Financial Accounting

Chapter 3: Completion of the Accounting Cycle

Adjusting for Deferred Items

Deferred Items

Deferred means to postpone or delay items.  We will be moving items that have already been record in our books.  We will move a liability to revenue or an asset to an expense.  The deferred items we will discuss are unearned revenue and prepaid expenses.  Unearned revenues are money received before work has been performed and is recorded as a liability.  Prepaid expenses are expenses the company pays for in advance and are assets including things like rent, insurance, supplies, inventory, and other assets.

  1. Liability / revenue adjustments come from companies receiving advance payments for items such as training services, delivery services, tickets, and magazine or newspaper subscriptions. Receiving assets before they are earned creates a liability called unearned revenue. The firm debits such receipts to the asset account Cash and credits a liability account. The liability account credited may be Unearned Revenue, Revenue Received in Advance, Advances by Customers, or some similar title. The seller must either provide the services or return the customer’s money. By performing the services, the company earns revenue and cancels the liability.

           Remember:  Unearned revenue is a liability account because we owe work to someone in the future. 

2.  Asset/ expense entries will initially be recorded as assets, then as the asset is used it will become an expense. If a business knows that they will use the asset before the end of the accounting period, they will initially record it as an expense.  Prepaid insurance, depreciation, prepaid rent and supplies on hand are all examples of asset/ expense entries.

Let's look at some examples.

Example 1 - Liability / revenue adjusting entry for future services rendered

On December 7, MicroTrain Company received  $4,500 from a customer in payment for future training services. The firm recorded the following journal entry:

Dec. 7  Debit Credit
Cash 4,500
         Unearned Revenue 4,500
To record the receipt of cash from a customer in payment for future training services.
The balance in the Unearned Service Revenues liability account established when MicroTrain received the cash will be converted into revenue as the company performs the training services. Before MicroTrain prepares its financial statements, it must make an adjusting entry to transfer the amount of the services performed by the company from a liability account to a revenue account.

If we assume that MicroTrain earned one-third of the $ 4,500 in the Unearned Revenue account by December 31, then the company transfers $ 1,500  (4,500 x 1/3) to the Service Revenue account in an adjusting entry as follows:

 Debit Credit
Dec. 31 Unearned Revenue 1,500
          Service Revenue 1,500
To record the receipt of cash from a customer in payment for future training services.

Example 2 - Asset / expense adjusting entry for prepaid insurance

MicroTrain Company purchased for cash an insurance policy on its trucks for the 12 month period beginning December  1. The journal entry made on December 1, to record the purchase of the policy is illustrated in the following table (remember, when we pay for expenses in advance we record them as an asset):

  Debit  Credit
 Dec. 1 Prepaid Insurance 2,400
   Cash 2400
Purchased truck insurance to cover a one-year period.
On December 31, an adjusting journal entry is made because it is the end of an accounting period and MicroTrain has not used all of the insurance they paid for. MicroTrain will record an adjusting entry for 1 month of insurance expense ($2,400 / 12 months) since the policy began December 1 and the year end is December 31.  The following table shows how to record this adjusting entry in the journal:

  Debit  Credit
 Dec. 31 Insurance Expense 200
   Prepaid Insurance 200
To record insurance expense for December.
Before this adjusting entry was made, the entire  $ 2,400 insurance payment made on December 1, was a prepaid expense for 12 months of protection. So on December 31, one month of protection had passed, and an adjusting entry transferred  $ 200 of the  $ 2,400 ( $ 2,400/12 =  $ 200) to Insurance Expense.

After journal entries have been adjusted, they must be posted to the ledgers again, the three-column ledger accounts appear as follows:

Prepaid Insurance   
Date Explanation Debit Credit Balance
Dec. 1 Purchased on Account   2,400   2,400
31 Adjustment 200   2,200
Insurance Expense
Date Explanation Debit Credit Balance
Dec. 31 Adjustment   200   200
Note that we are cycling through the second and third steps of the accounting equation again. On the income statement for the year ended December 31, MicroTrain reports one month of insurance expense,  $ 200, as one of the expenses it incurred in generating that year’s revenues. It reports the remaining amount of the prepaid expense,  $ 2,200, as an asset on the balance sheet. The  $ 2,200 prepaid expense represents 11 months of insurance protection that remains as a future benefit.

