Adjusting Entries and Financial Reporting Standards (NIF)

Why we need to adjust

Until now you recorded transactions when they happen: something was paid, collected, or bought. But time also passes without anyone paying anything: the insurance is gradually "used up," the van gradually wears out, and employees' wages are gradually earned even if they are paid later.

Before preparing the financial statements, the company reviews its accounts and records what has already happened economically even if there is not yet a cash movement or an entry. Those entries are the adjusting entries.

Compare the insurance expense for each month in the two cases. Top, without adjustment: the whole payment falls in January. Bottom, with adjustment: each month carries the same amount (the scale is the same in both graphs: 120 px equals 2,400 pesos, so 200 pesos measures 10 px).

Prepaid expenses

When a service that will be used for several months (insurance, rent, advertising) is paid for in advance, the payment is not yet an expense: it is something the company has (the right to use the service), so it is recorded in an asset account, for example Prepaid insurance. Each month, a portion is "used up" and becomes an expense.

Accrued unpaid expenses

The opposite also happens: the expense has already been incurred, but it has not been paid yet. Wages are the typical case: the staff works the last week of the month and is paid the following month. That expense belongs to the month in which the work was done, and the company owes the money, so a liability is recorded: Wages payable.

Straight-line depreciation

A van, a computer, or a machine serves for several years and gradually wears out. Its cost is not taken to expense on the day of purchase: it is spread over its useful life. That spreading is depreciation.

The simplest method is straight-line: the same amount is depreciated each period.

The adjusting entry is made like this: you debit Depreciation expense (it goes to the income statement) and you credit Accumulated depreciation (an account that subtracts from the asset on the balance sheet). You do not credit the van directly: its original cost is kept and the accumulated depreciation keeps adding up.

The NIF and the accrual basis

Who decides how depreciation is calculated or when revenue is recognized? If every business did it "its own way," their financial statements could be neither compared nor trusted. That is why the Financial Reporting Standards (NIF, Normas de Información Financiera) exist.

They make the information useful, reliable, and comparable: a bank, an investor, or the tax authority (SAT) can read the statements of two different companies in the same "language."

A central idea of the NIF is the accrual basis: revenue is recognized when it is earned (the good is delivered or the service is provided) and an expense when it is incurred, not when the money is collected or paid. The alternative, the cash basis, only records when money moves.

Adjusting entries are precisely the tool that brings accounting to the accrual basis: they spread out insurance and depreciation, and record accrued wages, even if there are no payments that month.

Summary

• An adjusting entry is made at the close of the period so that revenues and expenses end up in the period they belong to.

• A prepaid expense is first recorded as an asset and each month it is moved to expense (e.g., $\$2{,}400.00 \div 12 = \$200.00$ per month).

• An accrued unpaid expense (wages) is debited to expense and credited to a liability (Wages payable).

• Straight-line depreciation: $(\text{cost} - \text{salvage}) \div \text{useful life}$; you debit Depreciation expense and credit Accumulated depreciation.

• The NIF, issued by the CINIF, make financial information comparable and reliable.

• Accrual basis: record when it is earned or incurred, not when it is collected or paid.

• Go back to the beginning: without an adjustment, the insurance paid in January would make January and the other months look wrong; with the adjustment, each month carries $\$200.00$.