2.4: Adjusting Entries—Deferrals

Deferrals are adjusting entries that update a previous transaction. The first journal entry is a general one; the journal entry that updates an account in this original transaction is an adjusting entry made before preparing financialstatements. Deferrals are adjusting entries for items purchased in advance and used up in the future (deferred expenses) or when cash is received in advance and earned in the future (deferred revenue).

2.4.1 Deferred Revenue

Deferred revenues require adjusting entries. “Deferred” means “postponed into the future.” In this case a customer has paid you in advance for a service you will perform in the future. (Think of a gift card you issue to a customer.) When you receive the cash, you debit the Cash account. However, you cannot credit your revenue, or Fees Earned, account at that point because you have not yet earned the money. Instead you credit Unearned Fees, which is a liability account, to recognize that you owe the customer a certain dollar amount of service.

At the end of the month, you make an adjusting entry for the part of that pre- payment that you did earn because you did do some of the work for the customer during the month. At this time you debit Unearned Fees for the amount of service provided, which reduces what you owe the customer. The credit part of the adjusting entry is the revenue account, whose value is increased by the amount earned. Any remaining balance in the liability account is what you still owe and have left to earn in the future.

These are the two adjusting entries for deferred revenue we will cover.

Date	Account		Debit	Credit
6/30	Unearned Fees		100		▼ Unearned Fees is a liability account that is decreasing.
	Fees Earned			100	▲ Fees Earned is a revenue account that is increasing.
6/30	Unearned Rent		100		▼ Unearned Rent is a liability account that is decreasing.
	Rent Revenue			100	▲ Rent Revenue is a revenue account that is increasing.

Both transactions above for deferred revenue are essentially the same, so the discussion will cover only the first one. The difference is that a landlord who deals in rent may prefer to name the accounts to better suit the rental income business.

EXAMPLE

Here is a simple example to understand deferred revenue. Assume you are a hair stylist.

Customer A comes in and you cut her hair. She pays you $30 cash. This is similar to the first example discussed.

Customer B comes in and buys a gift card for $100 to give to her mother as a birthday present. At this point you have the cash but have not given any service in return. You owe the mother $100 worth of hair styling.

Customer B’s mother comes in at a later date and you cut and style her hair for $40. You don’t collect any cash since she gives you the gift card. You reduce what you owe her by $40 for the work performed that day - you have now earned that $40. You still owe her service, but now you only owe $60 instead of $100. This is a form of deferred revenue.

Unearned Fees - Deferred Revenue

When a customer pre-pays a company for a service that the company will perform in the future, the company experiences deferred revenue.

Fees are amounts that a company charges customers for performing services for them. A customer may pay the company immediately after the job is complete.

Method #1: A company completes a job for a customer and receives $600 cash.

The word “revenue” implies that the company has completed work for a customer. Fees Earned is an account that keeps track of sales to customers.

Date	Account		Debit	Credit
6/1	Cash		600		▲ Cash is an asset account that is increasing.
	Fees Earned			600	▼ Fees Earned is a revenue account that is increasing.

Here is the Fees Earned ledger where transaction above is posted. The $600 balance in the Fees Earned account will appear on the income statement at the end of the month.

Fees Earned

Date	Item	Debit	Credit	Debit	Credit
6/1			600		600

OR

Method #2: A customer prepays a company $1,000 for a job that the company will complete in the future.

If the customer pays in full before the company begins the job, the company records the receipt of cash as a liability since it now owes service in the future. The company cannot credit Fees Earned yet because it has not performed the work or earned the cash. New liability account: Unearned Fees.

Date	Account		Debit	Credit
6/1	Cash		1,000		▲ Cash is an asset account that is increasing.
	Unearned Fees			1,000	▲ Unearned Fees is a liability account that is increasing.

Here are the ledgers that relate to a prepayment for a service when the transaction above is posted.

