2.3: 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.
- Deferred expenses
- Deferred revenue
- Accrued expenses
- Accrued revenue
2.3.1 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 financial statements.
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).
Deferred Expenses
Deferred expenses require adjusting entries. “Deferred” means “postponed into the future.” In this case you have purchased something in “bulk” that will last you longer than one month, such as supplies, insurance, rent, or equipment. Rather than recording the item as an expense when you purchase it, you record it as an asset (something of value to the business) since you will not use it all up within a month. At the end of the month, you make an adjusting entry for the part that you did use up—this is an expense, and you debit the appropriate expense account. The credit part of the adjusting entry is the asset account, whose value is reduced by the amount used up. Any remaining balance in the asset account is what you still have left to use up into the future.
These are the five adjusting entries for deferred expenses we will cover.
| Date | Account | Debit | Credit | ▲ Supplies Expense is an expense account that is increasing . | |
| 6/30 | Supplies Expense | 100 | ▼ Supplies is an asset account that is decreasing . | ||
| Supplies | 100 | ||||
| 6/30 | Insurance Expense | 100 | ▲ Insurance Expense is an expense account that is increasing . | ||
| Prepaid Insurance | 100 | ▼ Prepaid Insurance is an asset account that is decreasing . | |||
| 6/30 | Rent Expense | 100 | ▲ Rent Expense is an expense account that is increasing . | ||
| Prepaid Rent | 100 | ▼ Prepaid Rent is an asset account that is decreasing . | |||
| 6/30 | Taxes Expense | 100 | ▲ Taxes Expense is an expense account that is increasing . | ||
| Prepaid Taxes | 100 | ▼ Prepaid Taxes is an asset account that is decreasing . | |||
| 6/30 | Depreciation Expense | 100 | ▲ Depreciation Expense is an expense account that is increasing . | ||
| Accumulated Depreciation | 100 | ▲ Accumulated Depreciation is a contra asset account that is increasing . |
These will now each be explained in more detail.
Supplies - Deferred Expense
Supplies are relatively inexpensive operating items used to run your business. There are two ways to record the purchase of supplies.
Method #1: A company purchases $100 worth of supplies that will be used up within one month.
| Date | Account | Debit | Credit | ||
| 6/1 | Supplies Expense | 100 | ▲ Supplies Expense is an expense account that is increasing . | ||
| Cash | 100 | ▼ Cash is an asset account that is decreasing . |
The word “expense” implies that the supplies will be used within the month. An expense is a cost of doing business, and it cost $100 in supplies this month to run the business.
Here is the Supplies Expense ledger where transaction above is posted. The $100 balance in the Supplies Expense account will appear on the income statement at the end of the month.
| Date | Item | Debit | Credit | Debit | Credit |
| 6/1 | 100 | 100 | |||
Method #2: A company purchases $1,000 worth of supplies that will NOT be used up within one month.
If you buy more supplies than you will use in a month (because it is convenient, because you get a good price, etc.), you record the purchase as an asset instead of an expense. New asset account: Supplies
| Date | Account | Debit | Credit | ||
| 6/1 | Supplies | 1,000 | ▲ Supplies is an asset account that is increasing. | ||
| Cash | 1,000 | ▼ Cash is an asset account that is decreasing . |
Here are the ledgers that relate to the purchase of supplies when the transaction above is posted.
| Supplies | Supplies Expense | |||||||||||
| Date | Item | Debit | Credit | Debit | Credit | Date | Item | Debit | Credit | Debit | Credit | |
| 6/1 | 1,000 | 1,000 | ||||||||||
During the month you will use some of these supplies, but you will wait until the end of the month to account for what you have used.
Let’s assume you used $100 of the $1,000 of supplies you purchased on 6/1. If you DON’T “catch up” and adjust for the amount you used, you will show on your balance sheet that you have $1,000 worth of supplies at the end of the month when you actually have only $900 remaining. In addition, on your income statement you will show that you did not use ANY supplies to run the business during the month, when in fact you used $100 worth.
