How to Adjust Accounting Records with Accruals and Deferrals
In accrual basis accounting, as opposed to cash basis accounting, you record revenue when it’s earned, and expenses when they’re incurred — regardless of when cash changes hands.
Suppose you pay for materials in February and use the material to make a product that’s sold in April. You record the purchase at different times depending on whether you’re using cash basis or accrual basis accounting:
Cash basis: You record the purchase when you buy the materials — in February. With cash basis accounting, you record transactions when money changes hands — when you write a check to purchase materials, for example, or deposit a check received from a customer.
Accrual basis: You record the purchase when you sell the product you made from the materials. The accrual method of accounting follows the matching principle. According to the matching principle, you must match revenue with expenses incurred to produce that revenue, regardless of when cash changes hands. You match the revenue to the related expense, regardless of when the cash moves into or out of your bank account.
In accrual accounting, because time passes between when a transaction occurs and when you record it, you adjust the books with accruals and deferrals:
Accrual: Posting activity to the accounting records before cash changes hands.
Deferral: An account in which the asset or liability isn’t recognized until a future date.
To ensure that your accounting records apply the matching principle, you must post adjustments at the end of each accounting period (month, year). The following sections explain a few typical accounting adjustments. In each case, note that the accounting entry impacts one income statement account and one balance sheet account.
Posting deferrals for prepaid assets
A prepaid asset is something you pay for in advance of receiving it. Prepaids are considered assets, because the balance represents an amount you can use as an expense in a later period.
Paying for six months of insurance in advance is a good example. When you pay the premium, you debit prepaid insurance and credit (reduce) cash. As each month passes, you debit insurance expense and credit prepaid insurance.
Insurance is a period cost — an expense incurred with the passage of time. You adjust insurance expense (income statement account) and prepaid insurance (balance sheet account).
Posting accruals for payroll
In some cases, you may pay for labor costs after you match those costs with revenue. In other words, the expense is posted before cash is paid for the expense. This concept is referred to as an accrued expense. The best example of an accrued expense is accrued payroll.
Many people have had jobs that run payroll on a particular day of the month (the 1st and the 15th of the month, for example). Other companies pay wages every two weeks, regardless of when those days fall in a given month. Assume that employees in your gift shop earn wages for the period from December 26 to December 31 of year one. You won’t pay payroll until January 5 of year two. What journal entries do you make?
Well, you need to get that payroll expense into year one — when you incurred the expense. You also want to match the payroll expense with December sales for the shop. So, on December 31, you debit (increase) payroll expense and credit (decrease) accrued payroll. That’s your adjusting entry.
On January 5, you pay the payroll owed for the end of December. You debit (reduce) accrued payroll and credit (reduce) cash. The accrued payroll now has a balance of $0.
Accountants use several other types of adjustments, including deferred revenue and accrued revenue entries. All period-end adjustments are posted to comply with the matching principle for revenue and expenses.