Prepaid expenses (a.k.a.

prepayments) represent payments made for expenses which have not yet been
incurred.
In other words, these are "advanced payments" by a company for supplies, rent, utilities and others that
are still to be consumed. Hence, they are included in the company's assets.
Expenses are recognized when they are incurred regardless of when paid. Expenses are
considered incurredwhen they are used, consumed, utilized or has expired.
Because prepayments they are not yet incurred, they are not recorded as expenses. Rather, they are
classified as current assets since they are readily available for use.
Prepaid expenses may need to be adjusted at the end of the accounting period. The adjusting entry for
prepaid expense depends upon the journal entry made when it was initially recorded.
There are two ways of recording prepayments: (1) the asset method, and (2) the expense method.
Asset Method
Under the asset method, a prepaid expense account (an asset) is recorded when the amount is paid.
Prepaid expense accounts include: Office Supplies, Prepaid Rent, Prepaid Insurance, and others.
In one of our previous illustrations (if you have been following our comprehensive illustration for Gray
Electronic Repair Services), we made this entry to record the purchase of service supplies:
Dec 7 Service Supplies 1,500.00
Cash 1,500.00
Take note that the amount has not yet been incurred, thus it is proper to record it as an asset.
Suppose at the end of the month, 60% of the supplies have been used. Thus, out of the $1,500, $900
worth of supplies have been used and $600 remain unused. The $900 must then be recognized as
expense since it has already been used.

In preparing the adjusting entry, our goal is to transfer the used part from the asset initially recorded into
expense – for us to arrive at the proper balances shown in the illustration above.
The adjusting entry will include: (1) recognition of expense and (2) decrease in the asset initially
recorded (since some of it has already been used). The adjusting entry would be:
Dec 31 Service Supplies Expense 900.00
Service Supplies 900.00
The "Service Supplies Expense" is an expense account while "Service Supplies" is an asset. After making
the entry, the balance of the unused Service Supplies is now at $600 ($1,500 debit and $900 credit).
Service Supplies Expense now has a balance of $900. Now, we've achieved our goal.
Expense Method
Under the expense method, the accountant initially records the entire payment as expense. If the
expense method was used, the entry would have been:
Dec 7 Service Supplies Expense 1,500.00
Cash 1,500.00
Take note that the entire amount was initially expensed. If 60% was used, then the adjusting entry at
the end of the month would be:
Dec 31 Service Supplies 600.00
Service Supplies Expense 600.00
This time, Service Supplies is debited for $600 (the unused portion). And then, Service Supplies Expense
is credited thus decreasing its balance. Service Supplies Expense is now at $900 ($1,500 debit and $600
credit).
Notice that the resulting balances of the accounts under the two methods are the same (Cash paid:
$1,500; Service Supplies Expense: $900; and Service Supplies: $600).
Another Example
GVG Company acquired a six-month insurance coverage for its properties on September 1, 2016 for a
total of $6,000.
Under the asset method, the initial entry would be:
Sep 1 Prepaid Insurance 6,000.00
Cash 6,000.00
On December 31, 2016, the end of the accounting period, part of the prepaid insurance already has
expired (hence, expense is incurred). The expired part is the insurance from September to December.
Thus, we should make the following adjusting entry:
Dec 31 Insurance Expense 4,000.00
Prepaid Insurance 4,000.00
Of the total six-month insurance amounting to $6,000 ($1,000 per month), the insurance for 4 months
has already expired. In the entry above, we are actually transferring $4,000 from the asset to the
expense account (i.e., from Prepaid Insurance to Insurance Expense).
If the company made use of the expense method, the initial entry would be:
Sep 1 Insurance Expense 6,000.00
Cash 6,000.00
In this case, we must decrease Insurance Expense by $2,000 because that part has not yet been incurred
(not used/not expired). Insurance Expense shall then have a balance of $4,000. The amount removed
from the expense shall be transferred to Prepaid Insurance. The adjusting entry would be:
Dec 31 Prepaid Insurance 2,000.00
Insurance Expense 2,000.00
Conclusion
What we are actually doing here is making sure that the incurred (used/expired) portion is included in
expense and the unused part into asset. The adjusting entry will always depend upon the method used
when the initial entry was made.
If you are having a hard time understanding this topic, I suggest you go over and study the lesson again.
Sometimes, it really takes a while to get the concept. Preparing adjusting entries is one of the challenging
(but important) topics for beginners.

