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Chapter 4.2

chapter 4.2

Financial Accounting
Course Code
Liang Chen

of 1
Chapter 4
Types of Adjusting Entries
Prepayments: prepaid expense or unearned revenues
Accruals: Accrued expense or Accrued revenues
Adjusting Entries for Prepayments
Prepayments are either prepaid expenses or unearned revenues. Adjusting entries for prepayments
record the portion of the payment that applies to the current accounting period. This type of adjusting is
necessary because the prepayment no longer has future benefit and consequently is no longer an asset
t it has been used.
Costs that are paid for in cash before they are used are recorded as prepaid expenses. When such a cost
is incurred, as asset (prepaid) account should be increased (debit) t to show the service or benefit that
will be received in the future t and cash should be decreased (credited). Prepaid expenses are costs
that expire either with the passage of time (i.e. insurance, rent) or through use (i.e supplies). At each
statement date, adjusting entries are made for two purposes: (1) to record the expenses (expired costs)
applicable to the current accounting period, and (2) to show the remaining amounts in the asset
Depreciation is the process of allocating the cost of a long-lived asset, such as property or equipment, to
expense over its useful life. When an asset (i.e. land) has unlimited life, you do not depreciate.
Depreciation is an allocation concept, not a valuation concept. That is, we depreciate an asset to
allocate its costs to the periods over which we use it. We are not trying to record a change in the actual
value of the asset. We are only trying to match expenses with the revenues they generate in each period.
Calculation of deprecation uses the common method of straight-line method of depreciation.
Cost/Number of useful life in years = annual depreciation expense. The depreciation expense will be
debited, while the contra asset, accumulated depreciation, will be credited. The difference between the
cost of a depreciable asset and its related accumulated depreciation is referred to as the carrying
amount of the asset (or net book value).
Cash received before revenue is earned is recorded by increasing a liability account called unearned
revenue. Unearned revenues are the opposite of prepaid expenses. When the service is completed,
unearned revenue becomes revenue.