 Example 3 - Asset / expense adjusting entry for supplies

When a company purchases supplies in bulk, it is recorded as an asset until the supplies are used.  An adjusting entry is used to record the amount of supplies used (supplies expense) during the period.  To determine the amount of supplies used during the period, a physical count is made of the supplies remaining or on hand.  We can use the following formula for supplies expense:

Beginning supplies + supplies purchases during the period  - physical count of supplies remaining

Note:  Beginning supplies + supplies purchased equals the Supplies balance in the Unadjusted Trial Balance.

MicroTrain has a beginning supplies balance of $ 500 and purchased $8,000 in supplies during the period.  A physical count of supplies on December 31 shows we have $1,500 remaining on hand.  The supplies expense for the period will be $7,000 ($500 beginning balance + $8,000 in supplies purchased - $1,500 remaining) and the adjusting entry will be:

  Debit  Credit
 Dec. 31 Supplies Expense 7,000
   Supplies 7,000
To record supplies expense.
Before this adjusting entry was made, the supplies asset account had a balance of $8,500.  After the adjusting entry, the account balance is $1,500 and matches the amount of supplies from the physical count.


Example 4 - Asset / expense adjusting entry for depreciation

A depreciable asset is a manufactured asset such as a building, machine, vehicle, or piece of equipment that provides service to a business. In time, these assets lose their utility because of (1) wear and tear from use or (2) obsolescence due to technological change. Since companies gradually use up these assets over time, they record depreciation expense on them.

Depreciation expense is the amount of asset cost assigned as an expense to a particular period. The three factors involved in computing depreciation expense are as follows:

  • Asset cost. The asset cost is the amount that a company paid to purchase the depreciable asset.
  • Estimated residual value. The estimated residual value (scrap value) is the amount that the company can probably sell the asset for at the end of its estimated useful life.
  • Estimated useful life. The estimated useful life of an asset is the estimated time that a company can use the asset. Useful life is an estimate, not an exact measurement, that a company must make in advance. However, sometimes the useful life is determined by company policy (e.g. keep a fleet of automobiles for three years).

Accountants use different methods for recording depreciation. The method illustrated here is the straight-line method. We discuss other depreciation methods later in the course. Straight-line depreciation assigns the same amount of depreciation expense to each accounting period over the life of the asset. The depreciation formula (straight-line) to compute straight-line depreciation for a one-year period is:

Formula for straight line depreciation is  annual depreciation = (asset cost - estimated residual value) / estimated years of useful life This video will explain the depreciation process and entries:

To illustrate the use of the straight line depreciation formula, let’s return to the MicroTrain Company. In December, it purchased four small trucks at a cost of $40,000. The journal entry was:

       Debit  Credit
Dec. 1 Trucks 40,000
Cash 40,000
To record the purchase of four trucks.
The estimated residual value for each truck was $ 1,000, so MicroTrain estimated the total residual value for all four trucks at $4,000 (1,000 x 4 trucks). The company estimated the useful life of each truck to be four years. Using the straight-line depreciation formula, MicroTrain calculated the annual depreciation on the trucks as follows:

annual depreciation = (asset cost $40,000 – estimated residual value $4,000)/ 4 year estimated useful life

= $ 9,000 per year but the amount of depreciation expense for one month would be 1/12 of the annual amount. Thus, depreciation expense for December is $9,000 ÷ 12 = $750.

When we record depreciation, we will debit depreciation expense and credit a new account called Accumulated Depreciation.  Accumulated Depreciation is an asset account but it is a contra-account meaning it works opposite the way accounts typically work and has a normal CREDIT balance.  Normal credit balance means we will credit the account to increase and debit to decrease. The company records the one month of depreciation as follows:

        Debit   Credit
Dec. 31 Depreciation Expense – Trucks  750  
        Accumulated Depreciation – Trucks   750
      To record depreciation expense for December.  
MicroTrain reports depreciation expense in its income statement. And it reports accumulated depreciation in the balance sheet as a deduction from the related asset.

Answer the following questions to test your reading comprehension of adjusting entries for deferred items.  Remember to rate your confidence to check your answer, maybe? probably. definitely!

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