At the end of the fiscal or accounting year, all but the smallest businesses adjust their accounts for accrued and prepaid revenues and expenses. This is a requirement of generally accepted accounting principles, or GAAP, because it provides a more accurate representation of the company's financial situation than a cash-based accounting system. Matching, reverse adjustments are required at the beginning of the new financial year to ensure accruals are accounted-for correctly.
Under the accrual accounting method, a company recognizes revenues in the period in which they are earned and matches them with the expenditure incurred to produce them. For example, work done in the last few days of the financial year may not be invoiced until the following month, and bills for utilities are usually received quarterly in arrears. Under the accrual method, the value of the work done would be included in the year it was earned and an adjustment for utilities not yet billed would be added to the expenditure for the year. This contrasts with the cash accounting method, which records income and expenditure only at the time they are paid. Cash-basis accounting is suitable only for very small businesses.
At the end of the accounting year, the business posts adjustments for revenue and expense items that have been earned or incurred in the year but not yet entered into the records. The adjustments are made by journal entries to the general ledger, and the subsidiary sales and purchase ledgers are not affected. The business also makes postings to account for prepaid expenses or revenues. Adjusting entries always involve an expense or revenue account and a balance sheet account.
Unrecorded expenses may include accrued salaries, interest, rent and utilities. After calculating or estimating the amounts incurred during the year, the business posts a debit to the expense account and the balancing credit to the accruals account. For example, if the telephone bill covers the period December to February and the company's year end is Dec. 31, the company will debit an estimate of one month's telephone usage to the telephone account in the general ledger and credit it to the accruals account. Similarly, the business credits accrued revenues such as client hours not yet billed to the revenue account and debits to the accounts receivable account.
During the following period, the company will record the actual revenues and expenses it accrued in the previous year. To avoid double-accounting for them, the year-end adjustments are reversed at the beginning of the new period. The company reverses accrued expenses by crediting the expense account and debiting the accruals account; for accrued revenues, the company debits the revenue account and credits accounts receivable.