Prepaid Expense (Deferred Expense)
We are going to talk about adjusting entries. Specifically in this segment we’ll talk about two adjusting entry situations, prepaid and supplies. So let’s get right into the material by asking the obvious question what is an adjusting entry. And adjusting entry is merely a journal entry that is made at the end of the month.
In order to adjust certain accounts now why do we need to adjust certain accounts? Because somethings may transpired during a month or it would just be simply because of the passage of time as we’ll demonstrate with the insurance prepaid insurance situation.
So let’s look at the example involving prepaid as a first adjusting entry situation. So what is a prepaid? A prepaid is nothing but making a payment in advance. So in this example on January 1st we made a payment of $3,000 in advance for three months. So January first payment of $3,000 was made for the months of January, February and March.
So the journal entry to record this transaction would be a debit to prepaid insurance and credit to cash. Now what kind of an account is prepaid insurance? All prepaid including prepaid insurance our assets account. Why assets? you may recall from an earlier discussion that an asset is something that you own. So in this example when the company pays money in advance for insurance.
The company owns the right to receive insurance coverage from the insurance carrier. So if this were to be health insurance for the employees then if the employees got ill during the next three months, the employees would go and get medical treatment either for a reduced fee or absolutely free of charge depending on the type of insurance coverage they have.
So the employer has purchased some peace of mind and player owns peace of mind in this case. Now let’s fast-forward to the end of the month on January 31st. Now this is where the adjusting entry comes into play. So let’s ask ourselves what are we making the adjusting entry for what is the reason.
During a month as a result of a month having elapsed the employer has used up one month of those three months of insurance coverage.
So adjusting entry that we have to make will reflect the usage of one month of insurance that’s your insurance expense. And at the same time simultaneously the process of using up a month of insurance reduces our prepaid insurance by one month. That’s why the two accounts affected and your adjusting entry would be insurance expense and prepaid insurance. We debit insurance expense for $1,000 and we credit prepaid insurance for $1,000.
Remember when you credit prepaid insurance you’re crediting an asset account that means you’re reducing your prepaid insurance by $1,000. Now let me give you another analogy to further help reinforce this concept of prepaid and adjusting entry.
Assume that you have a bucket of water and then you took a cup and you put the cup into the bucket and took out one cup of water and then you washed your hands. Let’s talk an example in this action. you have used up one cup of water to wash your hands haven’t you.
But what was the effect of taking the one cup of water on the level of water in the bucket? The level of water in the bucket dropped down by one cup. So two things happen simultaneously. You used up one cup of water to wash your hands and at the same time the level of water in your bucket dropped and that’s exactly what happens with prepaid insurance and your insurance expense in terms of the adjusting entry.
Now if you’ll notice I have on top an extra prepaid the words, differ expenses. Prepaid is an example of a deferred expense. Why?
What is the word differed mean to you? Deferred means postponed to a later period. So in this case what has happened is when first acquired that insurance coverage in advance. You recorded it as an asset.
And then a month later with a passage of time what has happened is that asset has become into an expense in small parts. So you have you acquired a $3,000 asset and one month later 1,000 of the $3,000 of an asset has become an expense. So this is why we call it a deferred expense in other words when you first spend the $3,000 cash at beginning of the month you did not record all 3,000 as an expense. You recorded it as an asset prepaid insurance.
And then you deferred the recognition of that asset into an expense with the passage of time and at the end of February a month later you would make the same adjusting entry debit insurance expense and credit prepaid insurance for another 1,000 for the same reason that we did it on January 31st. So you make that entry January 31st the adjusting entry for 1,000 you make the same entry on February 28 which is debit insurance expense and credit prepaid insurance for another 1.000 and then again you repeat the same entry debit insurance expense, credit prepaid insurance for the remaining 1,000 at the end of March.
So every month for the next three months you are making the same adjusting entry and at the end of each month your prepaid insurance balance is going down successively by 1,000. So on January 1st your prepaid insurance balance was 3,000, because we just acquired $3,000 of insurance coverage. At the end of January 31st your prepaid insurance balance was that’s right 2,000.
Okay, at the end of February 28 your insurance balance going down to 1,000. And at the end of March 31st your prepaid insurance balance was down to zero. And yes this makes sense because now as of the end of March you have used up all of the three month of prepaid insurance.
And what do you think happens on April 1st? That’s right you guessed it you start the whole process again by writing out a check on April 1st for the next three months April, May and June. And you repeat the cycle again and that’s why my friend we accountants will always have a job to do the same things in a repetitive fashion and humming a little facetious you get the point about the repetition cycle here.
