Adjusting entries I: accrual accounting and deferrals

The trial balance in lesson 4 balanced, but it was not yet ready to become financial statements. Birchwood Bikes had used a month of its insurance policy, used some of its supplies and worn its equipment by a month, yet none of that had been recorded, because no transaction with an outsider had taken place. Adjusting entries fix this. They are made at the end of each period so that revenues are recorded in the period they are earned and expenses in the period they are incurred. This lesson explains why adjustments are needed, contrasts accrual with cash accounting, and covers the first family of adjustments, deferrals: prepaid expenses and unearned revenues. Lesson 6 covers accruals and depreciation and prepares the adjusted trial balance.

Accrual accounting and the cash basis

Under the cash basis, revenue is recorded when cash is received and expenses when cash is paid. It is simple and is sometimes used for very small businesses' internal records and, within limits, for some tax purposes. But it can badly misstate performance. A business that paid a year's insurance in January would show a large expense in January and none for the rest of the year; a business that finished a big job in December but was paid in January would show the revenue in the wrong year. Accrual accounting, required by IFRS, ASPE and US GAAP, records the economic effects of transactions in the periods in which they occur, whether or not cash has moved.

Two ideas guide accrual accounting. Revenue recognition says revenue is recorded when the business satisfies its obligation to a customer, usually when goods are delivered or services performed, at the amount it expects to be entitled to. The full five-step model for contracts with customers (IFRS 15 and ASPE 3400 in Canada, ASC 606 in the US) is covered in ACCT-211; in this course, revenue is earned when the work is done or the goods are handed over. Expense recognition, often called matching, says expenses are recorded in the period in which they help earn revenue or in which the related benefit is used up. Rent for May is a May expense whether it is paid in April, May or June.

Why adjustments are needed

Most transactions are recorded when a source document arrives: an invoice, a receipt, a payroll register. But some revenues and expenses build up continuously or are used up gradually without any document marking each step. Insurance expires day by day. Supplies are used a few at a time. Equipment wears out over years. Employees earn wages every day but are paid every two weeks. Interest grows on a loan between payment dates. At the end of each period, the accountant must record these changes so that the statements are complete. Every adjusting entry involves one income statement account (a revenue or expense) and one balance sheet account (an asset or liability), and no adjusting entry involves cash. If an entry you are calling an adjustment debits or credits cash, it is not an adjustment; it is a transaction.

Prepaid expenses

A prepaid expense is a payment for goods or services that will benefit future periods. When it is paid, it is recorded as an asset. As the benefit is used, the used portion is moved to expense by an adjusting entry that debits the expense and credits the asset. Common examples are insurance, rent paid in advance, software subscriptions, supplies and advertising paid before it runs.

Supplies are a good example of why a physical count matters. Bookkeepers do not record each tube of grease or roll of tape as it is used, so the only practical way to measure usage is to count what is left. The same logic, on a larger scale, applies to merchandise inventory under a periodic system (lesson 8). If the count is skipped, the asset and the expense are both wrong.

# Prepaid expenses: how much to expense each month (illustrative)
def months_used(start_month, end_month):
    return end_month - start_month + 1

policy_cost, term = 3600, 12
for m in range(1, 4):                      # May, June, July
    used = months_used(1, m)
    expense_to_date = policy_cost * used / term
    print(f"After month {m}: expense to date {expense_to_date:,.0f}, "
          f"prepaid left {policy_cost - expense_to_date:,.0f}")

# Supplies: usage comes from a count
opening, bought, counted = 0, 1500, 900
print("Supplies expense for May:", opening + bought - counted)

After month 1: expense to date 300, prepaid left 3,300
After month 2: expense to date 600, prepaid left 3,000
After month 3: expense to date 900, prepaid left 2,700
Supplies expense for May: 600

Unearned revenues

An unearned revenue (deferred revenue, or contract liability) arises when a customer pays before the business delivers. When the cash arrives, the business debits cash and credits a liability, because it owes the customer goods, services or a refund. As the business delivers, it moves the earned portion to revenue by debiting the liability and crediting revenue. Airlines selling tickets in advance, magazines selling subscriptions, retailers selling gift cards, landlords collecting rent in advance and software companies selling annual licences all have large unearned revenue balances.

The alternative recording method

Some businesses record prepayments directly as expenses and advance receipts directly as revenue, and then adjust at period end to set up the asset or liability that remains. For example, if the $3,600 insurance payment had been debited to Insurance expense, the 31 May adjustment would debit Prepaid insurance $3,300 and credit Insurance expense $3,300, leaving $300 of expense. Both methods produce the same adjusted balances; the difference is only in the starting point. What matters is to know which method the business uses before writing the adjustment, by looking at where the original amount was recorded.

Effects of omitting deferral adjustments

It is worth knowing exactly how a missed adjustment distorts the statements, both to understand why adjustments matter and to answer questions about errors. If a prepaid expense adjustment is omitted, expenses are understated, net income is overstated, assets are overstated and equity is overstated, all by the same amount. If an unearned revenue adjustment is omitted, revenue is understated, net income is understated, liabilities are overstated and equity is understated. Cash is never affected by an adjustment, so cash is never misstated by a missed adjustment.

Professional judgement in deferrals

Most deferrals are simple arithmetic, but some involve judgement. If a tune-up package can be used at any time over a year, should revenue be recognized evenly, or as each tune-up is done? If customers often fail to use what they have paid for, when should that unused amount become revenue? If a supplier invoice covers both past and future periods, how should it be split? The general principle is to follow the pattern in which the business delivers to the customer or consumes the benefit, document the basis, and apply it consistently. Managers sometimes face pressure to recognize deferred revenue early to meet a target; that is one of the most common ways financial statements are manipulated, and auditors test deferred revenue closely for that reason.