Accrued and deferred expense and income accounts can be confusing, but they are necessary. Businesses can pay large expenses in one accounting period that might not have to be paid again for several accounting periods in the future. Reporting a large expense in one accounting period may give a false impression of the business's performance for that period, either understating or overstating income and expenses. Making adjustments to the accounting books to compensate for these concerns will eliminate this problem.
Identify any expenses that a business pays that cover more than one accounting period. Examples include insurance premiums and property taxes that cover more than one accounting period. These prepaid expenses are considered assets to the business because they have been paid, but have not yet been incurred. Do the same for any sales or other revenue that has been received but not yet earned, such as deposits on services to be performed later.
Create a prepaid account on the balance sheet for each prepaid expense. For example, name an account "Prepaid Insurance" to account for unused insurance premiums. Label a liability account "Deferred Income" to reflect any sales that have been paid for but not completed with delivery of the product or service.
Credit the cash account for the amount of money that you are paying for the expense. For example, if you are paying an annual business insurance bill for $1,200, credit the cash account $1,200 to reflect the reduction of the cash account. Make a corresponding debit entry to the prepaid insurance account to increase its value by the amount of the payment.
Post the correct entries to reflect depletion of the asset at the end of each accounting period. With the insurance payment in the example, in a business using a monthly accounting period, $100 is depleted, or used of the asset each month. Make a credit entry in the prepaid insurance account of $100 to reduce its balance, and make a corresponding debit entry into the insurance expense account for $100 to add the expense.
Account for deferred income the same way. If your business received a deposit of $1,000 for a service to be performed in the next accounting period, make a debit entry to the cash account to increase its value by the amount of cash received. Enter a credit to the liability account deferred income for the $1,000, increasing its value. In the next accounting period, when the sale is performed, enter a debit to the deferred Income account, and a credit to the sales account for the $1,000. The remaining amount paid at the time of service is entered into the cash and sales revenue accounts appropriately.
- IRS regulations require certain businesses to use the accrual method of accounting, such as any business carrying inventory. Be certain that you are using the correct method for your business.
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