Key takeaways
- Post the prepaid and unearned entries first, then accruals, depreciation, bad debt and inventory.
- Reverse every accrual on the first day of the new year, or the same cost posts twice.
- Check the policy term before booking a prepaid, because the 12-month rule changes the tax answer.
- A cash-basis firm cannot deduct an invoice it never recorded as income as a bad debt.
- Check the receiving log before posting an inventory shrink entry.
Set up the adjustment pass
Save the unadjusted trial balance as a PDF before you post anything. It is the starting point, and it is the proof of what the adjustments changed. Post the entries in this order: prepaid expenses and unearned revenue, then accruals, depreciation, bad debt and inventory. Inventory goes last because the physical count is compared with the book balance only after purchases and sales are recorded.
Put the period end date on every entry and the support file name in the memo line, so a reviewer can open the document from the journal line.
Before you start, pull the source records: bills and card statements for the weeks around year-end, the prepaid schedule for insurance, rent and software, the fixed asset register, the receivables aging report, the payroll register for the last pay period, and the inventory count sheet.
Decision rule for a bill that straddles year-end: if the work was done before year-end, accrue the full bill. If the service period runs past year-end, accrue only the part performed by year-end. The examples below use round figures written without a dollar sign, so they are easy to tell apart from IRS amounts.
Accrued expenses and accrued revenue
Under the accrual method, an expense belongs in the year the liability is fixed and the amount can be determined with reasonable accuracy. The date on the invoice does not decide it. A contractor who finished work in the last week of the year and invoiced in the first week of the next year is a year-end expense.
Illustrative entry: Debit Contract labor 4,200; Credit Accrued liabilities 4,200. Support: the signed statement of work, the completion email and any timesheet. Reverse the accrual on the first day of the new year, then record the vendor bill normally when it arrives. Without the reversal, the same cost posts twice.
Accrued revenue works the other way. If the firm completed a job and has not billed it, debit Accounts receivable and credit Service revenue. The support is the time detail or a job completion report signed by the person who did the work. An unbilled balance with no support is the first thing a reviewer questions.
Accrued payroll works the same way: accrue wages earned after the last pay date, plus the employer payroll taxes on them. The year-end payroll checklist covers that side.
Prepaid expenses and unearned revenue
Illustrative prepaid entry: the client paid 12,000 on July 1 for a 12-month insurance policy starting that day. At a calendar year-end, six months have passed, so 6,000 is expense. Debit Insurance expense 6,000; Credit Prepaid insurance 6,000. The remaining 6,000 stays on the balance sheet until the policy runs out.
Check the policy term before you book the prepaid, because the tax answer depends on it. The IRS says an expense paid in advance is deductible only in the year to which it applies, unless the 12-month rule applies. Under that rule, a benefit that does not extend beyond the earlier of 12 months after it begins or the end of the following tax year need not be capitalized. The 12,000 policy fits the rule, so the full amount can be deducted in the year paid, while the book entry still spreads it over six months. Track that difference on the tax workpaper.
Failure mode: a multi-year policy booked as a current expense. The IRS example is a $3,000 policy for 36 months starting July 1, 2021. It does not meet the 12-month rule, so the deduction spreads across four tax years: $500 in 2021, $1,000 in 2022, $1,000 in 2023 and $500 in 2024. The fix is a prepaid schedule for every policy, set up on the date it is paid.
Unearned revenue is the mirror image. Illustrative: a client prepays 6,000 for 12 months of bookkeeping, and two months of work is delivered by year-end. Debit Deferred revenue 1,000; Credit Service revenue 1,000, leaving 5,000 as a liability. For tax, advance payments follow section 451(c) and Regulations section 1.451-8, which offer full inclusion or a one-year deferral. Which one applies depends on whether the firm has an applicable financial statement, so confirm it with the preparer before booking the tax side.
Depreciation and the fixed asset register
Book depreciation and tax depreciation are different calculations. The book entry is the adjusting journal for the financial statements. Tax depreciation is claimed on Form 4562 under the MACRS recovery periods, and it does not have to match the book entry. Keep two columns in the register, one for book life and one for tax class, so the difference is visible every year.