The adjusting entry for supplies updates the Supplies and Supplies Expense balances to reflect what you really have at the end of the month. The adjusting entry TRANSFERS $100 from Supplies to Supplies Expense . It is journalized and posted BEFORE financial statements are prepared so that the income statement and balance sheet show the correct, up-to-date amounts.
| Date | Account | Debit | Credit | ||
| 6/30 | Supplies Expense | 100 | ▲ Supplies Expense is an expense account that is increasing . | ||
| Supplies | 100 | ▼ Supplies is an asset account that is decreasing . |
NOTE: There are two ways this information can be worded, both resulting in the same adjusting entry above.
- The company USED $100 of supplies this month. (So $900 worth remains.)
- The company has $900 of supplies on hand at the end of the month. (So $100 worth was used.)
Here are the Supplies and Supplies Expense ledgers AFTER the adjusting entry has been posted.
| Supplies | Supplies Expense | |||||||||||
| Date | Item | Debit | Credit | Debit | Credit | Date | Item | Debit | Credit | Debit | Credit | |
| 6/1 | 1,000 | 1,000 | 6/30 | 100 | 100 | |||||||
| 6/30 | 100 | 900 |
The $100 balance in the Supplies Expense account will appear on the income statement at the end of the month. The remaining $900 in the Supplies account will appear on the balance sheet. This amount is still an asset to the company since it has not been used yet.
Summary
You had purchased supplies during the month and initially recorded them as an asset because they would last for more than one month. By the end of the month you used up some of these supplies, so you reduced the value of this asset to reflect what you actually had on hand at the end of the month ($900). What was used up ($100) became an expense, or cost of doing business, for the month. To transfer what was used, Supplies Expense was debited for the amount used and Supplies was credited to reduce the asset by the same amount. Any remaining balance in the Supplies account is what you have left to use in the future; it continues to be an asset since it is still available.
The adjusting entry ensures that the amount of supplies used appears as a business expense on the income statement, not as an asset on the balance sheet.
I MPORTANT: If this journal entry had been omitted, many errors on the financial statements would result.
- The Supplies Expense amount on the income statement would have been too low ($0 instead of $100).
- Net income on the income statement would have been too high ( Supplies Expense should have been deducted from revenues but was not).
- The Supplies amount on the balance sheet would have been too high ($1,000 instead of $900).
- The total assets amount on the balance sheet would have been too high because Supplies , one asset, was too high.
- The total stockholders’ equity amount on the balance sheet would be too high because a net income amount that was too high would have been closed out to Retained Earnings.
Prepaid Insurance - Deferred Expense
Insurance is protection from damages associated with the risks of running a business. There are two ways to record the purchase of insurance.
Method #1: A company purchases $100 worth of insurance that will be used up within one month.
| Date | Account | Debit | Credit | ||
| 6/1 | Insurance Expense | 100 | ▲ Insurance Expense is an expense account that is increasing . | ||
| Cash | 100 | ▼ Cash is an asset account that is decreasing . |
The word “expense” implies that the insurance will expire, or be used up, within the month. An expense is a cost of doing business, and it cost $100 in insurance this month to run the business.
Here is the Insurance Expense ledger where transaction above is posted. The $100 balance in the Insurance Expense account will appear on the income statement at the end of the month.
| Date | Item | Debit | Credit | Debit | Credit |
| 6/1 | 100 | 100 |
OR
Method #2: A company purchases $1,200 worth of insurance that will apply toward the upcoming year (12 months).
If you buy more insurance than you will use in a month (because it is convenient, because you get a good price, etc.), you record the purchase as an asset. New asset account: Prepaid Insurance
| Date | Account | Debit | Credit | ||
| 6/1 | Prepaid Insurance | 1,200 | ▲ Prepaid Insurance is an asset account that is increasing . | ||
| Cash | 1,200 | ▼ Cash is an asset account that is decreasing . |
Here are the ledgers that relate to the purchase of prepaid insurance when the transaction above is posted.
| Prepaid Insurance | Insurance Expense | |||||||||||
| Date | Item | Debit | Credit | Debit | Credit | Date | Item | Debit | Credit | Debit | Credit | |
| 6/1 | 1,200 | 1,200 | ||||||||||
During the month you will use some of this insurance, but you will wait until the end of the month to account for what has expired.
