Introduction to Adjusting Journal Entries and Prepaid Expenses - Online Tutor, Practice Problems & Exam Prep

Adjusting journal entries are essential in accrual accounting, updating accounts for the passage of time. Key types include deferrals, where cash is received before revenue or expenses are recognized, and accruals, where expenses or revenues are recorded before cash is exchanged. Prepaid expenses, such as rent or insurance, are classified as assets until the benefit is realized. For example, if $12,000 is paid for a year of rent, the monthly expense is $1,000. After four months, an adjusting entry would debit rent expense for $4,000 and credit prepaid rent, reflecting the used portion of the asset.

Introduction to Adjusting Journal Entries

Alright. So now let's start our discussion of adjusting journal entries. These are a key feature of the accrual accounting system. Let's see how and when we're going to use them. So the whole idea behind adjusting journal entries is that accounts need to be updated for the passage of time. Some accounts need to be updated for the passage of time, okay? So there's going to be some balance in the account and time is going to pass and let's say the account balance is going to be used up, right? We need to adjust that balance. It's going to be sitting at that balance until we make these journal entries to bring it to the correct balance. Okay? We're going to see all types of adjusting entries. And mostly they're going to be deferrals and accruals. We're also going to discuss depreciation, but we go into that way deeper later in the book. Okay? So let's start here with deferrals and accruals. Let's define them. So a deferral, that's an adjustment for the payment of an item or receipt of cash in advance. Okay? So this is when the cash happens before the triggering event happens, okay? So the cash is happening before the expense or before the revenue. The cash is moving first, okay? So those are gonna be deferrals. Compare that to an accrual which is the opposite of a deferral. This is when we're recording the revenue or expense before collecting cash, okay? So this is where the revenue or expense happens before the cash moves, okay? Deferrals, the cash moves and then the revenue or expense. Accruals, we have the expense or the revenue and then the cash. Okay? So we're going to kind of see how those go hand in hand. Last but not least, we have depreciation. Okay?

So depreciation, this is where we allocate the cost of a long-term asset over its useful life. Okay? When I say long-term asset, this is like a machine, right? If we buy a machine to produce our product, that's going to last us a long time. Say that machine is going to last us 10 years, well, we want to allocate the cost of the machine over the 10 years. We don't want to just say, hey, we bought this really expensive machine right now, we just have to take all the expense right now. No. We take the expense little by little over time. Okay? So we'll see how that depreciation works. And just a quick note here, before we dive into our first type of adjusting entry, we're going to be studying these right here. Under deferrals, we've got these: the prepaid expenses, supplies, and unearned revenue. Under accruals, we're going to learn about accrued expenses and accrued revenue. I've got quotations there. I'll talk about that a little more later. And then last but not least, our depreciation. We're going to discuss depreciation expense and the associated accumulated depreciation. Alright? So let's take a quick pause here, and then we'll start with prepaid expenses. Our first type of adjusting entry.

Adjusting Journal Entries:Prepaid Expenses (Accrual Accounting Method)

