Appendix 3A: Alternative Treatment of Prepaid Expenses and Unearned Revenues 3-1
Appendix 3A
Alternative Treatment of Prepaid Expenses
and Unearned Revenues
LEARNING OBJECTIVE 5
Prepare adjusting entries for the alternative treatment of prepayments and
unearned revenues.
In our discussion of adjusting entries for prepaid expenses and unearned revenues, we illustrated transactions for which the company had previously made entries in balance sheet
accounts. In the case of prepaid expenses, the prepayment was debited to an asset account. In
the case of unearned revenue, the cash received was credited to a liability account. Recording
transactions in a balance sheet account improves internal control over assets and liabilities
and imitates the real flow of costs (i.e., from asset to expense).
Some businesses use an alternative treatment: (1) When a company prepays an expense, it
debits that amount to an expense account instead of an asset. (2) When it receives cash for future
services, it credits a revenue account instead of a liability account. The following sections describe
the circumstances that justify such entries and the different adjusting entries that may be needed.
Prepaid Expenses
Prepaid expenses become expired costs either as time passes, as with insurance, or as they
are used up, as with supplies. If, when it makes a purchase, the company expects to consume
the supplies before the next financial statement date, it may be more convenient to first debit
(increase) an expense account rather than an asset account.
Assume that Lynk Software Services expects that all of the supplies purchased on October
4 will be used before the end of the month. A debit of $2,500 to Supplies Expense on October
4, rather than to the asset account Supplies, will eliminate the need for an adjusting entry on
­October 31, if all the supplies are used. At October 31, the Supplies Expense account will show
a balance of $2,500, which is the cost of supplies purchased between October 4 and October 31.
But what if the company does not use all the supplies? What if an inventory of $1,000
of supplies remains on October 31? Obviously, an adjusting entry is needed. Lynk will need
to decrease its Supplies Expense account because it didn’t use all of the supplies purchased.
And it will need to increase an asset account, Supplies, to show it has supplies on hand. The
following adjusting entry is then made:
Oct. 31
Supplies
Supplies Expense
To record supply inventory.
A
=
+1,000
1,000
1,000
L
+
OE
+1,000
Cash Flows: no effect
After posting of the adjusting entry, the accounts show the following:
Supplies
Oct. 31 Adj.
1,000
Supplies Expense
Oct. 4
2,500
Bal.
Oct. 31 Adj.
1,000
1,500
After adjustment, the asset account Supplies shows a balance of $1,000, which is equal to
the cost of supplies on hand at October 31. In addition, Supplies Expense shows a balance of
$1,500, which is equal to the cost of supplies used between October 4 and October 31 ($2,500
− $1,000). If the adjusting entry is not made, expenses will be overstated and profit will be
understated by $1,000 in the October income statement. Also, both assets and owner’s equity
will be understated by $1,000 on the October 31 balance sheet.
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C H A PT E R 3
Adjusting the Accounts
A comparison of the entries and accounts for supplies in the chapter and here in the
appendix follows:
Prepayment Debited to Expense Account
(as in appendix)
Prepayment Debited to Asset Account
(as in chapter)
Oct. 4
Supplies
Accounts Payable
31 Supplies Expense
Supplies
2,500
1,500
2,500
1,500
Oct. 4
Supplies Expense
Accounts Payable
2,500
31
Supplies
Supplies Expense
1,000
2,500
1,000
After posting of the entries, the accounts appear as follows:
Prepayment Debited to Asset Account
(as in chapter)
Prepayment Debited to Expense Account
(as in appendix)
Supplies
Oct. 4
2,500
Bal.
Oct. 31
Supplies
Adj.
1,500
Oct. 31 Adj.
Supplies Expense
Oct. 31
1,000
1,000
Adj.
Supplies Expense
1,500
Oct. 4
2,500
Oct. 31 Adj. 1, 000
Bal. 1,500
Note that the account balances under each alternative are the same at October 31 (Supplies
$1,000, and Supplies Expense $1,500).
