Adjusting entries are entries that are required to be made before financial statements are created and published.
Adjusting entries are often categorized as Accruals or Deferrals.
It may help if you are clear on the reason why accrual and deferral entries are needed. The goal is to ensure that all the expenses and revenues that properly belong (were incurred) in a period get recorded in that period - MATCHING principle......
IMPORTANT POINT - Accruals and Deferrals never include CASH.
IMPORTANT POINT - Accruals and Deferrals never include CASH.
So - for ACCRUALS - An accrual means that we incurred something that related to this period - but the cash/money has not changed hands yet (i.e. we have not paid for a service/item we have received (accrued expense).....or...the customer has not paid us for work we have done (accrued revenue). HOWEVER - the transaction affected the current period - so we need to record it as an expense or revenue for the current period to ensure proper matching.
Now, since no cash has changed hands, the transaction will affect either Accounts Payable (for an expense) or Accounts Receivable (for revenue).
Now, since no cash has changed hands, the transaction will affect either Accounts Payable (for an expense) or Accounts Receivable (for revenue).
Example
DEBIT: Utilities Expense
DEBIT: Utilities Expense
CREDIT: Accounts Payable
Electric bill for May (not going to be paid until June).
Now - for DEFERRALS - A deferral means that we paid/got paid for something in the current period that will actually affect a FUTURE period. So since cash has changed hands (and so the Cash account is affected), it is being recorded in the current period - but we have to be sure that we do not (incorrectly) include the amount as Revenue or Expense for the current period; because it does not belong to the current period.
For example, Deferred/Prepaid Revenue - is an amount a customer pays us today for work we will (promise to) do in a FUTURE time-period. When we receive the cash it is not revenue until we complete the work (even though we have the cash). So we will show the increase in cash (with a DEBIT) - but show the amount received as as a liability, Prepaid/Deferred Revenue (with a CREDIT).
Why is Deferred Revenue a liability?
Because by taking the customer's cash we now have an 'obligation' to perform - and the definition of a Liability is a debt/obligation......
Now - here's the key next step.
When we actually DO the work (maybe next month....) we will need to create another transaction. In that future period when the work is complete, the transaction that is needed is to now record the revenue we have earned by doing the work, and we do this by transferring it out of Deferred Revenue (with a Debit, to decrease) and recording it in a Revenue account (with a credit).
Why is Deferred Revenue a liability?
Because by taking the customer's cash we now have an 'obligation' to perform - and the definition of a Liability is a debt/obligation......
Now - here's the key next step.
When we actually DO the work (maybe next month....) we will need to create another transaction. In that future period when the work is complete, the transaction that is needed is to now record the revenue we have earned by doing the work, and we do this by transferring it out of Deferred Revenue (with a Debit, to decrease) and recording it in a Revenue account (with a credit).
So - to recap the Journal Entries.....
May:
DEBIT: Cash
May:
DEBIT: Cash
CREDIT: Prepaid Revenue (liability)
Customer deposit for work to be completed in June
June:
DEBIT: Prepaid Revenue
Customer deposit for work to be completed in June
June:
DEBIT: Prepaid Revenue
CREDIT: Revenue
Record revenue for work completed
Hope this helps!
Record revenue for work completed
Hope this helps!
