In the cash basis of accounting, an expense is recorded when paid, and revenue is recorded when received. In the accrual basis of accounting, an expense is recorded when it is incurred, and revenue is recorded when earned. The accrual basis requires adjusting entries.
Adjusting entries are made at the end of an accounting period to apply the matching principle and to more accurately state the amount of assets and liabilities. Most adjusting entries can be grouped into two categories: accruals and deferrals.
Accruals[close] Accruals are the accumulation of expenses or revenue over a period of time. At the end of an accounting period, there are usually some items that have accrued but have not been recorded. In order to show the proper amount of items, adjusting entries should be made for all accruals.
Deferrals[close] Deferrals are the advance payment of expense items that benefit more than one accounting period or the advance receipt of revenue that will not be fully earned at the end of an accounting period. Adjusting entries should be made for deferrals to allocate the appropriate amount of expenses or revenue to the appropriate accounting period.
Accrued expenses represent both an expense and a liability. Thus, accrued expenses can also be referred to as accrued liabilities. Accrued expenses[close] Accrued expenses are those expenses that build up during the current accounting period but will not be paid until the next accounting period. A common example of an accrued expense is unpaid salaries at the end of an accounting period. An adjusting entry must be made to debit the Salaries Expense account and credit the Salaries Payable account. This has the effect of recording all salaries incurred in a period in an expense account and recognizing the liability for unpaid salaries. All accrued expenses involve a debit to an expense account and a credit to a liability account.
Accrued revenue represents both an asset and revenue. Thus, accrued revenue can also be referred to as accrued assets. Accrued revenue[close] Accrued revenue occurs when revenue has been earned but not collected at the time the accounting period ends. The adjusting entry for accrued revenue requires a debit to an asset account (such as Accounts Receivable, Rent Receivable, Interest Receivable, etc.) and a credit to a revenue account.
When an accrued expense is paid in the next accounting period - or when accrued revenue is received in the next accounting period - the entry must be split between the part of the accrual that pertains to the previous accounting period and the part that pertains to the current accounting period. Some accountants, however, do not like to split an entry between two accounting periods. In Chapter 10 we discussed a technique known as reversing entries that allows the accountant to make routine entries as if an accrual had not taken place. A reversing entry is made as of the first day of the next accounting period and is the exact reverse of the adjusting entry for the accrual.
A deferred expense[close] deferred expense is an advance payment for goods or services that benefits more than one accounting period. Deferred expenses are also referred to as prepaid expenses or deferred charges.
Prepaid expenses can be accounted for in two ways. The prepayment can be recorded (1) as an asset or (2) as an expense. Both methods yield identical results, but the end-of-period adjusting entry depends on how the prepayment was first recorded.
Deferred revenue[close] Deferred revenue is the advance receipt of revenue that will not be fully earned until a later period. Common examples of deferred revenue include sales of season tickets by an athletic team, subscriptions received in advance by a magazine, and rent collected at the beginning of a lease period. With regard to subscriptions, the Subscriptions Income account[close] Subscriptions Income account shows the amount earned from subscription sales, while the Unearned Subscriptions Income account[close] Unearned Subscriptions Income account shows the dollar amount of subscriptions due to subscribers.
Revenue that is deferred for a shorter period (less than a year) is referred to as unearned revenue and is listed on the balance sheet as a current liability. Revenue that is deferred for a longer period (in excess of a year) is referred to as deferred credits and is reported on the balance sheet under the heading Deferred Credits.
Deferred revenue can be accounted for in two ways. The advance receipt can be recorded (1) as a liability or (2) as revenue. Both methods yield identical results, but the end-of-period adjusting entry depends on the initial recording.
Materials posted on this site are copyrighted by Paradigm Publishing Inc. Permission is granted by the publisher to adopters of the text product that this electronic material accompanies to reproduce portions of these materials, and to adapt them as needed for educational use at a single location.