The IRS instructions give these recovery periods: 7 yrs. for office furniture and equipment, 5 yrs. for automobiles, 27.5 yrs. for residential rental property and 39 yrs. for nonresidential real property. For tax year 2026, the Section 179 maximum is $2,560,000, and the dollar-for-dollar reduction starts once property placed in service exceeds $4,090,000. Publication 946 says the 100% special depreciation allowance applies to certain qualified property acquired after January 19, 2025, under P.L. 119-21.
Illustrative book entry: equipment costing 12,000 placed in service on July 1 with a five-year straight-line life. The annual expense is 2,400, so six months is 1,200 at a calendar year-end. Debit Depreciation expense 1,200; Credit Accumulated depreciation 1,200. Reconcile the register to the ledger every year. A disposed asset that is still in the register keeps generating depreciation.
De minimis safe harbor: a purchase of $2,500 or less per invoice or item can be expensed without an applicable financial statement, and the limit is $5,000 with one. The IRS says the election is made by attaching a statement titled "Section 1.263(a)-1(f) de minimis safe harbor election" to the timely filed original return, including extensions. It is annual, and the IRS says it is not a change in accounting method.
Support for each asset: the vendor invoice, the date it was first ready for use, the asset tag, and the mileage log for vehicles. Form 4562 reports how listed property such as cars is used for business.
Bad debt and the allowance
Under the allowance method, estimate the receivables you expect not to collect at year-end. Illustrative: receivables of 30,000 with 1,500 judged uncollectible. Debit Bad debt expense 1,500; Credit Allowance for doubtful accounts 1,500. When a specific invoice is written off, debit the allowance and credit Accounts receivable, which leaves net receivables unchanged.
The tax rule is narrower. The IRS says a business bad debt is deductible only if the amount was previously included in income or the taxpayer loaned out cash, and only in the year the debt becomes worthless. Business bad debts can be deducted in full or in part. A cash-basis firm that never recorded an unpaid invoice as income has no bad debt deduction for it, and a year-end reserve on the books does not reduce taxable income.
Decision rule: if the receivable is still owed and collectible, keep it on the aging with an allowance. If the client has a bankruptcy notice, a closed business or a returned payment, get it in writing and write off the specific invoice. Do not write off a balance the client still pays. Require a dated collection attempt and a reason in the file first.
Inventory and cost of goods sold
The IRS says you must value inventory at the beginning and end of each tax year to figure taxable income. Cost of goods sold equals beginning inventory plus purchases minus ending inventory. Illustrative: 40,000 plus 120,000 minus 35,000 equals 125,000 of cost of goods sold.
Count on the last day of the period and cut off purchases and shipments on both sides of year-end, using receiving reports and shipping documents. A purchase received before year-end belongs in the count if the goods are on hand.
Shrink entry: book inventory is 38,000 and the physical count is 35,000. Debit Cost of goods sold 3,000; Credit Inventory 3,000. Check the receiving log before posting a shrink entry this size, because a gap that large is more often a cutoff or receiving error than a loss.
Form 1125-A is the cost of goods sold schedule. The IRS says to complete and attach it when a deduction for cost of goods sold is reported, and it is filed with returns such as Form 1065 and Form 1120-S. Make sure the cost of goods sold on the adjusted trial balance matches the figure carried to that form.
Tie out, reverse and lock the period
Prepare the adjusted trial balance and compare each line to the prior year and to the monthly trend. Any line that moved past your threshold needs a one-sentence explanation tied to a journal number. The common failure modes are an accrual posted with no reversal, a prepaid amortized twice, depreciation still running on a disposed asset, a write-off with no collection file, and a count that was not cut off.
Ask the client for the support as one list, not an email thread. Send something like: "Please upload the invoice for each service you received in the last two weeks of the year that you have not yet paid, and the declaration page for every insurance policy with a term that runs past year-end." Usual's requests are built from pages, sections and fields, so each field can ask for one upload and the list is easy to check.