Unearned Revenues
Unearned revenues are earned either as time passes, as with unearned rent, or by providing
the service, as with unearned fees. Rather than first crediting (increasing) an unearned revenue (liability) account, a revenue account may be credited (increased) when cash is received
for future services. Then a different adjusting entry may be necessary.
To illustrate, assume that when Lynk Software received $1,200 for future services on
October 3, the services were expected to be performed before October 31. In such a case, Service Revenue would be credited. If all the revenue is in fact earned before October 31, no
adjustment is needed. However, if at the statement date $800 of the services have not been
provided, an adjusting entry is needed to reduce revenue and increase liabilities by $800. The
following adjusting entry is made:
A
=
L
+800
Cash Flows: no effect
+
OE
–800
Oct. 31
Service Revenue
Unearned Revenue
To record unearned revenue.
800
800
After posting of the adjusting entry, the accounts show:
Unearned Revenue
Oct. 31
Service Revenue
Adj.
800
Oct. 31
Adj.
800
Oct. 3
1,200
Bal.
400
The liability account Unearned Revenue shows a balance of $800, which is equal to the
services that will be provided in the future. In addition, the $400 balance in Service Revenue is
equal to the services provided in October ($1,200 − $800). If the adjusting entry is not made,
both revenues and profit will be overstated by $800 in the October income statement. On the
October 31 balance sheet, liabilities will also be understated by $800, and owner’s equity will
be overstated by $800.
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Appendix 3A: Alternative Treatment of Prepaid Expenses and Unearned Revenues 3-3
A comparison of the entries and accounts for service revenue and unearned revenue in
the chapter and here in the appendix follows:
Unearned Revenue Credited to Liability Account
(as in chapter)
Oct. 3
Cash
Unearned Revenue
1,200
31 Unearned Service
Service Revenue
Unearned Revenue Credited to Revenue Account
(as in appendix)
Oct. 3
1,200
400
Cash
Service Revenue
Oct. 31 Service Revenue
Unearned Revenue
400
1,200
1,200
800
800
After posting the entries, the accounts will show:
Unearned Revenue Credited to Liability
Account (as in chapter)
Unearned Revenue Credited to Revenue
Account (as in appendix)
Unearned Revenue
Unearned Revenue
Oct. 31 Adj.
400 Oct. 3
Oct. 31 Bal.
1,200
Oct. 31
Service Revenue
Oct. 31 Adj.
Adj.
800
800
Service Revenue
400
Oct. 31
Adj.
800
Oct. 3
1,200
Oct. 31
Bal.
400
Note that the balances in the accounts are the same under the two alternatives (Unearned
Revenue $800, and Service Revenue $400).
As companies always record long-lived assets as assets, there isn’t an alternative method
of making an adjusting entry for depreciation. And there isn’t an alternative method of making
adjusting entries for accruals, because no entries occur before accrual adjusting entries are made.
Remember, with an accrual, cash is paid or received after the end of the accounting period.
DO IT! 3.5 Adjusting Entries for Prepayments and
Unearned Revenues (Alternative Treatment)
ACTION PLAN
Mansell Consulting records prepayments as expenses and cash received in advance of providing
services as revenue. During February, the following transactions occurred:
Feb. 4 Paid $950 for supplies.
10 Received $2,350 from a client for services to be performed in the future.
On February 28, Mansell determined that $1,750 of the service revenue had been earned and that
there was $750 of supplies on hand.
1. Journalize the February transactions.
2. Journalize the adjusting entries at February 28.
Solution
1.
Feb. 4
10
2.
28
28
Supplies Expense
Cash
To record purchase of supplies.
Cash
Service Revenue
To record cash received for services to be provided.
Supplies
Supplies Expense
To record supplies on hand as an asset.
Service Revenue
Unearned Revenue
To record the obligation to provide services in the
future ($2,350 − $1,750).
950
2,350
750
600
950
• Expenses are recorded
as debits and revenues
as credits.
• If a prepayment is
recorded as an expense,
an adjustment will be
required at the end of
the period if an asset
exists.
