Most organizations today employ the accrual accounting model. Accountants use accruals and deferrals to prepare journal entries and to properly recognize revenue and expenses according to the Generally Accepted Accounting Principles (GAAP.) Accruals and deferrals reflect the matching principle and the realization principle in accounting. The matching principle states that we must recognize expenses at the same time that we recognize related revenues. The realization principle states that the revenue should be recognized when the earning process is complete and there is a reasonable hope to collect the payment from the customer.
Deferrals or “prepayments” are transactions in which the cash flow precedes the time when the expense or revenue is recognized. Prepaid insurance, prepaid supplies and unearned revenue are examples of deferrals.
Accruals are transactions in which we recognize the expense or revenue before the money “changes hands.” Accrued rent, accrued salaries and accrued taxes are examples of accruals.
Accrued taxes are liability accounts which reflect the amount of taxes that must be paid in a certain period. It is the amount of taxes that the organization already owes, but has not paid yet.
Deferred taxes are asset accounts which will provide the economic benefit for the company in the future. Essentially, they are taxes that the organization paid ahead of time, but has not received the “bill” for yet.
Deferred taxes and accrued taxes are both accounts that need to be adjusted at the end of the period. This means that you need to make adjusting entries based on the accrual accounting principles.
Because prepaid expenses are assets, the adjusting entry is a debit to an expense and a credit to an asset. With accrued taxes the adjusting entry is a debit to an expense and a credit to a liability.
