Question

Describe why the adjusting process is necessary and give an example of one of the following 4 types of adjusting entries:

1) Prepaid expense

2) Unearned revenue

3) Accrued revenue

4) Accrued expense

Make sure to include which type of adjusting entry your are providing an example.

Answer 1

The main reason why the adjusting process is necessary is the company maintains its books on the accrual basis and Matching Principle.

1. This means the company will record the expense related to the current even if it is unpaid: Accrued expense but not paid (liability)
2. Similarly, revenues are also recorded even if they are not received but receivable: Accrued revenue but not received (asset)
3. But sometimes payments are made for the next period of time, they can not be written off in the Income Statement. These payments have to be forwarded to the next year: Prepaid expense (asset)
4. Similarly, some revenues are received in advance that is meant for the next year. This can not be treated as the income of the current year and must be forwarded to next year for which the income is meant: Unearned revenue (liability)

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Let's understand this concept with an example:

• For Expense, Let's take Salaries $100 per month.
• And for Revenue, Let's take Rent $200 per month.

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1) Accrued expense but not paid:

Suppose, the ABC Company had to pay $1,200 for 2019 ($100 x 12) but only paid $1,000. $200 is still outstanding. Now ABC paid $1,400 in 2020.

In this case, we can not treat expenses $1,000 for 2019 and $1,400 for 2020. The rationale behind this is the accrual concept.

So, we'll charge whole $1,200 in 2019 in two parts: $1,000 paid and $200 still payable(outstanding). This will turn into 2 entries:

S No.	Date		Debit ($)	Credit ($)
(1)	2019	Salaries expense dr. To Cash	1,000	. 1,000
(2)	2019	Salaries expense dr. To Salaries payable	200	. 200

(2) is the adjusting entry.

It is evident that in both the entires Salaries expense is debited and these Salaries expense will be charged from the Income Statement of 2019 (as follows):

Date		Debit ($)	Credit ($)
2019	Income Summary dr. To Salaries expense	1,200	. 1,200

Now, Salaries Payable is a liability and will be reflected in the Balance Sheet under Current Liabilities.

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Now continuing expense, Let's discuss prepaid expense in 2nd point. It is an expense opposite to outstanding, in which payment is done in advance. Let's discuss with the same example of salaries:

2) Prepaid Expense

Suppose, the ABC Company had to pay $1,200 for 2019 ($100 x 12) but paid $1,500. $300 is paid in advance. Now ABC needs to pay only $900 in 2020.

In this case, we can not treat expenses of $1,500 for 2019 and $900 for 2020. The rationale behind this is the accrual concept.

Each year Expense must be $1,200.

So, we'll charge $1,200 in 2019 and rest $300 will be adjusted through an adjusting entry (in simple words, forward to next year) as follows:

S No.	Date		Debit ($)	Credit ($)
(1)	2019	Salaries expense dr. To Cash	1,200	. 1,200
(2)	2019	Prepaid Salaries dr. To Cash	300	. 300

(2) is the adjusting entry.

It is evident that in both the entires Cash is credited.

Salaries expense will be charged from the Income Statement as follows:

Date		Debit ($)	Credit ($)
2019	Income Summary dr. To Salaries expense	1,200	. 1,200

Now, Prepaid Salaries is an Asset and will be reflected in the Balance Sheet under Current Assets.

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Now coming to the Revenues side, it must be noted that similar to expenses revenues can also be received in advance or still due and not received. Let's discuss it with Rent revenue of $200 per months i.e. $2,400 annually.

3) Accrued revenue but not received

Suppose, the ABC Company had to receive $2,400 for 2019 ($200 x 12) but received only $2,000. $400 is still receivable. Now ABC will receive $2,800 in 2020.

In this case, we can not treat income $2,000 for 2019 and $2,800 for 2020. The rationale behind this is the accrual concept.

So, we'll record whole $2,400 for 2019 in two parts: $2,000 received and $400 still receivable. $400 is also the revenue of 2019 This will turn into 2 entries:

S No.	Date		Debit ($)	Credit ($)
(1)	2019	Cash dr. To Rent Revenue	2,000	. 2,000
(2)	2019	Accrued Rent dr. To Rent Revenue	400	. 400

(2) is the adjusting entry.

It is evident that in both the entires Rent Revenue is credited and Rent Revenue will be transferred to the Income Statement of 2019 (as follows):

Date		Debit ($)	Credit ($)
2019	Rent Revenue dr. To Income Summary	2,400	. 2,400

Now, Accrued Rent is an Asset and will be reflected in the Balance Sheet under Current Assets.

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Now continuing revenue, Let's discuss Unearned revenue in the 4th point. It is a revenue opposite to Accrued revenue not received, in which payment is received in advance. Let's discuss with the same example of rent:

4) Unearned revenue

Suppose, the ABC Company had to receive $2,400 for 2019 ($200 x 12) but received only $3,000. $600 is still received in advance. Now ABC needs to receive only $1,800 in 2020.

In this case, we can not treat an income of $3,000 for 2019 and $1,800 for 2020. The rationale behind this is the accrual concept.

Each year Income must be $2,400.

So, we'll record $2,400 in 2019 and rest $600 will be adjusted through an adjusting entry (in simple words, forward to next year) as follows:

S No.	Date		Debit ($)	Credit ($)
(1)	2019	Cash dr. To Rent Revenue	2,400	. 2,400
(2)	2019	Cash dr. To Unearned Rent	600	. 600

(2) is the adjusting entry.

It is evident that in both the entires Cash is debited.

Rent Revenue will be transferred to the Income Statement as follows:

Date		Debit ($)	Credit ($)
2019	Rent Revenue dr. To Income Summary	2,400	. 2,400

Now, Unearned Rent is a liability and will be reflected in the Balance Sheet under Current Liabilities

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The difference in Accrued and Accrued but not paid/received needs to be understood:

1. Accrued Expense only means Expense needs to be paid.
2. Suppose ABC pays monthly salaries of $200 after each month. On completion of each month, $200 is an accrued expense.
3. Now, if ABC pays this amount, everything is fine but if not pays it will be termed as an Accrued expense but not paid.
4. If ABC pays unaccrued expenses, it will be termed as Prepaid expense.

So, Accrued Revenue / Expense is not an adjustment in itself. It just suggests that expense/revenue is due.

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I hope all things have been made clear.

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