• Differentiate between deferrals and accruals

 

In accounting, we classify adjustments in one of two ways: a deferral or an accrual. They are the opposite of each other. If you look up the word accrue, you’ll find it basically means to add to. The word defer actually means to put off to later.

In accounting, it’s easy to tell if an expense or revenue is deferred or accrued when the cash comes in.

• If you earn revenue before you get the cash, you have to accrue the revenue (add it to your books). Accrued revenue is an asset (accounts receivable, most likely).
• If you get the cash before you earn the revenue, you have to defer recognition of the revenue. In fact, getting the cash before you earn the revenue means you have a liability (deferred revenue = liability).

The same idea holds true for expenses.

• If you pay an expense in advance, like insurance, where you may pay an annual premium that expires (is used up) monthly, you have a deferred expense. A deferred expense is an asset.
• If you have expenses that you haven’t recorded yet, say a bill from your attorney, you have to accrue that expense (add it to your books). An accrued expense is a liability.

Accrued revenues are common at the end of the year when we are doing work but have not recorded the revenue yet. This would also apply to interest earned on notes receivable even if the interest is not due until the next year.

A common example of an accrued expense is when employees worked during the last week of the year but won’t be paid until the next regular payday, which is in the next year. The expense needs to be matched with the revenue of the period. Interest expense is another example: since it accrues by the day, we need to adjust for the expense for the amount of time the note is outstanding during the accounting period.

There is one more type of journal entry that doesn’t fit a tidy classification. For instance, if you find an error or some other material misstatement, you may use an adjusting entry to correct it.

In the next section, we’ll cover adjusting for deferred and accrued revenues, and then deferred and accrued expenses, as well as other kinds of adjusting journal entries that we may need to get our basic bookkeeping records to comply with Generally Accepted Accounting Principles (GAAP) so we can produce our financial statements.