Now another point we’ll ask ourselves is what if you forgot make this entry? You forgot to make this adjusting entry at the end of January. What would be the effect on the financial statements? If a question like this comes about what I would suggest in an exam situation is write out the entry first and then it’s earlier to answer the question as to what would happen if you did not make the entry if you wrote it out so you can look at it.
So to answer the question if you did not make this adjusting entry, let’s say at the end of January, what’s going to happen your insurance expense will be understated?
So anytime you have expense that’s understated your net income will be overstated, and your net income gets closed out into retain earnings or into capital it is a proprietorship so your equity also gets overstated and at the same time your assets also are overstated isn’t it?
So this is three are the ramifications of omitting this adjusting entry. These are the ramifications on the financial statements to be more specific. Now the next question is other books still in balance because you did not meke this entry. Other books still in balance if you did not make this adjusting entry and the answer is a resounding yes your books will still be in balance. How well take a look at the accounting equation assets equals liabilities plus equity.
Based of what I just said a minutes ago your assets will be overstated if you don’t make this entry, so your left side is overstated. There was no effect on your liabilities no change there but your equity also will be overstated because of your net income being overstated as I mentioned again a minutes back. So your right side also is overstated. So both your left your assets and your right side your equity both are overstated by the same amount.
So you are your books off are incorrect but they’re still in balance and this is where you have to be careful in accounting where you can be in balance but you’re still wrong as this situation just demonstrates. So this concludes our discussion on prepaid, now having got that behind us let’s move the next situation in moving supplies.
This time we are talking about adjusting entries and involving supplies. Supplies is a deferred expense just as prepaid were a deferred expense for all the same reasons that I mentioned earlier in the discussion on prepaid as to why that’s a deferred expense. Supplies follows the same pattern for being a deferred expense.
So on January 1st we purchase $500 of supplies in paid cash. Again on January 1st we bought purchased $500 of supplies and paid cash. So debit supplies to increase our supplies account, credit cash to reduce our cash and that’s our journal entry. To record the initial purchase now let’s fast-forward to the end of the month. But in fast fall to the end of the month we take a physical count of how much supplies is left.
And when we take account we find out then we have $200 of supplies left on hand. Remember we’ve got 500 at beginning of the month, now we have 200 left. What does that mean? That means assuming that there was no theft and no spoilage, you used up $300 of supplies. So if you have used up 300 other supplies, we now need to make an adjusting entry on January 31st to show the the consumption the usage of $300 of supplies.
That’s your supplies expense account that would reflect the consumption. But in the process of using of the supplies what did that do to your supplies balance. Your supplies balance went down so therefore the second account that would be affected in your adjusting entry would be the supplies account. So your supplies account gets credited to reduce it the supplies expense account gets debited to increase it.
So your adjusting entry at the end of the month would be debit supplies expense for $300 and credit supplies for 300. Be carefull because 300 you’re making the entry for what was consumed not what was left behind. Remember we had $200 left behind but the consumption was 300. So the entry of making the adjusting into your making is to show how much supplies you used up $300.
Okey the next question that is what would be the effect on the financial statement. If you forgot to make this adjusting entry, if you get this question in the exam it would be helpful to write out the adjusting entry first. So when you write it out then it’s easier to answer it in terms of what would happen or what would be the effect on the financial statements if you did not make the entry.
So in this case if you did not if it did not make the entry what would happen is your supplies expense would be understated would go down. And as a result of that your net income would be overstated, your net income would increase and your net income gets close out into retained earnings or capital.
So your equity also will be overstated. At the same time your supplies asset also would be overstated. So this would be the effect on the financial statements. If you did not or if you omitted the adjusting entry for supplies.
The next question here is other books still in balance if you omitted this entry, and the answer is a resounding yes your books are going wrong but they will still be in balance. How can I say that well let’s look at the accounting equation, assets equal liabilities plus equity, and a minute ago I told you that if you did not make the entry your asset will be overstated.
So your left side is too high, there was no effect on your liabilities no change there. But your equity also will be overstated because as I just mentioned again your new income was going to be overstated and net income gets closed out into your equity accounts like retained earnings of capital. So assets always stated on the left side, equity is overstated on the right side, both by the same amounts. So you will still be in balance but again your accounts are all wrong in there.