• If cash received in
advance of providing
services is recorded as
revenue, an adjustment
will be required at the
end of the period if part
of the revenue is still
unearned.
2,350
750
600
Related exercise material: BE3.1, BE3.2, E3.1, and E3.2.
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Adjusting the Accounts
Summary
1. Prepare adjusting entries for the alternative treatment of prepayments and unearned revenues (Appendix 3A). Prepayments may initially
be debited (increased) to an expense account. Unearned revenues may initially be credited (increased) to a revenue account. At the end of the period,
these revenue or expense accounts may be overstated. The adjusting entries
for prepaid expenses are a debit (increase) to an asset account and a credit
(decrease) to an expense account. Adjusting entries for unearned revenues
are a debit (decrease) to a revenue account and a credit (increase) to a liability account. It does not matter which alternative is used to record and adjust
prepayments, as the ending account balances should be the same with both
methods.
Self-Study Questions
Answers are at the end of the Appendix.
1. (SO 5) AP The trial balance shows Supplies $0 and Supplies
Expense $1,350. If $600 of supplies are on hand at the end of the
period, the adjusting entry is:
a. Supplies
Supplies Expense
b. Supplies Expense
Supplies
c. Supplies
Supplies Expense
d. Supplies Expense
Supplies
600
750
750
600
600
750
750
600
2. (SO 5) AP On February 1, Mag City received $6,000 for services
to be provided in the future and credited the Service Revenue account.
As at February 28, $3,200 of the services have been provided. How
should this be reported in the February 28 financial statements?
Balance Sheet
a. Unearned
revenue $3,200
b. Service
revenue $2,800
c. Unearned
revenue $2,800
d. Service
revenue $3,200
Income Statement
Service
revenue $2,800
Unearned
revenue $3,200
Service
revenue $3,200
Unearned
revenue $2,800
Questions
1. (SO 5) C Some companies debit an expense account at the time
an expense is prepaid instead of debiting an asset account. The problem with this approach is that expenses will always be overstated, and
assets understated. Do you agree or disagree? Why?
2. (SO 5) C If a company credits a revenue account when cash is
received in advance of providing a service, then the adjusting entry
is the same as if the company had credited a liability account when it
received the cash. Is this correct? Why or why not?
Brief Exercises
Prepare and post adjusting entry for
supplies.
BE3.1 (SO 5) AP Hahn Consulting Company’s general ledger showed $825 in the Supplies account on
January 1, 2021. On May 31, 2021, the company paid $3,165 for additional supplies. A count on December 31, 2021, showed $1,015 of supplies on hand. Instead of debiting an asset account for the purchases
of supplies, Hahn Consulting Company debits an expense account.
a. Using T accounts, enter the January 1, 2021, balance in the Supplies and Supplies Expense accounts.
b. Prepare the journal entry to record the purchase of supplies on May 31, 2021. Post the part of the
journal entry that affects only the Supplies or Supplies Expense account.
c. Determine what amounts should appear on the 2021 financial statements for Supplies and Supplies
Expense.
d. Prepare and post the adjusting entry required at December 31, 2021.
Prepare and post adjusting entry for
unearned revenue.
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BE3.2 (SO 5) AP On March 1, 2021, Big North Insurance received $4,800 cash from Eire Co. for a
­one-year insurance policy. Big North Insurance has an October 31 fiscal year end and adjusts accounts
annually. Assume that instead of crediting a liability account for the $4,800, one-year insurance policy,
Big North Insurance credits a revenue account on March 1, 2021.
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Appendix 3A: Alternative Treatment of Prepaid Expenses and Unearned Revenues 3-5
a. Prepare the adjusting entry at October 31, 2021. Using T accounts, enter the balances in the accounts,
post the adjusting entry, and indicate the adjusted balance in each account.
b. Does it matter whether an original entry is recorded to a liability account or a revenue account?
Explain.