All right. So let's dive into prepaid expenses. These are payments for expenses, and typically when we talk about prepaid expenses, we're talking about rent or insurance. So we prepay some rent or prepay for an insurance policy and this is when we pay in advance. Okay? So we're paying an expense in advance. So pop quiz real quick. Prepaid expenses are A, expenses, B, liabilities, C, assets, or D, revenue. What do you guys think? Prepaid expenses. Yep. I heard one of you out there. Definitely, C. It's an asset. I know this is pretty tricky. A lot of students get tripped up with this at first because they see the word expense. Right? And I did tell you when you see the word expense, it's generally going to be an expense. But one of our keywords that tells us that it's not an expense is when we see prepaid. Anything that says prepaid expense, prepaid rent, prepaid insurance, anything like that, it's going to be an asset, okay? And let me tell you why it's going to be an asset. So the idea here is that we're prepaying for something. So if we're paying for, let's say, a year of rent in advance, right? We have a rent contract that's starting for the next year. We paid for the whole thing right now, right? We paid for 12 months of rent. Well, we haven't earned, we haven't received any of the benefits from renting the place, right? We paid for it, but we haven't occupied the space, used it for our business. We haven't received any of the benefits. We just paid in advance. So what we did is by paying this cash, we have this value saved up, right? We create this asset which holds the value for all this rent that we aren't going to have to pay in the future, right? So let's go ahead and dive into these adjusting entries and see how this is an asset here. Okay? So these prepaid expenses, they're going to be assets and let's think about a certain example here. Okay? So when we're dealing with most adjusting entries, we're going to be dealing with 2 dates, okay? One date is going to be the date for the expense or the revenue, and one date for the cash. Okay? So let's check this out. For prepaid expenses, we're going to start with the expense payment date. Okay? We start where the expense is actually paid for, right? We are talking about a deferral. The cash happens first, and the expense happens later. So let's see this one. We're going to pay for the expense in advance and create the prepaid expense account. So in our example, on September 1st, the company pays $12,000 for a full year of rent in advance. Okay. So they're paying $12,000 for a full year of rent, but they haven't received any benefit from it yet, right? They paid for the whole upcoming year, but that year hasn't happened yet. So what happened is we definitely paid money, right? Our cash left our pocket. So we're going to be crediting cash, and we're going to debit. We're going to create this asset for prepaid rent, right? It could go into just a prepaid expenses broad category, but I'm going to call it prepaid rent. Okay? And this prepaid rent is an asset, right? Because we have all this value stored up for rent that we aren't going to have to pay in the future, right? We already paid for it, and we're going to be able to use that space overtime without paying more cash. So we're going to debit our prepaid rent for $12,000, right? So now we've had this asset worth $12,000 and we're going to credit cash for $12,000, right? This lowers our cash by $12,000 because we paid it out. And now we have this value of $12,000 sitting in our books. Okay. Notice I've got two columns here too. In the blue columns which we're going to fill out now, this is where we're going to, deal with the very correct and accrual accounting way to do it. And in the red side, we're going to deal with the situation where maybe we started in the cash basis of accounting and then we have to transfer it into accrual basis. Okay? So we'll see how that works. So here we go. We've got the prepaid rent for $12,000 and the cash for $12,000. So that's the first entry we would make when we actually paid for the cash, paid for the rent. Okay? And then there's the second date. And this is the date where we're updating the books, the adjusting date. So we're going to adjust the Prepaid Expense account based on the time that's passed. So you can imagine, time is going to be passing. We're not going to be paying money for rent because we already paid it, and then as that time passes, we're eventually going to have to be taking the expense, right? So now it's December 31st and the company's updating their books, and they're adjusting the records for the passage of time. Okay? So remember, at first, they had $12,000 on their books for the prepaid rent. But months have passed by. We've used up some of that prepaid rent. Right? So how many months have passed by? That's the first thing we have to find out. So it started in September. So the month of September went by, October, November, and December. It's been 4 months, right? So 4 months have passed, so we need to take 4 months of the expense. How do we find out what 4 months of the expense is going to be? Well, we want to start by finding out what 1 month of the expense is. So if we had $12,000 for the full year, let's divide that by the 12 months, and we'll find a monthly expense of $1,000 per month. So now that it's December 31st, well, September past October, November, December, those were the 4 months, right? Times 4, that tells us that there should be $4,000 that we've used up, right? So if we were paying for this rent monthly, if we were just paying it in cash every month, we would have paid $4,000 by now, right? We would have paid rent for September, October, November, December. And we would have paid $4,000. So in the same sense, it's the same as if we had paid cash every month. We would have had the same total amount of expense, right? So this is what we want to do at this point. We need a rent expense that signifies that we've used up 4 months of rent, right? So our rent expense should be $4,000. So we're going to debit rent expense, right? And we increase our expenses with debits and that's why we're debiting it here for the $4,000, right? These $4,000 is the 4,000 of expense we've used up. But we didn't pay cash in this situation, right? The cash was already paid upfront. So what we need to do is we need to lower the value of our prepaid rent, right? Because right now our prepaid rent account says that we have $12,000 in prepaid rent, but that's not true. We've used some of it up. So we need to lower the value down to the correct amount and that would be the $4,000 we've used up, right? So we would want to credit prepaid rent by $4,000 to lower the value of prepaid rent by $4,000. Right? Because we no longer have that asset or that $4,000 worth of that asset. We've used that up. There's still some prepaid rent left for the remaining months, but not the full $12,000. So what happened here? Our prepaid rent account started at $12,000, right? I'm going to put 12K, K for 1,000. $12,000 minus $4,000, right? We've used up 4 $1,000 of it, so it's going to be sitting at $8,000. I will write that one out for the final number. $12,000 minus $4,000 gets us to the $8,000 balance. So on December 31st, if we're going to show a balance sheet, the balance sheet would show $8,000 in prepaid rent as an asset. Right? And our rent expense would be $4,000, right? The $4,000 for the 4 months that have passed, and we made that journal entry in the second in the second box there. Cool? Alright. So let's pause here and then let's consider the same transactions from a cash basis and then we're going to adjust it into an accrual basis of accounting. Okay? So we start the cash basis, and move to accrual basis. Let's check that out, in the upcoming video.

