Types of Adjusting Entries Deferred expense Accrued liability ALL RECOGNIZE REVENUE OR EXPENSES BEFORE OR AFTER CASH IS EXCHANGED Adjusting entries are made at the end of the accounting period in an accrual-based company. Adjusting entries are internal transactions that never involve an increase/decrease to Cash. At least one Balance Sheet and one Income Statement account is involved. When we talk about a deferred expense or revenue, the event has not taken place but cash has flowed. When we talk about an accrued asset or liability, the event has taken place but cash has not flowed. Accrued asset Deferred revenue LO5

Accruals (deferred expenses) Cash paid before expense is incurred Examples: Prepaid rent Prepaid insurance Office supplies Property and equipment Costs are initially recorded as assets and allocated to expenses in future periods Accruals (Deferred Expense): cash paid before the expense is incurred. These are some common examples. Deferred expense = prepaid expense = prepaid asset

Accrual Example Initial journal entry: 9/1 Prepaid Rent 2,400 Prepay rent on office space for one year on September 1 Initial journal entry: 9/1 Prepaid Rent 2,400 Cash 2,400 Monthly adjusting journal entry: 9/30 Rent Expense 200 Prepaid Rent 200 ($2,400 annual × 1/12 = $200 per month for 12 months) An asset is created. as asset expires it becomes an expense, via adjusting entry prepaid rent becomes rent expense, a month at a time

Unearned (Deferred) Revenue Cash received before revenue is earned Examples: Insurance collected in advance Subscriptions collected in advance Gift certificates Receipts are initially recorded as liabilities (unearned or refundable receipts) and recorded as revenues in future periods when earned Deferred revenue: cash received before revenue is earned liability created because goods or services are still owed Deferred revenue = unearned revenue

Deferred Revenue Example Received $2,400 for an insurance policy in advance on September 1 Initial journal entry: 9/1 Cash 2,400 Insurance Collected in Advance 2,400 Monthly adjusting journal entry: 9/30 Insurance Collected in Advance 200 Insurance Revenue 200 ($2,400 annual × 1/12 = $200 per month for 12 months) "the other company" from the deferred expense entries: for example, the landlord who received the prepaid rent has a deferred revenue as the revenue is earned, liability is reduced, revenue increased, via adjusting entry magazine subscriptions received by a publisher in advance, earned as magazines are mailed

Accrued Liability Expense incurred before cash is paid Examples: Payroll Taxes Interest Record expense (and corresponding liability) in period incurred; pay for it in a future period No cash flow on recording, only when paid Accrued liability: expense incurred before cash is paid opposite of deferred expense no cash has changed hands but the transaction has been completed

Accrued Liability Example #1 Pay biweekly wages of $28,000 At end of month, between pay periods: Wages Expense 4,000 Wages Payable 4,000 Next payday: Wages Payable 4,000 Wages Expense 24,000 Cash 28,000 taxes, payroll, utilities, interest

Accrued Liability Example #2 On March 1, assume a 9%, 90-day, $20,000 loan is taken out with a bank Initial journal entry: 3/1 Cash 20,000 Note Payable 20,000 Monthly adjusting journal entry: 3/31 Interest Expense 150 Interest Payable 150 ($20,000 principal × 9% × 3/12 = $450 for 3 months or $450/3 = $150 per month) adjusting entry records expense even though no payment was made interest for short-term loan often paid at maturity with principal I = P  R  T is formula to calculate interest liability at any point in time Interest, Principal, Rate, Time

Accrued Asset Revenue earned before cash is received Examples: Rent Interest Record revenue (and corresponding receivable) in period earned; receive payment in a future period Accrued asset: revenue is earned before cash is received

Accrued Asset Example First day of the month: Rent Receivable 2,500 Rent payment of $2,500 due within first 10 days of month First day of the month: Rent Receivable 2,500 Rent Revenue 2,500 Upon receipt of cash: Cash 2,500 Rent Receivable 2,500 both rent and interest are earned as time goes by, regardless of when cash is received need adjusting entry if payment is not received

Steps in the Accounting Cycle 1. Collect and analyze info 7. Close the accounts 2. Journalize transactions 6. Record and post adjusting entries 3. Post transactions to general ledger 5. Prepare financial statements 4. Prepare work sheet LO6