Before end-of-period financial reports are prepared, adjustments to prepaid and accrued accounts are made. This process helps provide a true indication of where the company stands financially and it matches income and expenses to the period they effect. There are several types of accounts that require adjustments:
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Prepaid Expenses - items or services that are paid for up-front. They are classified as assets when purchased.
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Unearned Revenues - revenues received before they are earned. They are classified as liabilities when cash is received.
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Accrued Revenues - revenues that have been earned but cash has not yet been received and no transaction has been recorded.
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Accrued Expenses - expenses that have been incurred but not paid for yet and no transaction has been recorded.
Each of these adjustment types is described below along with examples and sample journal entries.
Prepaid Expenses
When an expense is prepaid (for example - prepayment of a 6-month insurance policy for $1,200) an asset is created. Think of it this way; the company is due something of value - the insurance coverage for a 6-month period in the future. To simply expense the $1,200 at the time cash is spent would inaccurately allocate the full amount to that period. Instead, accountants create a Prepaid Insurance account and subtract from it, each month, the amount that should be allocated to it ($1,200 ÷ 6 = $200). The first example entry below journalizes the prepayment of the 6-month policy; the second is the adjusting entry for the end of the first month.
| General Journal | Page: 1 | ||||
| Date | Account Titles/Explanation | Ref | Debit | Credit | |
| 20XX | 1 | Prepaid insurance Cash Paid insurance in advance | 1200.00 | | |
| 31 | Insurance expense Prepaid insurance To record insurance expense. | 200.00 | 200.00 | ||
After posting these transactions, the Prepaid Insurance account will have a balance of $1,000. At the end of each of the next 5 months an adjustment similar to the one above would be made. After the June 30th entry, the Prepaid Insurance account would have a zero balance and Insurance Expense would have a $1,200 balance.
Unearned Revenues
When revenue is received in advance (for example, receipt of a 6-month cleaning service fee of $600 up-front) a liability is created -- the company owes something of value (cleaning services) to another. If the $600 were posted directly to revenue on the date it was received, it would incorrectly allocate the entire revenue to one month rather than spread it over 6 months, when it is actually earned. The example entries below record receipt of the fee (which creates the liability) and the adjustment at the end of the first month to record the revenue earned during January ($600 ÷ 6 = $100).
| General Journal | Page: 1 | ||||
| Date | Account Titles/Explanation | Ref | Debit | Credit | |
| 20XX | 1 | Cash Unearned revenue Received revenue in advance | 600.00 | | |
| 31 | Unearned revenue Service revenue To record revenue for services completed | 100.00 | 100.00 | ||
At the end of each of the next 5 months, an adjustment similar to the one above would be made. After the June 30th entry, the revenue collected in advance would be correctly allocated to each of the months it was earned.
Accrued Revenues
When revenue has been earned but cash has not yet been received, accountants make an accrual adjusting entry. If an advertising company charges $1,500 for a month's services payable at the end of 30 days and begins working in the middle of the month (i.e. Jan. 15 - Feb. 15), an entry must be made at the end of January to record the revenue earned during the period ($1,500 ÷ 2 = $750) as follows:
| General Journal | Page: 1 | ||||
| Date | Account Titles/Explanation | Ref | Debit | Credit | |
| 20XX | 31 | Accounts receivable Service revenue Paid insurance in advance | 750.00 | | |
In February, when the customer makes payment of $1,500, Cash is debited $1,500, Accounts Receivable is credited $750 and Service Revenue is credited $750.
Accrued Expenses
Expenses are often incurred in one month or period and paid for in another. Examples include interest, rent, and salaries. Consider an employee who is paid $2,400 on February 5th for the work he/she completed in January. In order to reflect the expense in the correct month, an adjustment must be made at the end January.
| General Journal | Page: 1 | ||||
| Date | Account Titles/Explanation | Ref | Debit | Credit | |
| 20XX | 31 | Salary expense Salary payable To accrue salary expense | 2400.00 | | |
On February 5th, when the employee is paid, Salary Payable is debited $2,400 and Cash is credited $2,400.