Adjusting Journal Entries:Prepaid Expenses (Cash Basis to Accrual Method)

Alright. So here in the red boxes on the right, I want to do the cash basis to accrual basis conversion. Okay? So I just want to write that up here that we're doing cash basis to accrual. Okay? So what would these entries look like from a cash basis, alright? So the first entry, on September 1st, the company pays $12,000 for a full year of rent in advance, okay? So if the company is paying cash, remember in a cash basis, when the cash goes out, you take the expense regardless of when we use it up. So the cash basis right here would have taken a rent expense. We would have debited rent expense right now for $12,000, and we would credit cash. Right? Because we need to lower our cash balance by $12,000. Notice what's happened in a cash basis of accounting, regardless of us having to use the space or not, we take the full expense for all the rent expense, right? And you can already see why that's not as correct as the accrual accounting basis, right?

So if that is the first entry we make, the rent expense and the cash, now we want to adjust to an accrual basis of accounting, right? Now it's the end of the period. Say we keep our books in cash and then we adjust to accrual basis. It happens sometimes. So what would we do? We have this entry where rent expense is sitting at $12,000, right? But based on the same logic where we found our monthly expense of $1,000 — $12,000 total divided by the 12 months gave us $1,000 a month. And it's been 4 months, right? September, October, November, December. Well, our rent expense should be $4,000, right? From an accrual basis of accounting, we should have $4,000 in rent expense. But right now, our rent expense is sitting at $12,000 right? So how do we bring that rent expense down from $12,000 down to $4,000? So if you think about it, I'm going to do it right down here. Our rent expense T account, right? Remember, we've got our T accounts and our rent expense is sitting at $12,000 right here. Right? Well, we want it to end at $4,000. So how do we bring that debit balance of $12,000 down to $4,000? We need to credit it by $8,000, right? A credit of $8,000 would do $12,000 minus the credit of $8,000 bring it down to a final balance of $4,000, right? Right? So this credit is what we need to take right now. And that brings it down to the correct final balance. Okay?