At the end of the month 1/12 of the prepaid insurance will be used up, and you must account for what has expired. After one month, $100 of the prepaid amount has expired, and you have only 11 months of prepaid insurance left. If you DON’T “catch up” and adjust for the amount you used, you will show on your balance sheet that you have $1,200 worth of prepaid insurance at the end of the month when you actually have only $1,100 remaining. In addition, on your income statement you will show that you did not use ANY insurance to run the business during the month, when in fact you used $100 worth.
The adjusting entry for insurance updates the Prepaid Insurance and Insurance Expense balances to reflect what you really have at the end of the month. The adjusting entry TRANSFERS $100 from Prepaid Insurance to Insurance Expense . It is journalized and posted BEFORE financial statements are prepared so that the income statement and balance sheet show the correct, up-to-date amounts
| Date | Account | Debit | Credit | ||
| 6/30 | Insurance Expense | 100 | ▲ Insurance Expense is an expense account that is increasing . | ||
| Prepaid Insurance | 100 | ▼ Prepaid Insurance is an asset account that is decreasing . |
- The amount of insurance expired (used) this month is $100. (So $1,100 worth remains.)
- The amount of unexpired insurance is $1,100. (So $100 worth was used.)
Here are the Prepaid Insurance and Insurance Expense ledgers AFTER the adjusting entry has been posted.
| Date | Item | Debit | Credit | Debit | Credit | Date | Item | Debit | Credit | Debit | Credit | |
| 6/1 | 1,200 | 1,200 | 6/30 | 100 | 100 | |||||||
| 6/30 | 100 | 1,100 | ||||||||||
The $100 balance in the Insurance Expense account will appear on the income statement at the end of the month. The remaining $1,100 in the Prepaid Insurance account will appear on the balance sheet. This amount is still an asset to the company since it has not expired yet.
The same adjusting entry above will be made at the end of the month for 12 months to bring the Prepaid Insurance amount down by $100 each month. Here is an example of the Prepaid Insurance account balance at the end of October.
| Date | Item | Debit | Credit | Debit | Credit |
| 6/1 | 1,200 | 1,200 | |||
| 6/30 | 100 | 1,100 | |||
| 7/31 | 100 | 1,000 | |||
| 8/31 | 100 | 900 | |||
| 9/30 | 100 | 800 | |||
| 10/31 | 100 | 700 | |||
After 12 full months, at the end of May in the year after the insurance was initially purchased, all of the prepaid insurance will have expired. If the company would still like to be covered by insurance, it will have to purchase more.
Summary
You prepaid a one-year insurance policy during the month and initially recorded it as an asset because it would last for more than one month. By the end of the month some of the insurance expired, so you reduced the value of this asset to reflect what you actually had on hand at the end of the month ($1,100). What was expired ($100) became an expense. To transfer what expired, Insurance Expense was debited for the amount used and Prepaid Insurance was credited to reduce the asset by the same amount. Any remaining balance in the Prepaid Insurance account is what you have left to use in the future; it continues to be an asset since it is still available.
The adjusting entry ensures that the amount of insurance expired appears as a business expense on the income statement, not as an asset on the balance sheet.
IMPORTANT: If this journal entry had been omitted, many errors on the financial statements would result.
- The Insurance Expense amount on the income statement would have been too low ($0 instead of $100).
- Net income on the income statement would have been too high ( Insurance Expense should have been deducted from revenues but was not).
- The Prepaid Insurance amount on the balance sheet would have been too high ($1,200 instead of $1,100).
- The total assets amount on the balance sheet would have been too high because Prepaid Insurance , one asset, was too high.
- The total stockholders’ equity amount on the balance sheet would be too high because a net income amount that was too high would have been closed out to Retained Earnings.
Prepaid Rent - Deferred Expense
Rent is the right to occupy the premises owned by another party. There are two ways to record the payment of rent.
Method #1: A company pays $1,000 worth of rent that will be used up within one month.
| Date | Account | Debit | Credit | ||
| 6/1 | Rent Expense | 1,000 | ▲ Rent Expense is an expense account that is increasing . | ||
| Cash | 1,000 | ▼ Cash is an asset account that is decreasing . |
The word “expense” implies that the rent will expire, or be used up, within the month. An expense is a cost of doing business, and it cost $1,000 in rent this month to run the business.
