Accruals and Deferrals- Part One

Accruals and deferrals are posted when you use the accrual basis method of accounting. This method differs from cash basis accounting. So, before we get to accruals and deferrals, let’s review cash vs. accrual accounting:

Cash basis accounting:

The cash basis means posting revenue and expenses based on your checkbook activity. When you deposit a client’s payment, you post revenue. On the other hand, when you write a check for an expense, the expense is posted to your accounting records.

Accrual basis accounting:

Accrual basis accounting complies with the matching principle. Revenue is matched with the expenses incurred to generate the revenue. You match the revenue and the related expense- regardless of when they occur.

You might pay for materials in February and use them to make a product that’s sold in April. Accrual accounting states that the material cost should be part of the cost of sales. So, the material cost would be posted as cost of sales in April- even though the material was purchased in February.

Prepaid Assets:

A prepaid asset is created when you pay for something in advance. Prepaids are considered assets, because the balance represents an amount you can use as an expense in a later period.

Insurance premiums are a good example. You probably prepay for insurance coverage. That is, you pay your premiums before the period (month) of insurance coverage. When you pay the premium in advance, you debit prepaid insurance and credit (reduce) cash. As each month passes, you debt insurance expense and credit (reduce) prepaid insurance. Insurance is a period cost- an expense that is incurred with the passage of time.

Accrued Payroll:

You may pay for labor costs after you match those costs with revenue. In other words, the expense is posted before cash is paid for the expense.

We’ve all had jobs that run payroll on a particular day of the month (1^st or the 15^th). Other companies pay wages every two weeks- regardless of when those days fall in a given month. Assume that employees in your gift shop earn wages for the period from December 26^th to December 31^st of year one. You won’t pay payroll until January 5^th of year two. What journal entries do you make?

Well, you need to get that payroll expense into year one- when you incurred the expense. You paid employees for those last days in December, and you want to match the payroll expense with December sales for the shop. So, on December 31^st, you debit (increase) payroll expense and credit accrued payroll.

On January 5^th, you pay the payroll owed for the end of December. You debit (reduce) accrued payroll and credit (reduce) cash. The accrued payroll now has a balance of $0.

I’ll do more on accruals and deferrals later. In the meantime, here are two videos that might help:

http://www.youtube.com/watch?v=eIkfl6OKxYA

http://www.youtube.com/watch?v=wKOUzIrwMtw

Click here to attend the Toughest Accounting Topics reviews:

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Thanks!

Ken Boyd

St. Louis Test Preparation

(cell) (314) 913-6529

(email) ken@stltest.net

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