So that's the trick here. You want to think of what the rent expense should be. The rent expense, in this case, should be $4,000 and what is it currently? It's currently $12,000. So we need to bring it down to $4,000. We're going to have a credit to rent expense, so I'm going to indent it already. I'm going to do the credit entry first. I'm going to do rent expense for $8,000. Now what would be the debit in this transaction? Well, there's $8,000 right? This $8,000 is rent that we still haven't received yet or rent that we still haven't used up yet, right? So what we're going to do is now we create the prepaid rent account for $8,000. So notice in both cases, what is our prepaid rent account in the second case? Well, we only made the one entry for prepaid rent on the adjusting date, where we created the prepaid rent for the 8 months remaining. Right? So we have a prepaid rent balance of $8,000 and our rent expense, well, it was $12,000, right? We started with $12,000 and then we subtracted $8,000 and it left us with $4,000, right? So notice in both cases, our prepaid rent final balance and our rent expense final balance are the same, right? Because all we did was adjust the accounts to be the correct amount on the adjusting date. So the big trick here is to think about on the adjusting date, what the rent expense should have been, right? Regardless of how the cash was paid. And then we want to make sure our prepaid balance is correct, and our rent expense balance is correct. Cool? Alright. Let's go ahead and move on to the next video.

Step-by-Step Process for Prepaid Expenses

So as I was noting before, I just want to have it here in writing one time. When dealing with prepaid expenses, it's best to consider what the final balance in each account would be, right? Just like we consider what should the balance in rent expense be or what should the balance in prepaid rent be, right? So, you want to think about that. What would the final balance be? And we're generally going to do something like this where we first find a monthly expense, we take the total payment. In that case, it was $12,000 for the full year, and we divide it by the number of months covered. In that case, it was 12 months, right? So, that gives us the monthly expense, and then we want to find what, well, we know what the monthly expense was going to be. We need to know what the final amount total of expense would be, right? So we need to know how many months went by. We take the monthly expense and we multiply it by the number of months that have actually passed, right? In our case, it was 4 months that had passed, so we multiply the $1,000 monthly expense times the 4 months. And last, we want to think about the final balance in the prepaid expense account. And that's going to be the total payment, all the cash, right? The total cash payment, which in our case was the $12,000 payment minus the final expense balance, which was $4,000, right? So the final prepaid expense balance in our case, that was where we took the total cash we paid minus the amount we used up. Alright? Excuse me. So let's go ahead and do this example here, and then you guys can try a practice problem.

So on September 1st, a company paid $24,000 for the next 12 months of rent. At this time, the company included the entire amount in the prepaid rent account. The adjusting entry necessary when preparing the December 31st year-end financial statements would include. So let's go ahead and think about the entry that the company did make already, okay? So the company paid $24,000 for 12 months of rent, right? And it says that at this time when they paid, the company included the entire amount in the prepaid rent. So let's think about the entry that they made. They must have made an entry that included it all in prepaid rent. They created the asset. So they debited prepaid rent for $24,000, right? The total amount. And they credited. What do you think they credited? Well, they paid $24,000. They paid it in cash, right? So we got to credit our cash for $24,000. That's the entry that they made on the purchase date, right? On September 1st.

So now we're thinking, what happened? It's now December 31st, 4 months later, right? September, October, November, December have passed. So we've used up some of that prepaid rent. Now we got to think about how much did we use up. So first, let's think about the monthly expense. $24,000 divided by 12 months, well, that gives us $2,000 a month, right? So $2,000 a month times the 4 months that have passed, right? Excuse me, September, October, November, December that tell us that the $8,000 should be our rent expense, okay? So our rent expense should be $8,000. To do that, we need to debit rent expense for $8,000. What about the other side of the entry? Well, we got to credit our prepaid rent, right? We no longer have as much prepaid rent. We've used some of it up, so we got to lower the balance of the prepaid rent with a credit. So there we go. That's what our entry would look like. This is our adjusting entry here, and where is that in the answers? Let's see. It looks like it's answer b. Debit rent expense, credit prepaid rent $8,000. Cool? Alright. Let's move on to the next one.