Here is the Rent Expense ledger where transaction above is posted. The $1,000 balance in the Rent Expense account will appear on the income statement at the end of the month.
| Date | Item | Debit | Credit | Debit | Credit |
| 6/1 | 1,000 | 1,000 | |||
The $100 balance in the Insurance Expense account will appear on the income statement at the end of the month. The remaining $1,100 in the Prepaid Insurance account will appear on the balance sheet. This amount is still an asset to the company since it has not expired yet.
The same adjusting entry above will be made at the end of the month for 12 months to bring the Prepaid Insurance amount down by $100 each month. Here is an example of the Prepaid Insurance account balance at the end of October.
| Date | Item | Debit | Credit | Debit | Credit |
| 6/1 | 1,200 | 1,200 | |||
| 6/30 | 100 | 1,100 | |||
| 7/31 | 100 | 1,000 | |||
| 8/31 | 100 | 900 | |||
| 9/30 | 100 | 800 | |||
| 10/31 | 100 | 700 | |||
After 12 full months, at the end of May in the year after the insurance was initially purchased, all of the prepaid insurance will have expired. If the company would still like to be covered by insurance, it will have to purchase more.
Summary
You prepaid a one-year insurance policy during the month and initially recorded it as an asset because it would last for more than one month. By the end of the month some of the insurance expired, so you reduced the value of this asset to reflect what you actually had on hand at the end of the month ($1,100). What was expired ($100) became an expense. To transfer what expired, Insurance Expense was debited for the amount used and Prepaid Insurance was credited to reduce the asset by the same amount. Any remaining balance in the Prepaid Insurance account is what you have left to use in the future; it continues to be an asset since it is still available.
The adjusting entry ensures that the amount of insurance expired appears as a business expense on the income statement, not as an asset on the balance sheet.
IMPORTANT: If this journal entry had been omitted, many errors on the financial statements would result.
- The Insurance Expense amount on the income statement would have been too low ($0 instead of $100).
- Net income on the income statement would have been too high ( Insurance Expense should have been deducted from revenues but was not).
- The Prepaid Insurance amount on the balance sheet would have been too high ($1,200 instead of $1,100).
- The total assets amount on the balance sheet would have been too high because Prepaid Insurance , one asset, was too high.
- The total stockholders’ equity amount on the balance sheet would be too high because a net income amount that was too high would have been closed out to Retained Earnings.
Prepaid Rent - Deferred Expense
Rent is the right to occupy the premises owned by another party. There are two ways to record the payment of rent.
Method #1: A company pays $1,000 worth of rent that will be used up within one month.
| Date | Account | Debit | Credit | ||
| 6/1 | Rent Expense | 1,000 | ▲ Rent Expense is an expense account that is increasing . | ||
| Cash | 1,000 | ▼ Cash is an asset account that is decreasing . |
The word “expense” implies that the rent will expire, or be used up, within the month. An expense is a cost of doing business, and it cost $1,000 in rent this month to run the business.
Here is the Rent Expense ledger where transaction above is posted. The $1,000 balance in the Rent Expense account will appear on the income statement at the end of the month.
| Date | Item | Debit | Credit | Debit | Credit |
| 6/1 | 1,000 | 1,000 |
OR
Method #2: A company prepays $12,000 worth of rent that will apply toward the upcoming year (12 months).
If you pay for more rent than you will use in a month (because it is convenient, because you get a good price, etc.), you record the payment as an asset New asset account: Prepaid Rent
| Date | Account | Debit | Credit | ||
| 6/1 | Prepaid Rent | 12,000 | ▲ Prepaid Rent is an asset account that is increasing . | ||
| Cash | 12,000 | ▼ Cash is an asset account that is decreasing . |
Here are the ledgers that relate to the purchase of prepaid rent when the transaction above is posted.
| Prepaid Rent | Rent Expense | |||||||||||
| Date | Item | Debit | Credit | Debit | Credit | Date | Item | Debit | Credit | Debit | Credit | |
| 6/1 | 12,000 | 12,000 | ||||||||||
During the month you will use some of this rent, but you will wait until the end of the month to account for what has expired.
