Which system requires adjusting entries to recognize earnings and expenses?

The concept of adjusting entries is essential in accounting to ensure that the financial statements accurately reflect the economic events of a business during a specific period. The accrual basis accounting system is characterized by its recognition of revenues when they are earned and expenses when they are incurred, regardless of when cash is actually received or paid.

Adjusting entries are necessary in this system to align recorded revenues and expenses with the periods in which they are earned or incurred. For instance, if a company provides services in December but does not receive payment until January, accrual accounting requires recognizing that revenue in December. Similarly, if an expense is incurred for utilities in December but the bill is not paid until January, an adjusting entry will recognize that expense in December to match it with the corresponding revenue.

This process is in contrast to cash basis accounting, which only recognizes revenues and expenses when cash is exchanged, thereby not requiring any adjusting entries since transactions are recorded based on actual cash flow. Modified cash basis accounting typically incorporates elements of both cash and accrual accounting, but still does not necessitate the comprehensive adjusting entries required by pure accrual accounting. Thus, the accrual basis accounting system fundamentally relies on adjusting entries to comply with the matching principle, ensuring that financial statements provide a true and