Deferrals Adjusting Entry Overview

Trial Balances and Deferrals

  • A deferral is a postponement of revenue or expense recognition.
  • A trial balance lists all active accounts and their ending balances, categorized as either debit or credit based on their normal balance.

Types of Trial Balances

  • Unadjusted Trial Balance:
    • Prepared at the end of the period.
    • Done after transactions are recorded in the journal and posted to the general ledger.
    • It is the first trial balance.
  • Adjusted Trial Balance:
    • Prepared after adjusting entries are recorded.
    • The second trial balance.
  • Post-Closing Trial Balance:
    • Prepared after closing entries are recorded.
    • It is the final trial balance.
    • Balances become the beginning balances for the next period.

Purpose of a Trial Balance

  • The primary purpose is to show the equality of debits and credits.
  • It doesn't guarantee that all transactions are recorded or correctly categorized; it only confirms that the accounting equation (Assets = Liabilities + Equity) is in balance.

Accrual Basis Accounting

  • Under accrual accounting (required by GAAP), revenues and expenses are recognized when earned or incurred, regardless of when cash changes hands.
  • This system creates receivables and payables.

Adjusting Entries

  • Adjusting entries are necessary at the end of a period to:
    • Update accounts.
    • Ensure proper revenue and expense recognition in the correct accounting period.
    • Match resources used with earned revenue in the same period.
  • Made after the unadjusted trial balance.

Types of Adjustments

  • Accruals and Deferrals.
Accruals
  • Cash has not yet been received or paid.
  • For example, recognizing a receivable when service is provided without immediate payment.
Deferrals
  • Cash has already been exchanged (received or paid).
  • It is a postponement of revenue or expense recognition.
Revenue Deferral
  • Occurs when a customer pays in advance, but the service or product has not yet been provided.
Expense Deferral
  • Occurs when an asset (e.g., supplies) is purchased, but the expense is deferred until the asset is used.

General Rule for Adjusting Entries

  • Each adjusting entry affects one income statement account and one balance sheet account.
  • Cash is never affected in adjusting entries.

Deferred Revenues (Unearned Revenues)

  • Cash is received before the service or product is provided.
  • Initially, cash and unearned revenue (a liability) are increased.

Adjusting Entry for Deferred Revenue

  • Made at the end of the period when the service or product is provided.
  • The liability (unearned revenue) is decreased (debited), and revenue is recognized (credited).
Accounting Equation Effects for Deferred Revenues Adjusting Entry
  • Debit (Decrease) to Liabilities (Balance Sheet).
  • Credit (Increase) to Equity (Revenue Account, Income Statement).
  • No effect on assets.

Deferred Expenses (Prepaid Expenses)

  • Expense is paid in advance, but the benefit (resource usage) is deferred until later.
  • Initially, an asset (e.g., prepaid insurance) is increased, and cash is decreased.

Adjusting Entry for Deferred Expenses

  • Made at the end of the period when the asset (or part of it) is consumed or used.
  • An expense account is debited, and the asset account is credited.
Accounting Equation Effects for Deferred Expenses Adjusting Entry
  • Debit (Increase) to Expense (Income Statement).
  • Credit (Decrease) to Assets (Balance Sheet).
  • Expenses decrease equity.

Review of Deferrals

  • Deferrals involve cash transactions occurring before revenue or expense recognition.
  • Revenue recognition is postponed until earned.
  • Expense recognition is postponed until the asset is consumed.

Effects of Deferred Revenue

  • Decrease in liability (unearned revenue) on the balance sheet.
  • Increase in revenue on the income statement.

Effects of Deferred Expenses

  • Increase in expense on the income statement (decreasing equity).
  • Decrease in the asset on the balance sheet.

Key points to remember:

  • Every adjusting entry impacts both the income statement and balance sheet.
  • Cash is never affected by adjusting entries.