At the end of the month 1/12 of the prepaid rent will be used up, and you must account for what has expired. After one month, $1,000 of the prepaid amount has expired, and you have only 11 months of prepaid rent left. If you DON’T “catch up” and adjust for the amount you used, you will show on your balance sheet that you have $12,000 worth of prepaid rent at the end of the month when you actually have only $11,000 remaining. In addition, on your income statement you will show that you did not use ANY rent to run the business during the month, when in fact you used $1,000 worth.
The adjusting entry for rent updates the Prepaid Rent and Rent Expense balances to reflect what you really have at the end of the month. The adjusting entry TRANSFERS $1,000 from Prepaid Rent to Rent Expense . It is journalized and posted BEFORE financial statements are prepared so that the income statement and balance sheet show the correct, up-to-date amounts.
| Date | Account | Debit | Credit | ||
| 6/30 | Rent Expense | 1,000 | ▲ Rent Expense is an expense account that is increasing . | ||
| Prepaid Rent | 1,000 | ▼ Prepaid Rent is an asset account that is decreasing . |
There are two ways this information can be worded, both resulting in the same adjusting entry above.
- The amount of rent expired (used) this month is $1,000. (So $11,000 worth remains.)
- The amount of unexpired rent is $11,000. (So $1,000 worth was used.)
Here are the Prepaid Rent and Rent Expense ledgers AFTER the adjusting entry has been posted.
| Prepaid Rent | Rent Expense | |||||||||||
| Date | Item | Debit | Credit | Debit | Credit | Date | Item | Debit | Credit | Debit | Credit | |
| 6/1 | 12,000 | 12,000 | 6/30 | 1,000 | 1,000 | |||||||
| 6/30 | 1,000 | 11,000 | ||||||||||
The $1,000 balance in the Rent Expense account will appear on the income statement at the end of the month. The remaining $11,000 in the Prepaid Rent account will appear on the balance sheet. This amount is still an asset to the company since it has not expired yet.
The same adjusting entry above will be made at the end of the month for 12 months to bring the Prepaid Rent amount down by $1,000 each month. Here is an example of the Prepaid Rent account balance at the end of October.
| Date | Item | Debit | Credit | Debit | Credit |
| 6/1 | 12,000 | 12,000 | |||
| 6/30 | 1,000 | 11,000 | |||
| 7/31 | 1,000 | 10,000 | |||
| 8/31 | 1,000 | 9,000 | |||
| 9/30 | 1,000 | 8,000 | |||
| 10/31 | 1,000 | 7,000 | |||
After 12 full months, at the end of May in the year after the rent was initially purchased, all of the prepaid rent will have expired. If the company would like to continue to occupy the rental property, it will have to prepay again.
Summary
You prepaid a one-year rent policy during the month and initially recorded it as an asset because it would last for more than one month. By the end of the month some of the prepaid rent expired, so you reduced the value of this asset to reflect what you actually had on hand at the end of the month ($11,000). What was expired ($1,000) became an expense. To transfer what expired, Rent Expense was debited for the amount used and Prepaid Rent was credited to reduce the asset by the same amount. Any remaining balance in the Prepaid Rent account is what you have left to use in the future; it continues to be an asset since it is still available.
The adjusting entry ensures that the amount of rent expired appears as a business expense on the income statement, not as an asset on the balance sheet.
I MPORTANT: If this journal entry had been omitted, many errors on the financial statements would result.
- The Rent Expense amount on the income statement would have been too low ($0 instead of $1,000).
- Net income on the income statement would have been too high ( Rent Expense should have been deducted from revenues but was not).
- The Prepaid Rent amount on the balance sheet would have been too high ($12,000 instead of $11,000).
- The total assets amount on the balance sheet would have been too high because Prepaid Rent , one asset, was too high.
- The total stockholders’ equity amount on the balance sheet would be too high because a net income amount that was too high would have been closed out to Retained Earnings.
Business License Tax - Deferred Expense
A business license is a right to do business in a particular jurisdiction and is considered a tax. There are two ways to record the payment of this tax.
Method #1: The company is charged $100 per month by the county licensure department.
