record the following accrual adjusting entry as of December 31 (assuming its billing will take place in early January): debit the asset account Commissions Receivable for $5,000; credit Commissions Revenues for $5,000. Without this accrual entry as of December 31, Sales Rep Company's December financial statements will have the following problems:
- Its December income statement will report $0 in revenues that were earned from representing New Corp during December
- Its January income statement will report $5,000 in revenues that were actually earned in December when Sales Rep Company was incurring expenses in order to make the sales calls
- Its December 31 balance sheet will not be reporting the receivable of $5,000 that it has a right to receive for its December's efforts
Since accrual adjusting entries will be followed by the actual transactions (checks written, billing invoices issued, etc.), a helpful accounting procedure is to record reversing entries on the first day of the next accounting period.
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