Adjusting Entries: Accruals, Deferrals, Depreciation

Why adjustments are needed

Under accrual accounting, revenue is recorded when it is earned and expenses when they are incurred, whatever the date of the cash payment. During the year, most entries are triggered by documents: an invoice, a receipt, a bank statement. At the end of the period some amounts have changed without any document: insurance has expired a month at a time, employees have worked days that will be paid next month, a machine has been used for another year. Adjusting entries bring the accounts up to date before the financial statements are prepared.

Two features of adjusting entries help you check them:

• each adjusting entry affects one income statement account (revenue or expense) and one balance sheet account (asset or liability);
• in the US textbook convention, an adjusting entry never involves Cash. If you find yourself debiting or crediting Cash, the transaction is a payment, not an adjustment.

The four kinds of adjustment

Kind	Situation	Typical entry
Deferred expense (prepaid)	Paid in advance, partly used	Debit expense, credit prepaid asset
Deferred revenue (unearned)	Received in advance, partly earned	Debit unearned revenue, credit revenue
Accrued expense	Incurred, not yet paid or recorded	Debit expense, credit payable
Accrued revenue	Earned, not yet received or recorded	Debit receivable, credit revenue

Deferrals postpone the recognition of an amount already paid or received. Accruals recognize an amount before it is paid or received. Depreciation is a special kind of deferral: the cost of a long-lived asset is spread over the years that use it.

Worked examples

All examples use a year ending December 31.

1. Prepaid insurance (deferred expense)

On October 1 the business paid $1,200 for a 12-month insurance policy and debited Prepaid Insurance. By December 31, three months have expired: 1,200 × 3 / 12 = $300.

Account	Debit	Credit
Insurance Expense	300
Prepaid Insurance		300

Prepaid Insurance now shows $900, the cost of the nine months still to come.

2. Unearned revenue (deferred revenue)

On November 1 a client paid $3,000 in advance for six months of service, and the business credited Unearned Revenue. By December 31 two months of service have been provided: 3,000 × 2 / 6 = $1,000 has been earned.

Account	Debit	Credit
Unearned Revenue	1,000
Service Revenue		1,000

The remaining $2,000 stays a liability: the business still owes four months of service.

3. Accrued salaries (accrued expense)

Employees earned $2,000 in the last days of December that will be paid on January 5. The expense belongs to December.

Account	Debit	Credit
Salaries Expense	2,000
Salaries Payable		2,000

On January 5 the payment debits Salaries Payable, not Salaries Expense, so the expense is not counted twice. Accrued revenue works the same way in reverse: interest earned on a note receivable but not yet collected is recorded by debiting Interest Receivable and crediting Interest Revenue.

4. Depreciation

Equipment bought at the start of the year for $10,000 has a useful life of 5 years and no salvage value. Straight-line depreciation is (cost − salvage value) ÷ useful life = 10,000 ÷ 5 = $2,000 a year.

Account	Debit	Credit
Depreciation Expense	2,000
Accumulated Depreciation—Equipment		2,000

Equipment stays at its cost of $10,000. Accumulated Depreciation is a contra-asset with a credit balance; the book value is 10,000 − 2,000 = $8,000. If the asset is bought during the year, only the months in use are charged (for an April 1 purchase, 9/12 of the annual amount).

Two ways to record a prepayment

The example above records the payment in an asset account first and moves the used part to expense. Another method records the whole payment as an expense and, at year end, moves the unused part to an asset: on October 1, Insurance Expense is debited for $1,200, and on December 31 Prepaid Insurance is debited and Insurance Expense credited for $900. Both methods give the same balances after the adjustment (expense $300, prepaid asset $900); only the adjusting entry differs. Read the item text to see which account was used when the cash moved. The same choice exists for revenue received in advance.

How the conventions differ

The Spanish, French and German conventions on PractiBalance use the second method for prepayments: the expense or revenue is recorded in full when it is paid or invoiced, and the part that belongs to the next year is moved at year end to 480 Gastos anticipados or 485 Ingresos anticipados (PGC), 486 Charges constatées d’avance or 487 Produits constatés d’avance (PCG), or Aktive or Passive Rechnungsabgrenzung (German). Depreciation also differs: Spain and France credit an accumulated depreciation account (2813, 28154), while the German convention on this site uses direct depreciation, crediting the asset account itself (“Abschreibungen auf Sachanlagen an Maschinen”). An accrued expense in German textbooks is usually credited to Sonstige Verbindlichkeiten.

A checklist before closing

• Is every prepaid asset reduced by the part that has expired?
• Is every unearned revenue reduced by the part that has been earned?
• Are wages, interest, utilities and other costs incurred but unpaid recorded?
• Is revenue earned but not billed recorded?
• Is depreciation recorded for every depreciable asset, for the right number of months?

Practice

Try the adjusting and closing items and the depreciation items in fixed assets. The next step at year end is covered in closing entries, and terms such as accrual, deferral and book value are in the glossary.