Deferrals

Deferrals can be one of the following:

• Prepaid Expenses: Expenses paid for in cash and recorded as assets before they are used or consumed. Esentially, exchanging one asset (cash) for another.

• Unearned Revenues: Revenues received in cash and recorded as liabilities before they are earned.

The adjusting entries for deferrals are needed at month-end to record either the expense incurred (due to either the passage of time or through use and consumption) or the revenue that has been earned in the current accounting period. In the event that a company fails to record adjustments for deferrals, then the assets and liabilities are overstated and the corresponding expense and revenue accounts are understated.

​Let's first look at two examples of prepayments in the adjusting entry below.

First, account of supplies reveals $3,200 on hand. If we were to look at the unadjusted trial balance, we would notice that we have supplies valued at $4,000. This means we must have used $800 during the month. So the answer would be to debit supplies expense for $800 and credit supplies, as they have decreased, for the $800 as well.

The other prepaid item we had was insurance. Remember when we purchased six months worth of insurance? We considered that an asset because someone owed us insurance. However, now that a month has passed, we have used up one of those months and they only owe us five months. So if we assume that each month costs the same, we take the $2,400 divided by six months and get $400 per month. So we would debit insurance expense for $400, and credit prepaid insurance for $400 as well.

Let's now look at an example of unearned revenue in the adjusting entry below.

In our example we have earned $4,000 of the unearned revenue. We can now debit the liability because we no longer owe them that $4,000, and credit the revenue account because because we have now earned it.

Accruals

Accruals can be one of the following:

• Accrued Revenues: Revenues that have been earned but not yet received in either cash or recorded in the accounting records.

• Accrued Expenses: Expenses that have been incurred but not yet paid in cash or recorded in the accounting records. Another name for Accrued Expenses is Accrued Liabilities. Remember, this is a liability account on the Balance Sheet.

The adjusting entries for accruals are needed at month-end to record unrecognized revenues earned and expenses incurred in the current accounting period. In the event that a company fails to record adjustments for accruals, then either the revenue account (and related asset account) or the expense account (and the corresponding liability account) are understated. As a result, adjusting entries for accruals will increase both a balance sheet and an income statement account.

Let's look at two examples of accruals in adjusting entry below.

Remember we took out a note when we purchased the equipment. Although we will not pay this note today, we have had the note for the last month and, therefore, have used up one month of interest expense.

One month of interest would be found by taking the note, $40,000, times the interest rate, 5%, times 1 over 12 because we've had the loan for one month. If it were two months, it would be 2 out of 12. We get then $166.67. So we would debit interest expense for that amount and credit interest payable because we now owe that amount in interest.

The last adjusting entry, then, is that of an accrued revenue. This is where we have earned revenue but have not billed the client or been paid for it. Is it a revenue, then? Yes, because, again, we recognize revenues when we earn them.

So even though we haven't billed the client, we can still debit accounts receivable because they still owe us, whether we sent the bill or not. We performed the service, we will eventually bill them, so they certainly owe it to us. We'll debit accounts receivable and then credit the revenue account because, again, we have earned the revenue.