In accrual-based accounting, the matching principle says that revenues should be recognized in the same period as the expenses used to generate them. Accountants, however, typically book transactions based on the date a document was processed or generated, such as an invoice date. This does not always produce results that follow the matching principle, so adjusting entries are used to move revenues and expenses into the correct period for financial reporting purposes.
Accruals and Deferrals
Accruals are adjusting entries used to accelerate the recognition of an item. Assume a company pays payroll on the first of every month for the previous month’s work. It would need to accrue one month’s payroll expense at the end of the year. Although the expense is being paid on January 1, it was owed to the employees at the end of December. This entry would increase payroll expense on the income statement and increase accrued payroll liabilities on the balance sheet.
Deferrals are adjusting entries used to postpone the recognition of an item. For instance, a company receives a down payment in December for work to be completed in January. When the company is closing its books for December, it will defer the recognition of that revenue until it is earned. An entry would be made to reduce revenue on the income statement and increase deferred revenue, a current liability, on the balance sheet.
Impact on the Income Statement
The income statement is used to measure the flow of revenues and expenses over a period of time. Adjusting entries aim to match the recognition of revenues with the recognition of the expenses used to generate them. A company’s net income will increase when revenues are accrued or when expenses are deferred and decrease when revenues are deferred or when expenses are accrued.
Impact on the Balance Sheet
The balance sheet is a snapshot of a company’s financial position at a particular point. Correcting timing differences on the income statement will also correct the corresponding balance sheet items. For instance, if the company pays interest expense on January 15 that was due on December 31, the company would accrue interest expense on the income statement and interest payable on the balance sheet.
Impact on the Statement of Cash Flows
Adjusting entries will not impact a company’s statement of cash flows in a meaningful way. This is because the statement of cash flows is designed to demonstrate a company’s performance without accounting estimates and adjustments. The first item on the statement of cash flows is net income. Accruals and deferrals can increase or decrease net income, but they are also reversed through adjustments in the operating activities section on the statement of cash flows. So, the impact of adjusting entries on net income is reversed before "Net Cash Flows from Operating Activities,” the first important subtotal; it has no impact on the company's ending cash position.