On January 1, a company purchased a two-year insurance policy at $2,400 per year in cash. At this time, the company included the entire value of the policy in Prepaid Insurance. The coverage began immediately. The adjusting entry necessary when preparing the June 30 financial statements would include:

• A. Debit Prepaid Insurance $1,200; Credit Insurance Expense $1,200
• B. Debit Insurance Expense $1,200; Credit Prepaid Insurance $1,200
• C. Debit Prepaid Insurance $2,400; Credit Insurance Expense $2,400
• D. Debit Insurance Expense $2,400; Credit Prepaid Insurance $2,400

On January 1, a company signed a two-year rental agreement policy at $4,800 per year in cash. At this time, the company included the payment of the lease in Rent Expense. The lease began immediately. The adjusting entry necessary when preparing the June 30 financial statements would include:

• A. Debit Prepaid Rent $2,400; Credit Rent Expense $2,400
• B. Debit Rent Expense $2,400; Credit Prepaid Rent $2,400
• C. Debit Prepaid Rent $7,200; Credit Rent Expense $7,200
• D. Debit Rent Expense $7,200; Credit Prepaid Rent $7,200

The prepaid insurance balance on December 31, 2017 was correctly shown as $900. On April 1, 2018 an additional premium of $600 was paid by the company. The balance sheet at December 31, 2018 showed the appropriate amount of prepaid insurance as $500. The correct amount of insurance expense for 2018 would be:

• A. $600
• B. $1,000
• C. $1,400
• D. $1,500

Here’s what students ask on this topic:

What are adjusting journal entries and why are they important in accrual accounting?

Adjusting journal entries are essential in accrual accounting to update accounts for the passage of time. They ensure that revenues and expenses are recorded in the period they occur, not necessarily when cash is exchanged. This is crucial for providing an accurate financial picture of a company. Adjusting entries typically involve deferrals, where cash is received or paid before the revenue or expense is recognized, and accruals, where the revenue or expense is recorded before cash is exchanged. Without these adjustments, financial statements would not accurately reflect a company's financial position and performance.

How do you account for prepaid expenses in adjusting journal entries?

Prepaid expenses are initially recorded as assets because they represent future economic benefits. For example, if a company pays $12,000 for a year's rent in advance, it debits Prepaid Rent and credits Cash. As time passes, the prepaid expense is gradually expensed. After four months, an adjusting entry would debit Rent Expense for $4,000 (4 months x $1,000/month) and credit Prepaid Rent for $4,000. This reflects the portion of the prepaid asset that has been used up, ensuring the financial statements accurately represent the company's expenses and remaining prepaid assets.

What is the difference between deferrals and accruals in adjusting journal entries?

Deferrals and accruals are two types of adjusting journal entries. Deferrals involve cash transactions occurring before the related revenue or expense is recognized. For example, prepaid expenses (like rent) and unearned revenue are deferrals. Accruals, on the other hand, involve recognizing revenue or expenses before the cash transaction occurs. Examples include accrued expenses (like wages payable) and accrued revenue (like interest receivable). Deferrals adjust for cash received or paid in advance, while accruals adjust for revenues earned or expenses incurred before cash is exchanged.

How do you adjust prepaid rent in financial statements?

To adjust prepaid rent, you need to account for the portion of the rent that has been used up over time. For instance, if a company pays $24,000 for a year's rent in advance, it initially debits Prepaid Rent and credits Cash. After four months, the company needs to recognize the rent expense for those months. The adjusting entry would debit Rent Expense for $8,000 (4 months x $2,000/month) and credit Prepaid Rent for $8,000. This reduces the prepaid rent asset and recognizes the expense in the correct period, ensuring accurate financial statements.

Why are prepaid expenses considered assets?

Prepaid expenses are considered assets because they represent future economic benefits that the company will receive. When a company prepays for an expense, such as rent or insurance, it has not yet received the benefit of that payment. Instead, it holds a right to future services or use of an asset. For example, if a company prepays $12,000 for a year's rent, it has an asset worth $12,000, representing the future use of the rented space. As time passes and the company uses the space, the prepaid expense is gradually expensed, reducing the asset.