The word “expense” implies that the taxes will expire, or be used up, within the month. An expense is a cost of doing business, and it cost $100 in business license taxes this month to run the business.
| Date | Account | Debit | Credit | ||
| 6/1 | Taxes Expense | 100 | ▲ Taxes Expense is an expense account that is increasing . | ||
| Cash | 100 | ▼ Cash is an asset account that is decreasing . |
Here is the Taxes Expense ledger where transaction above is posted. The $100 balance in the Taxes Expense account will appear on the income statement at the end of the month.
| Date | Item | Debit | Credit | Debit | Credit |
| 6/1 | 100 | 100 | |||
OR
Method #2: The company prepays $1,200 worth of taxes that will apply toward the upcoming year (12 months).
If prepay for your business license for the year, you record the payment as an asset. New asset account: Prepaid Taxes
| Date | Account | Debit | Credit | ||
| 6/1 | Prepaid Taxes | Prepaid Taxes | ▲ Prepaid Taxes is an asset account that is increasing . | ||
| Cash | 1,200 | ▼ Cash is an asset account that is decreasing . |
Here are the ledgers that relate to the purchase of prepaid taxes when the transaction above is posted.
| Prepaid Taxes | Taxes Expense | |||||||||||
| Date | Item | Debit | Credit | Debit | Credit | Date | Item | Debit | Credit | Debit | Credit | |
| 6/1 | 1,200 | 1,200 | ||||||||||
During the month you will use some of these taxes, but you will wait until the end of the month to account for what has expired.
At the end of the month 1/12 of the prepaid taxes will be used up, and you must account for what has expired. After one month, $100 of the prepaid amount has expired, and you have only 11 months of prepaid taxes left. If you DON’T “catch up” and adjust for the amount you used, you will show on your balance sheet that you have $1,200 worth of prepaid taxes at the end of the month when you actually have only $1,100 remaining. In addition, on your income statement you will show that you did not pay ANY taxes to run the business during the month, when in fact you paid $100.
The adjusting entry for taxes updates the Prepaid Taxes and Taxes Expense balances to reflect what you really have at the end of the month. The adjusting entry TRANSFERS $100 from Prepaid Taxes to Taxes Expense . It is journalized and posted BEFORE financial statements are prepared so that the income statement and balance sheet show the correct, up-to-date amounts.
| Date | Account | Debit | Credit | ||
| 6/30 | Taxes Expense | 100 | ▲ Taxes Expense is an expense account that is increasing . | ||
| Prepaid Taxes | 100 | ▼ Prepaid Taxes is an asset account that is decreasing . |
There are two ways this information can be worded, both resulting in the same adjusting entry above.
- The amount of taxes expired (used) this month is $100. (So $1,100 worth remains.)
- The amount of unexpired taxes is $1,100. (So $100 worth was used.)
Here are the Prepaid Taxes and Taxes Expense ledgers AFTER the adjusting entry has been posted.
| Prepaid Taxes | Taxes Expense | |||||||||||
| Date | Item | Debit | Credit | Debit | Credit | Date | Item | Debit | Credit | Debit | Credit | |
| 6/1 | 1,200 | 1,200 | 6/30 | 100 | 100 | |||||||
| 6/30 | 100 | 1,100 | ||||||||||
The $100 balance in the Taxes Expense account will appear on the income statement at the end of the month. The remaining $1,100 in the Prepaid Taxes account will appear on the balance sheet. This amount is still an asset to the company since it has not expired yet.
The same adjusting entry above will be made at the end of the month for 12 months to bring the Prepaid Taxes amount down by $100 each month. Here is an example of the Prepaid Taxes account balance at the end of October.
| Date | Item | Debit | Credit | Debit | Credit |
| 6/1 | 1,200 | 1,200 | |||
| 6/30 | 100 | 1,100 | |||
| 7/31 | 100 | 1,000 | |||
| 8/31 | 100 | 900 | |||
| 9/30 | 100 | 800 | |||
| 10/31 | 100 | 700 |
After 12 full months, at the end of May in the year after the business license was initially purchased, all of the prepaid taxes will have expired. If the company would like to continue to do business in the upcoming year, it will have to prepay again.
