Accounting has evolved a lot over time, and it has become a lot more than credit, debit, journal, ledger, and financial reporting.
When we define the purpose of accounting for any business entity, the emphasis is put on ‘True representation of the financial position of an entity and real picture of the profitability.’
Every step the accounting professionals go through during the preparation of financial statements and day-to-day accounting is directed toward that bigger objective. We often heard of the term truing up the financial records.
It is a term that accountants often use, but a layman or an accounting student is often unfamiliar with the term. The generic meaning of the term true-up is ‘to reconcile or match the balance of two or more items.’ The accounting perspective of the term is more or less the same.
This blog is intended to have an in-depth understanding of the term true-up in the accounting field. And why accounting data needs a true-up will also be part of our effort of explaining the term.
What Is True-up?
The literal meaning of the term ‘true up’ says to make level, balance, or align something.
But, if we understand the term true-up for the accounting procedures, it has almost the same meaning. The term true-up means reconciling or matching two and more than two accounts’ balances.
Further breaking down of the definition explains that the reconciliation or matching is done by making adjustments in accounts.
Therefore, the entries made in books of accounts for this purpose are called adjustment entries or true-up journal entries.
The adjustments are usually made after the end of a financial period once the accounts have been closed. The difference between actual and estimated amounts is adjusted by employing the process of truing up your financial data.
Why is adjustment necessary for the accounts? We will see it in the coming section.
Why Is True-up Necessary? Matching Principle And Accrual Basis
There are two systems of accounting. One is cash-based accounting, whereas the other one is accrual-based accounting.
If we look in-depth, cash-based accounting treats the expenses and revenues based on when the cash was received or paid.
On the other hand, the accrual basis accounting system works on certain accounting principles. The accrual system’s main concept is that expenses and revenues related to a certain financial period should be recorded in the same period, irrespective of payments made and cash received.
The accrual system is based on the matching principle of accounting. The matching principle says that revenues and expenses for a certain period should match.
In other words, expenses related to certain revenues should be recorded in the same period when revenue was generated.
As an example, we can consider the salaries of the employees. Let’s suppose employees are paid on an accrual basis, which means that January’s salary will be paid in February.
In this case, if the salaries paid to employees in January are charged as an expense of January and not of December, it will overstate the profit for the month of December. As a result, the objective of true profitability will be violated.
Therefore, the truing up of financial statements, data, and figures is critical to the objectives and requirements of fair financial reporting.
Is True-up Another Name For Adjustment Journal Entries?
In the official language of accounting, you would rarely end up finding a clause of IFRS or IAS having the term ‘true-up.’ Another confusion I often faced was if the term true-up was synonymous with what we generally call adjustment entries.
So here we are, answering the question.
Adjustment entries are made for the true representation of financial statements. The adjustment entries encompass correction of any erroneous transaction, inappropriate recording of a transaction, difference in estimates and actual values, accruals, and deferrals.
The principle behind adjusting entries is also the matching principle to ensure that all revenues or expenses of a specific financial year are recorded properly.
The purpose of truing up is also compliance with the matching principle, and accountants often use this lingo slang for the same concept of adjustments.
The only difference between the two is that the term truing up is mostly used when Budget variances are concerned. However, adjustment entries are more focused when the correction of errors is concerned.
However, in most cases, both terms are interchangeably used, and the entries made for adjustments of balances can be called Adjustment Journal Entries or True-Up Journal Entries.
When Does An Entity Need True-Up Of Financial Records?
We have understood that accounting records and the truing up of accounting records are almost the same concepts. But, the real question is when an entity needs to true up its financial records?
The general answer to this question is that truing up or adjustments are necessary at the closing of every financial period.
But to give a better idea of which scenarios require adjustment and truing up, we have listed the events when a need to true up financial records arises.
The operational budget of the entities is all about the estimations of the recurring expenses. These budgets are often made for one financial year, a quarter, and even a month.
According to the International Financial Reporting Standards, an entity can estimate or provide the expected expenses or revenues.
After the closing of a financial period, the comparison of actual expenses and revenues is made with the estimations. The budget variances are either favorable or unfavorable.
However, the true-up entries’ purpose is to adjust the balance to match the actual value. Expenses and revenues are adjusted for the budget differences in their respective credit or debit accounts.
Errors And Omissions
Errors and omissions are a big reality of not just in the corporate world but in everyday life. In recording, sorting, analyzing, posting balances, and making financial statements, there is a high probability of errors and omissions.
As a result, frustrating unequal trial balances and, therefore, misappropriation of profit and balance sheet are waiting.
As the audit progresses, the errors and omissions are identified, which need to be adjusted for an accurate financial position representation.
The journal entries are made to record the omitted entries or some aspects of a transaction. The errors of balance, incorrect value, overstating, or understating are also adjusted accordingly by the mean of true-up entries.
The timing difference is also more relatable to budgeting, but it is not the budgeting variance. The best example of the timing difference can be given as an electricity bill is received once the electricity has been consumed.
Now, when closing financial statements, the bill has not yet been charged, but according to previous consumption patterns, the entity can estimate.
Mostly, the companies post these estimates to the related expense account. Now when the bill was received, it was either more than the estimate or less than the estimate.
This difference has to be adjusted for a true representation of financial position and profitability. Therefore, the true-up entry will be posted for adjustment.
According to the International Financial Reporting Standards, some expenses cannot be ascertained with complete accuracy due to unexpected events.
In that case, the company will have to make adjustments for the actual values once the financial period has been completed. The best example of this is the insurance of the employees in an entity.
It can not be estimated with certainty how many new employees will be hired and how many of them will quit. Therefore, once the year is completed, actual figures can be calculated by the facts. The entities will pass the true-up journal entries in this case too.
True Up Journal Entries
Here are some examples of the true-up entries for different scenarios present in an entity.
Example 1(Budgeting Variance)
A company estimated the cost of refreshments to be 3,000$ per quarter for the year 2017. In the last quarter, it was found out that the actual cost incurred per quarter was 4,000$.
There was a total difference of 3,000$ that required to be adjusted for the year’s profit and loss statement.
The journal entry for the cost of refreshments in the 4th quarter will be made as:
|Refreshment Expense Account||7,000|
Another example of the timing difference can be illustrated in the payment of electricity bills as discussed above. From the previous estimations, the company has debited $15,000 as the electricity bill for the month.
However, when the actual bill was charged, it was of amount $12,000. Now, this scenario shows that the profit has been understated due to more charging of electricity bills.
An adjustment entry would be made to reconcile the balance. The entry will be such as
|Electricity Bill Payable Account||3,000|
|Electricity Bill Expense Account||3,000|
We have tried to sum up the concept of truing up in a comprehensive way so that no ambiguity is left in the readers’ minds.
The truing up concept is just like the adjustment journal entries for any accounting period. We hope our effort will help you have a better and clear understanding of the concept.