Adjusting Entries for Deferrals

From previous article you learned about Definition, Types & Example of Adjusting Entries. Today’s topic is on Adjusting Entries for Deferrals. Prepaid expenses and unearned revenues are the example of deferrals. Generally prepaid means which is paid before and prepaid expense means the expense which is paid in advanced.

Unearned revenue is received of cash in advance before having the benefit. Deferrals of prepaid expense and unearned revenues are appeared in the adjusting entries to show the amount of incurred expense and earned revenue in the current accounting period.

So how the prepaid expenses are included in the adjusting column in the accounting will be discussed by using some example of prepaid expense.

Prepaid Expenses: Prepaid expense means the expense which is paid before the expense is incurred. Prepaid expense consists or includes the assets that will be finished or definitely consumed in the near future. Prepaid expenses are recorded in the adjusting entries which are prepared by the respective company because it will affect or bring profit in more than one accounting period. Whenever expense is prepaid it is considered as an asset because prepaid expense brings future benefit.

Prepaid rent and prepaid insurance are the most common examples of prepaid expense. Prepaid advertising and prepaid supplies are also examples of prepaid expense. All expenses are not prepaid because the payment of salary expense and utility expense are not paid before. When any company purchases any assets then they make prepayments.

 

Example: Adjusting Entries for Deferrals

Prepaid Rent: Rent is usually paid in advance. This transaction of prepayment is an asset for the tenant because it has a future benefit. For example, the independent real estate company makes a prepayment for 5 months on February 1, 2009 for a lease for official purpose. It will run out 5000 USD per month.

Prepaid rent is debited because it is an asset. The adjusting entry for the prepaid rent is as follows:

February-1:
Prepaid Rent……………………………….. 25,000
Cash…………………………………………………25,000
[(500 x 5) Advance payment of 5 months for rent]

After posting prepaid rent is as follows:

Assets
Prepaid Rent

Feb.1                                     25000

The debit balance of prepaid rent is running out at beginning period. However, at the end of the period the trial balance will not have a balance of 25000. At the end of the month the used amount will appear, the amount, which has been actually used or expired that, is expense. The used 1/5 of the total balance is transferred from prepaid rent account to rent expense. The debit side increases by rent expense and credit side decreases the asset by posting pre-paid rent.

February-28:
Rent expense……………………………….. 5,000
Prepaid rent…………………………………5,000
(To record rent expense 25000×1/5)

                Assets
Prepaid Rent

Feb   1          25000 Feb. 28           5000
Balance     20000

Expense
Rent Expense:

Feb.    28         5000
Balance         5000

Following the matching principle, out of the total amount of 25000, 4/5th is counted for asset and 1/5th is counted for expense.

Prepaid insurance:

Insurance is a system to protect the purchaser from any unpredictable event. Insurance must be paid before expense is incurred. Insurance premiums increase the debit column and decrease the credit column. Suppose the independent real estate company paid 1200 $ for a one year theft insurance policy. This transaction began on 1 November. Prepaid insurance increases the credit column of independent real estate account. If it is monthly expire or monthly calculated then at the end of November the account has an amount of $ 100 (1200/12). The adjusting entry for prepaid insurance:

NOV 31   Insurance Expense…………………100
Prepaid insurance……………100
(To record insurance expired)
After posing the adjustment entry the account of independent real estate appeared as follows:
Prepaid Insurance

November. 1                         1200 Nov31           Adj           100
November 31      Balance   1100

Insurance Expense

November. 31       Adj           100

As the prepaid insurance increases the debit column so it is an asset. After posting the entry the account represents a balance of $ 1100.

Supplies:

Supplies have the same effect as prepaid expense. On February 3, the Independent Real Estate company paid $ 900 in advance for office supplies. However, at the end of the month it has been identified that $ 600 has unexpired. So at the end of the month the cost of supplies will be $ 300 and $ 600 is an asset. The adjusted entry will be:

Feb 28 Office supplies expense……………………300
Supplies…………………………………300
(To record service used)

After posting the adjusting entry the account of independent real estate appeared as follows:

Office Supplies

February 3                                 900 February   28     Adj         300
February        28   Balance      600

Office Supplies Expense

February    28         Adj           300

The office supplies account will represent the balance of 600 which is the equal of the amount of supply on hand and the office supplies expense account will represent the balance of $300 which is equal to the amount of the cost of the supplies.

Unearned Revenue:

Unearned revenue referred to the concept that cash received in advance before revenue is earned. Rent, magazines, subscriptions, customer deposits for future service are the some examples of unearned revenues. Unearned revenue is a liability because cash received in advance and as it is a liability so earned revenue increases the credit column and decreases the debit column.

Though both unearned revenue and pre-paid expense deal with prepayments but those are just opposite from each other. Prepaid expense increases the debit side and unearned revenue increase the credit side. Example:  Independent Real Estate company received 5000$ on November 5 from ABC company for providing the equipment service which is expected to be completed within December 31.this amount will be reported in the account of unearned revenue as credit entry. On November 31 the trial balance of Independent Real Estate company will represents the balance of 5000.But during the month of November company receive service revenue 1000$ out of the total amount. The adjusting entry for this cash received transaction:

NOV 31 Unearned revenue……………………..1000
Service revenue……………………1000
(To record revenue for service provided)

After posting the adjusting entry the account of independent real estate company is appeared as follows:

Unearned Revenue

NOV31Adj                          1000 November       5             5000
  November    31   Bal     4000  

Service Revenue

November    31    Bal 14000
November    31   Adj     1000

Here the unearned revenue is a liability with a balance amount of $4000 which refers the remaining prepaid office service to be completed in the future. And the account of service revenue represent total amount of revenue 15000 which is earned in November.