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Lesson 12 of 13The Accounting Cycle: Merchandising Business
Unit 3 · Lesson 12 of 13

Accruals & Deferrals

Some revenues and expenses belong to the current period even though no cash has changed hands yet, and some cash already received or paid actually belongs to a future period — adjusting entries fix both.

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Key things to remember

  1. 1Accrued expenses/salaries: incurred but not yet paid — debit the expense, credit a payable.
  2. 2Accrued revenue: earned but not yet billed or collected — debit a receivable, credit revenue.
  3. 3Unearned revenue: cash already received, but not yet earned — starts as a liability, moves to revenue as earned.
  4. 4Accruals: cash has NOT moved yet. Deferrals: cash HAS already moved.
  5. 5All four adjustments exist to satisfy the matching principle under accrual-basis accounting.

The matching principle and the accrual basis of accounting demand that revenue and expenses be recorded in the period they are actually earned or incurred — regardless of when cash happens to move. Four adjusting entries handle the situations where cash timing and earning/incurring timing don't line up: accrued expenses, accrued revenue, and unearned (deferred) revenue.

SituationDefinitionAdjusting entry
Accrued ExpensesExpenses that have been incurred but not yet recorded in the booksDr Expense / Cr Payable (liability)
Accrued SalariesSalaries earned by employees but not yet paidDr Salaries Expense / Cr Salaries Payable
Accrued RevenueRevenue earned during the fiscal period but not yet recorded in the booksDr Accounts Receivable / Cr Revenue
Unearned RevenueRevenue that has been received but is not yet earnedDr Unearned Revenue (liability) / Cr Revenue, for the portion now earned
Accruals vs. deferrals

Accrued Salaries is really just a specific, very common example of Accrued Expenses: employees have worked the days, the business owes them for that time, but payday falls in the next period. Unearned Revenue works in the opposite direction from the other three — cash has ALREADY arrived, but the work has not yet been done, so it starts life as a liability (an obligation to either deliver the service or refund the money) and is only moved into revenue as it is actually earned.

Accrued Expenseexpense incurred now, cash paid latere.g. wages earned by staff but not yet paidrecognizecash movesPrepaid Expensecash paid now, expense recognized latere.g. insurance paid for 12 months in advancecash movesrecognizeAccrued Revenuerevenue earned now, cash received latere.g. service completed, invoice sent next monthrecognizecash movesUnearned Revenuecash received now, revenue earned latere.g. customer deposit for work not yet donecash movesrecognize
Fig 1Four timing mismatches between cash and the accrual basis of accounting
A quick test
Ask two questions: (1) Has cash moved yet? (2) Has the revenue/expense actually been earned/incurred yet? If cash has NOT moved but it IS earned/incurred — that's an accrual. If cash HAS moved but it is NOT YET earned — that's a deferral (unearned revenue, or its mirror image, a prepaid expense).

Worked examples

Reveal one step at a time and try to beat it to the next line.

Example 1
A company's fiscal year ends on December 31, a Wednesday. Employees are paid every second Friday, and the last payday was December 26, covering work through December 26. Employees worked December 29, 30, and 31 (3 days) that have not yet been paid, earning a total of $3,200. Journalize the required year-end adjustment.
Example 2
On November 1, a customer pays $1,500 in advance for a 5-month service contract (Nov–Mar). By the December 31 fiscal year end, 2 of the 5 months have been fully delivered. Journalize the original receipt and the December 31 adjusting entry.

Where marks get lost

  • Recording accrued revenue only when the cash is finally collected, instead of in the period it was actually earned.
  • Treating unearned revenue as if it were already earned the moment cash is received — it must sit in a liability account until actually earned.
  • Reversing the accrued expense adjusting entry incorrectly, causing an expense to be recorded twice (once accrued, once again when actually paid).
  • Forgetting that accrued salaries is really just a common form of accrued expenses, and trying to memorize it as an unrelated, separate rule.
  • Mixing up which account is debited and which is credited when unearned revenue is finally earned — Unearned Revenue (a liability) is debited DOWN, and Revenue is credited UP.

Flashcards 5

Accrued Expenses
Accrued Salaries
Accrued Revenue
Unearned Revenue
+ 1 more

Practice

1
A customer pays $2,000 in advance for services not yet performed. This should be recorded as:
2
Employees have worked 3 days that have not yet been paid at year end. The adjusting entry is:
3
What do we call revenue that has been earned during the period but not yet billed or recorded?
4
A landlord receives $6,000 for a 6-month rent-in-advance contract. By year end, 4 months have been earned. How much should be recognized as revenue?
$
5
Which of the four situations does NOT involve a liability account in its adjusting entry?
6
In the quick test for accruals vs. deferrals, what question distinguishes the two?
7
Interest of $150 has accrued on a note payable but will not be paid until next period. What amount is debited to Interest Expense at year end?
$

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