Another type of adjusting entry involves the opposite of the accrual of revenue or expense. These entries create deferred revenues and expenses. In some situations, cash is paid before an expense has been incurred or cash is received before revenue has been earned. This results in prepaid (deferred) revenue or expense and usually necessitates an entry to defer the recognition of the revenue or expense to some point in time later than the receipt or payment of cash.
a. Deferred Revenues
To illustrate deferred revenue, assume that a business receives, on December 1, 201x, a semi-annual rent payment of $30,000 giving the payor the right to use the rented property for the period from December 1, 201x, through May 31 of the following year. On the date of receipt, none of the rental revenue associated with the $30,000 payment has been earned, it is prepaid rent. There are two approaches for dealing with this prepaid rent.
Under one approach, the following entry would be made at the time of receipt of the
$30,000 payment:
Cash $30,000
Deferred Rental Income $30,000
The deferred rental income account is a liability account. Since the business has not earned the rent
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revenue on the date of payment, the liability account is a mechanism that permits deferral of the revenue. In effect, the business is recognizing its obligation to make the property available for the next six months. The liability account is used in this fashion even though there may be no legal obligation to return the cash to the lessee because the use of the property has been interrupted for some reason.
If this approach to recording prepaid revenues is taken, then an appropriate amount of rent revenue must be recognized as it is earned. On December 31, 201x, one-sixth of the
$30,000 will have been earned. On that date, the following adjusting entry would be made to recognize the rent earned in December:
Deferred Rental Income $5,000
Rental Income (or Revenue) $5,000
A similar entry or entries would have to be made during the first five months of the following year to transfer the remaining deferred rental income from the liability account to the revenue account as it is earned.
An alternative approach for the prepaid revenue would be to ignore the prepayment feature at the time of cash receipt and record the rent receipt as follows:
Cash $30,000
Rental Income $30,000
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This, of course, would overstate the rental income for 201x. Therefore, at December 31, 201x, an adjusting entry to defer the appropriate portion of the revenue would be made as follows:
Rental Income $25,000
Deferred Rental Income $25,000
This entry reduces the revenue for the year to $5,000, which is the correct result. It also establishes the liability account that is used to defer recognition of the revenue related to the following year. If this approach is used, then a reversing entry could be made at the beginning of the next year as follows:
Deferred Rental Income $25,000
Rental Income $25,000
No further entries would be necessary, unless, of course, monthly financial statements are prepared, in which case one of the procedures described above would be necessary at each month end.
b. Prepaid Expenses
Prepayments and the requirement for deferral also occur in connection with expenses.
Assume that a business has taken out a three-year fire insurance policy covering the three-year period beginning September 1, 201x. The business pays the full cost of the policy ($90,000) on September 1, 201x. Because this policy covers a three-year period, the full premium does not represent an expense of 201x. The premium paid is a prepaid expense and the recognition
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of the expense in the income statement must be deferred.
One way to account for the actual payment of the insurance premium is as follows:
Prepaid Insurance $90,000
Cash $90,000
Prepaid insurance is an asset sometimes called a deferred charge or deferred expense account. At the end of 201x, the following adjusting entry would be made:
Insurance Expense $10,000
Prepaid Insurance $10,000
This transfers from the asset to an expense account the portion of the insurance premium that relates to coverage in 201x. The total premium is being amortized over the period covered by the policy. Similar entries would be made in the next three years to recognize as expense an appropriate amount of the balance of the premium.
An alternative approach would be to record the entire premium as expense when paid:
Insurance Expense $90,000
Cash $90,000
At the end of 201x, an adjusting entry would be made to reclassify the deferred portion of the insurance premium and record it in the prepaid insurance current asset account:
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Prepaid Insurance $80,000
Insurance Expense $80,000
The combination of these two entries leaves an asset (prepaid insurance) of $80,000 and expense for the year of $10,000. At the beginning of the next year, a reversing entry would be made as follows:
Insurance Expense $80,000
Prepaid Insurance $80,000
At the end of the next year, an adjusting entry would be made to recognize as an asset the then unexpired portion (20/36) of the premium:
Prepaid Insurance $50,000
Insurance Expense $50,000
The entries to the insurance expense account for the year following 201x would be a debit of $80,000 and a credit of $50,000, leaving a net debit balance of $30,000. This is the correct amount of the insurance premium to be recognized as an expense in that year ($90,000/3).