Summary
You prepaid for a one-year business license during the month and initially recorded it as an asset because it would last for more than one month. By the end of the month some of the prepaid taxes expired, so you reduced the value of thisasset to reflect what you actually had on hand at the end of the month ($1,100). What was expired ($100) became an expense. To transfer what expired, Taxes Expense was debited for the amount used and Prepaid Taxes was credited to reduce the asset by the same amount. Any remaining balance in the Prepaid Taxes account is what you have left to use in the future; it continues to be an asset since it is still available.
The adjusting entry ensures that the amount of taxes expired appears as a business expense on the income statement, not as an asset on the balance sheet.
I MPORTANT: If this journal entry had been omitted, many errors on the financial statements would result.
- The Taxes Expense amount on the income statement would have been too low ($0 instead of $100).
- Net income on the income statement would have been too high ( Taxes Expense should have been deducted from revenues but was not).
- The Prepaid Taxes amount on the balance sheet would have been too high ($1,200 instead of $1,100).
- The total assets amount on the balance sheet would have been too high because Prepaid Taxes , one asset, was too high.
- The total stockholders’ equity amount on the balance sheet would be too high because a net income amount that was too high would have been closed out to Retained Earnings.
Prepayments are common in business. As a college student, you have likely been involved in making a prepayment for a service you will receive in the future. When you paid your tuition for the semester, you paid “up front” for about three months of service (the courses you are taking!) As each month you attend class passes, you have one fewer month to go in terms of what you paid for. If you want to attend school after the semester is over, you have to prepay again for the next semester.
The payment arrangement could be different. Your college could ask for four years’ tuition before you take your first class. Can you see this would be unrealistic? Alternatively, the college could ask for no payment up front at all and just charge a $10 cover charge as students arrive each day, stationing a bouncer at each classroom door. Equally unreasonable? Finally, the college could wait until the semester is over and collect all the tuition at the end. Craziest plan of all?
The point is that a business has to select payment options that are reasonable and appropriate for their situations and circumstances and require payments in reasonable increments. What is suitable for one type of business may not work for another.
Fixed Assets - Deferred Expense
A fixed asset is a t angible/physical item owned by a business that is relatively expensive and has a permanent or long life—more than one year. Examples are equipment, furnishings, vehicles, buildings, and land. Each of these is recorded as an asset at the time it is purchased. Its initial value, and the amount in the journal entry for the purchase, is what it costs.
Example Journal Entry: A company purchased equipment that cost $6,000, paying cash. It is expected to last five years—its useful life.
| Date | Account | Debit | Credit | ||
| 1/1 | Equipment | 6,000 | ▲ Equipment is an asset account that is increasing . | ||
| Cash | 6,000 | ▼ Cash is an asset account that is decreasing . |
Although fixed assets cost a company money, they are not initially recorded as expenses. (Notice in the journal entry above that the debit account is “Equipment,” NOT “Equipment Expense”). Fixed assets are first recorded as assets that later are gradually “expensed off,” or claimed as a business expense, over time.
The process of “expensing off” the cost of a fixed asset as it is “used up” over its estimated useful life is depreciation. (NOTE: Land is property that does not “get used up;” therefore it is not depreciated.)
Example
In this case, assume that the equipment depreciates at a rate of $100 per month, which is determined by dividing its cost of $6,000 by 60 months (five years). After one month, the equipment is no longer worth $6,000. It has lost $100 of its initial value, so it is now worth only $5,900. An adjusting entry must be made to recognize this loss of value.
Although supplies is not directly related to fixed assets, it may help to remember the adjusting entry for using up supplies in a month:
| Date | Account | Debit | Credit | ||
| 1/31 | Supplies Expense | 100 | ▲ Supplies Expense is an expense account that is increasing . | ||
| Supplies | 100 | ▼ Supplies is an asset account that is decreasing . |
If we “expensed” off equipment in a similar way, the journal entry would look like this:
| Date | Account | Debit | Credit | ||
| 1/31 | Equipment Expense | 100 | ▲ Equipment Expense is an expense account that is increasing . | ||
| Equipment | 100 | ▼ Equipment is an asset account that is decreasing . |
It makes sense since it follows the same pattern as supplies. In theory, it does do the job. However, the items in red are considered incorrect. There are two changes that will be made so that the journal entry is CORRECT for depreciation.