Unearned revenue (also known as deferred revenue or deferred income) represents revenue already
collected but not yet earned.
Hence, they are also called "advances from customers".
Following the accrual concept of accounting, unearned revenues are considered as liabilities.
t is to be noted that under the accrual concept, income is recognized when earned regardless of when
collected.
And so, unearned revenue should not be included as income yet; rather, it is recorded as a liability. This
liability represents an obligation of the company to render services or deliver goods in the future. It will
be recognized as income only when the goods or services have been delivered or rendered.
At the end of the period, unearned revenues must be checked and adjusted if necessary. The adjusting
entry for unearned revenue depends upon the journal entry made when it was initially recorded.
There are two ways of recording unearned revenue: (1) the liability method, and (2) the income method.
Liability Method of Recording Unearned Revenue
Under the liability method, a liability account is recorded when the amount is collected. The common
accounts used are: Unearned Revenue, Deferred Income, Advances from Customers, etc. For this
illustration, let us use Unearned Revenue.
Suppose on January 10, 2016, ABC Company made $30,000 advanced collections from its customers. If
the liability method is used, the entry would be:
Jan 10 Cash 30,000.00
Unearned Revenue 30,000.00
Take note that the amount has not yet been earned, thus it is proper to record it as a liability. Now, what
if at the end of the month, 20% of the unearned revenue has been rendered? This will require an
adjusting entry.
The adjusting entry will include: (1) recognition of $6,000 income, i.e. 20% of $30,000, and (2) decrease
in liability (unearned revenue) since some of it has already been rendered. The adjusting entry would be:
Jan 31 Unearned Revenue 6,000.00
Service Income 6,000.00

We are simply separating the earned part from the unearned portion. Of the $30,000 unearned revenue,
$6,000 is recognized as income. In the entry above, we removed $6,000 from the $30,000 liability. The
balance of unearned revenue is now at $24,000.
Income Method of Recording Unearned Revenue
Under the income method, the accountant records the entire collection under an incomeaccount. Using
the same transaction above, the initial entry for the collection would be:
Jan 10 Cash 30,000.00
Service Income 30,000.00
If at the end of the year the company earned 20% of the entire $30,000, then the adjusting entry would
be:
Jan 31 Service Income 24,000.00
Unearned Income 24,000.00
By debiting Service Income for $24,000, we are decreasing the income initially recorded. The balance of
Service Income is now $6,000 ($30,000 - 24,000), which is actually the 20% portion already earned. By
crediting Unearned Income, we are recording a liability for $24,000.
Notice that the resulting balances of the accounts under the two methods are the same (Cash: $30,000;
Service Income: $6,000; and Unearned Income: $24,000).
Another Example
On December 1, 2016, DRG Company collected from TRM Corp. a total of $60,000 as rental fee for three
months starting December 1.
Under the liability method, the initial entry would be:
Dec 1 Cash 60,000.00
Unearned Rent Income 60,000.00
On December 31, 2016, the end of the accounting period, 1/3 of the rent received has already been
earned (prorated over 3 months).

We should then record the income through this adjusting entry:

Dec 31 Unearned Rent Income 20,000.00
Rent Income 20,000.00
In effect, we are transferring $20,000, one-third of $60,000, from the Unearned Rent Income (a liability)
to Rent Income (an income account) since that portion has already been earned.
If the company made use of the income method, the initial entry would be:
Dec 1 Cash 60,000.00
Rent Income 60,000.00
In this case, we must decrease Rent Income by $40,000 because that part has not yet been earned. The
income account shall have a balance of $20,000. The amount removed from income shall be transferred
to liability (Unearned Rent Income). The adjusting entry would be:
Dec 31 Rent Income 40,000.00
Unearned Rent Income 40,000.00
Conclusion
If you have noticed, what we are actually doing here is making sure that the earned part is included in
income and the unearned part into liability. The adjusting entry will always depend upon the method
used when the initial entry was made.
If you are having a hard time understanding this topic, I suggest you go over and study the lesson again.
Sometimes, it really takes a while to get the concept. Preparing adjusting entries is one of the most
challenging (but important) topics for beginners.