The basics of period matching adjustments
If you already understand the accounting principles behind adjustments, skip ahead to learn how to make adjustments in Wave.
Why make adjustments?
An adjustment is a journal transaction or entry that brings your account balance up to date. Adjustments rely on two basic, fundamental accounting concepts: accounting periods and the matching principle.
What are accounting periods?
In bookkeeping, just like with the calendar year, we break up the life of a business into segments so that we can simplify its complexity, and understand its progression.
An accounting period is an arbitrary period of time that divides the life of your business so that you can better understand your finances and notice any patterns.
A period can be a year, a quarter, a month, or really any duration that fits your business or helps you get a deeper understanding of your financial data.
The most commonly used accounting period is the fiscal year—and that's why we're here. At the end of a fiscal year, you'll "close the books" so that you can review what happened throughout that period, but also to break out that period's accounting data and send it off to the tax authority.
The duration of accounting periods might be arbitrary, but there are only three kinds of periods you need to remember: this period, last period, and next period.
What is the matching principle?
Your business is an entity that consumes things (goods and services), converts them into value, and turns that value into revenue.
You'll get the most accurate picture of how your business is performing when you can match expenses to the revenue that they helped generate. This concept is known as the matching principle.
Period matching adjustments, and why you should make them
Remember that accounting periods are arbitrary, and they don't necessarily reflect what's going on in the real life of your business.
Just because a fiscal year ends doesn't mean your business stops and starts over at the beginning of a new year— in fact, quite the opposite. Your business will continue doing what you do best, providing goods or services to your customers, and making sales.
If that's not making sense, think about it this way. If you spent the last 6 months of the year training for a marathon that you were going to run on January 2nd, it wouldn't make sense to attribute all 6 months of training to the first two days of January, just because that's when you finally saw the results (and ran that marathon).
In the same way, if you purchased raw materials in November, built a chair, and sold it on January 2nd, it wouldn't make sense to assume that all of the costs and the labour behind the sale happened in the first two days of January, just because that's when you saw the results (and made that sale).
Common adjustments and how to make them in Wave:
Work in progress
If you're working on a project for a customer that won't be completed before your fiscal year-end, you'll need to recognize the income for that project as un-invoiced income, which is sometimes called "work in progress."
Don’t record speculative work (work you've done without a firm and reliable customer agreement) as income. Un-invoiced income should only be recorded for confirmed customer orders or projects where you know the sale will be completed.
In the case of the unfinished project, you won't be ready to send your customer the invoice and collect payment until your new fiscal year—but you still want to recognize that the income from the project was earned in the current fiscal year when you did the work.
If you have any projects like this, there are three simple steps to perform a year-end period matching adjustment to ensure that that work is reflected in Wave.
- Review partially completed orders and customer projects to determine the percentage of work that has been completed, and the value of that work. For example, if you have two projects that are both half complete, and one project is worth $2,000 and the other $1,000, you've earned $1500 total from those projects in the current fiscal year. To account for this, add an “un-invoiced income” asset account on the Chart of Accounts page.
- On the transactions page, post an adjusting journal entry to capture the un-invoiced income. Debit the "un-invoiced income" account and credit the relevant income category for the projects (i.e. Sales) by the same amount.
- Next year, when you invoice your customer and collect your income, create a journal transaction to reverse the period matching entry you made before year-end. Essentially, you're posting the same journal transaction, but in the opposite direction. Debit the income category you used last time, and credit the "un-invoiced income" account—the opposite of what you did before. And you're balanced!
The same way you might have un-invoiced income, you may have expenses that you've incurred, but haven't been billed for yet, like your phone or credit card bills. You'll want to recognize that your business incurred expenses in this period and reflect that in Wave.
Create a bill for that vendor and date it for the date you incurred the expense. Once you receive and pay the bill in the new fiscal year, mark the bill as paid.
Sometimes customers pay you before work is completed. These payments can be classified as prepayments or deposits, and are sometimes referred to simply as "unearned income."
For your books to be accurate, you need to record the obligation that you have to your customer to fulfill the work. That means recognizing the unearned income as a liability until you’ve fulfilled your obligation to complete the work.
Create an Unearned Income liability account in your Chart of Accounts. You may prefer to call it Customer prepayment—either is fine!
Record an adjusting journal entry. Credit the Unearned Income liability account, increasing your liability, and debit the income account you'd normally use for this sale.
Once you fulfil the obligation to your customer by completing the work, create a journal transaction to reverse the period matching entry you made before year-end. Credit the income account you used, and debit the Unearned Income account.
What if you pay vendors this year for expenses that haven’t yet been incurred? Maybe you pre-pay your rent by the quarter or pay your phone bill at the beginning of each month. Until those expenses are actually incurred, you need to recognize those amounts as an asset to the business.
Create an asset account called prepaid expenses, or vendor prepayment if you prefer.
Post an adjusting journal entry to recognize the prepayment by debiting the prepaid expenses account, and crediting the expense account where you would normally categorize the bill.
Once you enter your next fiscal year and the expenses are incurred, post a second journal transaction in the opposite direction.
If your business has a bank loan or line of credit, your lender will have assigned part of each payment to interest and part to reducing the outstanding loan balance (the ”principal”).
The split between interest and principal repayment changes with every payment, and it’s rarely easy or convenient to record the split every time you make a loan payment.
At year-end, you'll need to make an adjustment to ensure the total interest you've recorded for the year is correct, and the amount outstanding on your balance sheet reflects the actual amount of principle your business still owes.
At the end of the year, your lender should send you a statement of payments made throughout the year, showing how much of each payment was interest, and how much was applied to the principal. If you don’t already have this statement handy, ask your bank to provide one.
Once you have that statement, you’ll know exactly how much of your loan repayments represented capital, and how much interest.
The most common error with loan repayment transactions is classifying the entire payment as repayment of the principal. If your situation is different, check out page 102 of Fearless Accounting.
If you haven't been tracking your interest payments separately throughout the year, the easiest way to make this adjustment in Wave is with a journal entry.
Make sure you have an "Interest" expense account specific to this loan (this makes life easier if you have multiple loans or lines of credit).
Post a journal entry debiting the interest expense account by the amount of interest you paid this year, and crediting the loan account by the same amount.
This is an easy mistake to make, but it's also an easy mistake to fix!
If you haven't been recording inventory in a consistent way, on a regular basis, you may find that there’s a discrepancy between your actual inventory and what’s listed on your balance sheet in Wave.
At the end of the year, take a careful, physical count of your inventory, and make sure that everything matches. If it doesn’t, you’ll need to make an adjustment.
First, take a physical count of your inventory so you know exactly where you stand. If you find you have more inventory than what's been accounted for against sales, create a journal entry that debits your Cost Of Goods Sold account, and credits your inventory account.
If you have more inventory recorded in Wave than you actually purchased, your journal entry will be the opposite, crediting CoGS and debiting your inventory account.
Other common adjustments you may want to make, depending on your business:
- Write off bad debt. If a customer hasn't paid their invoice, and you don't think that they will, you need to write off their debt to balance your books.
- Record depreciation entries. If you purchased an expensive asset, like a car, you'll want to record the amount it depreciated this year.
- Accounting for the business use of your home or vehicle. If you have a room in your home that you exclusively use as a business office, or if you sometimes use your personal vehicle for business, you'll want to account for these expenses.