- Equipment Expense may be a valid account, but it is not used for depreciation. It might instead be used for costs associated with owning and running the equipment, such as maintenance, oil, parts, etc. To recognize part of ANY fixed asset’s cost as a business expense, use Depreciation Expense (not Equipment Expense) .
-
In accounting, the
cost principle
requires that a fixed asset’s ledger balance be the cost of the asset, or what was paid for it. In this example it means that we are not allowed to credit the
Equipment
account to reduce its balance from $6,000 to the updated $5,900. Its balance must stay at $6,000.
Therefore, we will credit a different account instead since we require a credit account to complete the entry. This account is Accumulated Depreciation . Accumulated Depreciation is a contra asset account that appears on the balance sheet with a credit balance under the particular asset it relates to (which has a debit balance). This account is used as a substitute for the fixed asset account, which cannot be credited for the depreciation amount since the asset’s balance must always be its cost.
The following is the CORRECT monthly adjusting entry for the depreciation of a fixed asset:
| Date | Account | Debit | Credit | ||
| 1/31 | Depreciation Expense | 100 | ▲ Depreciation Expense is an expense account that is increasing . | ||
| Accumulated Depreciation | 100 | ▲ Acc. Depreciation is a contra asset account that is increasing. |
Notice that Depreciation Expense substitutes for Equipment Expense, and Accumulated Depreciation substitutes for Equipment.
Here are the Equipment , Accumulated Depreciation , and Depreciation Expense account ledgers AFTER the adjusting entry above has been posted.
| Date | Item | Debit | Credit | Debit | Credit |
| 1/1 | 6,000 | 6,000 | |||
| Date | Item | Debit | Credit | Debit | Credit |
| 1/31 | Adjusting | 100 | 100 | ||
| Date | Item | Debit | Credit | Debit | Credit |
| 1/31 | Adjusting | 100 | 100 | ||
Since the Accumulated Depreciation account was credited in the adjusting entry rather than the Equipment account directly, the Equipment account balance remains at $6,000, its cost. The adjusting entry above is made at the end of each month for 60 months.
Book Value is what a fixed asset is currently worth, calculated by subtracting an asset’s Accumulated Depreciation balance from its cost. This calculation is reported on the balance sheet.
| At the end of | Cost | - | Accumulated Depreciation | = | Book Value |
| 1 month | $ 6,000 | $ 100 | $ 5,900 | ||
| 2 months | 6,000 | 200 | 5,800 | ||
| 3 months | 6,000 | 300 | 5,700 | ||
| 12 months | 6,000 | 1,200 | 4,800 | ||
| 59 months | 6,000 | 5,900 | 100 | ||
| 60 months | 6,000 | 6,000 | 0 | ||
| 66 months | 6,000 | 6,000 | 0 |
Accumulated Depreciation appears in the asset section of the balance sheet, so it is not closed out at the end of the month. Instead, its balance increases $100 each month. Here is its ledger after three months.
| Date | Item | Debit | Credit | Debit | Credit |
| 1/31 | 100 | 100 | |||
| 2/28 | 100 | 200 | |||
| 3/31 | 100 | 300 | |||
Here is the balance sheet presentation after three months:
| Equipment | $ 6,000 |
| Less: Accumulated depreciation | 300 |
| \(\ \overline{$ 5,700}\) |
The adjusting entries split the cost of the equipment into two categories. The Accumulated Depreciation account balance is the amount of the asset that is “used up.” The book value is the amount of value remaining on the asset. As each month passes, the Accumulated Depreciation account balance increases and, therefore, the book value decreases.
After 60 months, the balance in the Accumulated Depreciation account is $6,000 and therefore the equipment is fully depreciated and has no value. However, the business may continue to own and use the equipment. It just will not report any value for it on the balance sheet. After the asset is fully depreciated, no further adjusting entries are made for depreciation no matter how long the company owns the asset.
Here is calculation of the book value after 60 months:
| Equipment | $ 6,000 |
| Less: Accumulated depreciation | 6,000 |
| \(\ \overline{$0}\) |