Unearned Fees

Fees Earned

Date

Item

Debit

Credit

Debit

Credit

Date

Item

Debit

Credit

Debit

Credit

6/1

1,000

1,000

During the month the company may earn some, but not all, of the cash that was prepaid if it performs some of the work for the customer but does not yet complete the job entirely. The company will wait until the end of the month to account for what it has earned. Let’s assume it earned $600 of the $1,000 that was prepaid. If the company DOES NOT “catch up” and adjust for the amount it earned, it will show on the balance sheet that it has $1,000 of service still due to the customer at the end of the month when it actually has only $400 still owed. In addition, on the income statement it will show that it did not earn ANY of the prepaid amount when in fact the company earned $600 of it.

The adjusting entry for deferred revenue updates the Unearned Fees and Fees Earned balances so they are accurate at the end of the month. The adjusting entry is journalized and posted BEFORE financial statements are prepared so that the company’s income statement and balance sheet show the correct, up-to- date amounts.

ADJUSTING ENTRY

Date	Account		Debit	Credit
6/30	Unearned Fees		600		▼ Unearned Fees is a liability account that is decreasing.
	Fees Earned			600	▲ Fees Earned is a revenue account that is increasing.

Note

There are two ways this information can be worded, both resulting in the same adjusting entry above.

1. The company earned $600 of the amount the customer prepaid. (So $400 of service is owed.)
2. The amount of unearned fees at the end of the month is $400. (So $600 worth was earned.)

Here are the ledgers that relate to a prepayment for a service when the transaction above is posted.

Unearned Fees

Fees Earned

Date

Item

Debit

Credit

Debit

Credit

Date

Item

Debit

Credit

Debit

Credit

6/1

1,000

1,000

6/30

600

600

6/30

600

400

The adjusting entry transfers $600 from the “unearned category” into the “earned category.” The $600 will become part of the balance in the Fees Earned account on the income statement at the end of the month. The remaining $400 in the Unearned Fees account will appear on the balance sheet. This amount is still a liability to the company since it has not been earned yet.

Summary

You accepted cash in advance of doing a job during the month and initially recorded it as a liability. By the end of the month you earned some of this prepaid amount, so you reduced the value of this liability to reflect what you actually earned by the end of the month. What was earned became revenue. To do this, Unearned Fees was debited for the amount earned and Fees Earned was credited to increase revenue by the same amount. Any remaining balance in the Unearned Fees account is what you still owe in service in the future; it continues to be a liability until it is earned.

The adjusting entry ensures that the correct amount of revenue earned appears on the income statement, not as a liability on the balance sheet.

IMPORTANT: If this journal entry had been omitted, many errors on the financial statements would result.

1. The Fees Earned amount on the income statement would have been too low by $600.
2. Net Income on the income statement would have been too low (this revenue should have been included but was not).
3. The Unearned Fees amount on the balance sheet would have been too high ($1,000 instead of $400).
4. The total liabilities amount on the balance sheet would have been too high because Unearned Fees, one liability, was too high.
5. The total stockholders’ equity amount on the balance sheet would be too low because a net income that was too low amount would have been closed out to Retained Earnings.

2.4.2 Summary of Revenues

There are three points in time: past, present, and future. There are also only possible debit accounts when Fees Earned is credited, reflecting these different points in time. All three are possible ways business can be conducted.

PAST – Cash was received before the services are provided. Unearned Fees is debited when work is completed.

Date	Account		Debit	Credit
6/30	Unearned Fees		600		▼ Unearned Fees is a liability account that is decreasing.
	Fees Earned			600	▲ Fees Earned is a revenue account that is increasing.

PRESENT – Cash is received when the services are provided. Cash is debited when work is completed.

Date	Account		Debit	Credit
6/30	Cash		600		▲ Cash is an asset account that is increasing.
	Fees Earned			Fees Earned	▲ Fees Earned is a revenue account that is increasing.

FUTURE – Cash will be received after the services are provided. Accounts Receivable is debited when work is completed.

Date	Account		Debit	Credit
6/30	Accounts Receivable		600		▲ Accounts Receivable is an asset account that is increasing.
	Fees Earned			600	▲ Fees Earned is a revenue account that is increasing.

2.4.3 Adjusting Entries

There are two types of adjusting entries—deferrals and accruals. Deferrals may be either deferred expenses or deferred revenue. Accruals may be either accrued expenses or accrued revenue.