And this again is a danger in accounting you could be lulled into a false sense of security, because you are in balance and you assume that everything is correct, but as I just demonstrated to you, you are balanced but your numbers are wrong or the account balance could be incorrect in there and so this basically will concludes our discussion on adjusting entries involving supplies.
Unearned Revenues (Deferred Revenue)
We’re going to talk about unearned revenues so let’s get into our transactions here on the board. On January 1st a CPA receives $2,000 of cash in advance of services to be provided. Again he has not provided service yet but he receives the money in advance from a customer.
So the entries of the CPA will make on his books or his own company books will debit cash to increase the cash because that’s how much is received and the offsetting account will be a liability account called unearned revenues. Please don’t confuse unearned revenues with earned revenues.
Unearned revenues is a liability account. Let’s examine why is it a liability account. When the CPA received $2,000 of cash in advance at that moment when he or she got the money, they owe the customer the service the work to be done or if they choose not to do the work they have to refund the money isn’t it.
So again CPA at the time he or she receives the money owes the customer the work or alternatively always the customer the money the key word is owe. So therefore the offsetting account of cash in this case would be a liability account called unearned revenue and CPA’s liability has just increased when you receive this cash.
Now let’s fast-forward to next month this was in January next month during on the February he finishes the work he start the work and finishes at all in February.
So if this is a case then at the end of February the CPA is required to make an adjusting entry. What is the purpose of this adjusting entry? The purpose of this adjusting entries are two for remember it’s double entry system, one reason for making the entry is to show that he now has earned this $2,000 that he had received last month and in the process of earning the $2,000, what happens to his liability? His unearned revenue liability that liability does not exist anymore.
Why? because once he has earned the money, he does not owe the money any longer to the client. So therefore the adjusting entry we’re going to make reflects these two things. What two things? we have to reduce the liability by $2,000 and we have to show earned revenue of $2,000.
So the accounts in this case the adjusting entry will be a debit to unearned revenue to reduce the liability get off your books in this case and to credit a revenue account called service revenue for 2,000.
Let’s assume that the CPA only did half the work in February, and the other half in March. If that was the case, he would make the same entry in February but only for $1,000. And at the end of March he would again repeat the same entry the remaining $1,000. So that would be the only variation to what I just showed you here on the board.
Now let’s now earlier I had noted up here that unearned revenue is an example of a deferred revenue. Let’s try to understand why we call this deferred revenue. As you may recall from earlier discussion, deferred means postpone to a future date isn’t it.
So when the CPA first received the cash at startup chat at the beginning of January, that cash was not recorded as a revenue, but that cash was recorded in the cash account and then the offset was a liability. And later in February when the CPA provided the services that initial liability then became a revenue.
So the revenue recognition was postponed to a later date. What later date? A later date when the CPA completed the work. This is why unearned revenue is an example of a deferred revenue.
So again the CPA did not recognize the revenues when he got the money when you receive the cash instead he recognized the $2,000 as revenues a month later when he completed the job.
Okey, question to ask ourselves then what if we did not make this adjusting entry. What is CPA omitted the adjusting entry what would be the effect on his financial statement.
As I’ve said before with other adjusting entries when you get a question like this it always helps to write out the adjusting entry anyway, because it’s easier to answer the question that I just posed when you’re looking at the adjusting entry.
So if you did not make this adjusting entry, then what would happen is and we have it listed here, you do not make this adjusting entry, your unearned revenue would be overstated at an arrow going up would be overstated.
Your service revenue would be understated, if your service revenue is understated, then your net income also is understated and as you may recall your net income gets closer into your equity account like retain earnings or capital.
So then your equity also would be understated. Well in conjunction with that the next question we want to ask ourselves is are our books in balance if we don’t make this entry. And I think by now after listening to my earlier segments you should know the answer and yes the books will still be in balance even though we may not make this adjusting entry.
How so here’s a proof again for that this is the accounting equation assets equals liabilities plus equity. So if you don’t make this entry, no effect on your asset. So no change say but on this side your liability gets overstated and your equity gets understated both by the same amounts.
So each family offsets the other, so there is so the net the cumulative effect of these two would be zero. So no change the right side, no change on the left side, so yes your books will still be in balance, your account total will be wrong but you’ll still be in balance and as I’ve cautioned you before, this is one of dangers of accounting where your books may be in balance but you are still wrong your accounts are so wrong.
So that concludes our discussion on unearned revenue I hope you have a better appreciation of this concept and the adjusting entry that is associated with unearned revenues.