Editor's Note: December is "Managing Your Year-end Month'" at Insightful Accountant, which includes a series of features to help you prepare for year-end. Look for both payroll and non-payroll topics. This feature examines common year-end adjustments.
Several common year-end adjustments must be made to the Balance Sheet and Profit & Loss statement when a business uses the full "accrual basis" of accounting. These adjustments typically are made by journal entries to ensure that year-end reports accurately reflect the business’ accounts.
The types of year-end adjustments commonly made include accruals, deferrals and non-cash expenses.
Accrual adjustments include accrued revenues and accrued expenses
Accrued revenues are those that have been recognized by the business, but which have not yet been invoiced to the customer. So let’s get really specific here with an example that will be meaningful to most of our readers. If you're an accountant and you and your staff have worked long hours preparing a client’s financial statements or tax return, but you haven’t invoiced them for the work done (even though you have a record of all that work), that’s accrued revenue.
Many small accounting systems do not consider "sales orders" as posting transactions; therefore, they do not record the value of sales orders to your books. But if your business operates on an accrual basis, you and your accountant may recognize these unrecognized revenues as accrued revenues by posting adjusting entries that debit accounts receivable (or an accrued revenues asset account) on the balance sheet, and credit the appropriate income account on the income statement.
Accrued expenses are expenses a business has incurred, but for which it has not yet been invoiced by the vendor. For example, many small accounting systems do not consider "purchase orders" as posting transactions until they're received.
Still, you and your accountant may recognize these accrued expenses by posting adjusting entries that debit the appropriate expense account on the income statement and credit the accounts payable account (or an accrued expense liability account) on the balance sheet.
Deferral adjustments include deferred revenues and prepaid expenses
Deferred revenues are from a customer for products or services the customer has yet to receive, such as yearly memberships or subscriptions. Again, if we want to tie an example back to our own profession, we could use the one about an accountant who receives a prepayment for 12-months of financial statements he will "compile" over the next year.
Revenues like this should be recorded as a liability in an unearned revenues account on the balance sheet when received since the business has not earned them. Then, over time, these deferred revenues are adjusted to reflect that they have been earned by debiting unearned revenues and crediting the appropriate revenue account on the income statement.
When a business makes an expense that benefits more than one accounting period—such as paying insurance premiums—they must be recognized as prepaid expenses. Initially, these prepayments should be recorded on the balance sheet as an asset in a prepaid expense account.
Then, over time, they are expensed by use of journal entries that debit the appropriate expense account on the income statement (such as insurance expense, in our example), and credit the prepaid expense (asset) account on the balance sheet.
Non-cash Expenses
Non-cash expenses represent depreciation and similar adjusting entries. Depreciation is different than other adjusting entries in that you must consider the long-term aspects of this account reflected in the accumulated depreciation of each tangible asset over the lifetime of the asset. While we depreciate assets, the accumulation of depreciation occurs in a contra-asset account.
Appropriately done, depreciation should begin the moment an asset is acquired. Still, from a practical standpoint, it is computed monthly, starting with the first month after acquiring an asset. In reality, many businesses only post depreciation on a quarterly, semi-annual or annual basis depending on the frequency they produce financial statements.
Amortization essentially is identical in theory, but applies to intangible assets. It is the practice of writing down the value of intangible assets over the useful life of those assets. Amortization expense appears on the income statement, and accumulated amortization is the contra-asset account appearing on the balance sheet for the corresponding intangible asset.
It should be noted that both depreciation and amortization can have significantly different posting values between a company’s book value and reported income tax (amount reported on the return) value based on the methods of computation elected for book and tax reporting purposes.