Exercises
E3.1 (SO 5) AP Action Quest Games adjusts its accounts annually. The following information is
available for the year ended December 31, 2021. Assume that prepaid expenses are initially recorded
as expenses. Assume that revenues collected in advance of the work are initially recorded as revenue.
Prepare and post transaction and
adjusting entries for prepayments.
1. A $4,020 one-year insurance policy was purchased on April 1, 2021.
2. Paid $6,500 on August 31, 2021, for five months’ rent in advance.
3. On September 27, 2021, received $3,600 cash from a corporation that sponsors games for the most
improved students attending a nearby school. The $3,600 was for 10 games, worth $360 each, that
are played on the first Friday of each month starting in October. (Use the Unearned Revenue and
Admission Revenue accounts.)
4. Signed a contract for advertising services starting December 1, 2021, for $500 per month. Paid for the
first three months on November 30, 2021.
Instructions
a. For each transaction: (1) prepare the journal entry to record the initial transaction, and (2) prepare
the adjusting journal entry required on December 31, 2021.
b. Post each of these entries to T accounts and calculate the final balance in each account. (Note: Posting to the Cash account is not necessary.)
E3.2 (SO 2, 5) AP At Richmond Company, the following select transactions occurred in January, the
company’s first month of operations:
Jan. 1
2
5
19
31
Prepare and post transaction and
adjusting entries for prepayments.
Paid rent of $1,000 for January.
Paid $1,920 for a one-year insurance policy.
Paid $1,700 for supplies.
Received $6,100 cash for services to be performed in the future.
Paid rent of $1,000 for February.
Additional information:
1. On January 31, it is determined that $2,500 of the service revenue has been earned.
2. On January 31, a count of supplies shows that there is $650 of supplies on hand.
Instructions
a. Assume Richmond records all prepaid costs as expenses, and all revenue collected in advance as revenue. Journalize the January transactions and post to T accounts. (Note: Posting to the Cash account
is not necessary.)
b. Journalize and post the January 31 adjustments.
c. Determine the ending balances in each of the accounts.
Problems: Set A
P3.1A (SO 2, 5) AP Horowitz Piano Co. began operations on January 1, 2021. Its fiscal year end is
December 31. It prepares financial statements and adjusts its accounts annually. Selected transactions
for 2021 follow:
Prepare and post transaction and
adjusting entries for prepayments.
1. On January 15, 2021, bought supplies for $960 cash. A physical count on December 31, 2021, revealed
$245 of supplies still on hand.
2. Bought a $3,090, one-year insurance policy for cash on April 1, 2021. The policy came into effect on
this date.
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3. On November 1, 2021, received a $1,750 advance cash payment from five clients ($350 each) for
services expected to be provided in the future. As at December 31, 2021, services had still not been
performed for two of the clients.
Instructions
a.Assume that Horowitz Piano Co. records all prepaid costs as assets and all revenues collected in
advance as liabilities.
1. Prepare the journal entries for the original transactions.
2. Prepare the adjusting journal entries at December 31, 2021.
3. Post these journal entries to T accounts and calculate the balance in each account after adjustments. You do not need to post to the Cash account.
b.Assume instead that Horowitz Piano Co. records all prepaid costs as expenses and all revenues collected in advance as revenues.
1. Prepare the journal entries for the original transactions.
2. Prepare the adjusting journal entries at December 31, 2021.
3. Post these journal entries to T accounts and calculate the balance in each account after adjustments. You do not need to post to the Cash account.
Taking it Further Compare the balance in each account calculated under (a) above with the balances
calculated in (b). Comment on your findings.
Prepare adjusting entries and adjusted
trial balance using the alternative treatment of prepayments.
P3.2A (SO 3, 4, 5) AP Winter Designs was organized on January 1, 2021, by Katie Brownsey. Winter
Designs records all prepaid costs as expenses and revenue received in advance as revenue. At the end of
the first year of operations, the trial balance had the following accounts:
Winter Designs
Trial Balance
December 31, 2021
Debit
Cash
Accounts receivable
Equipment
Accounts payable
Note payable
K. Brownsey, capital
K. Brownsey, drawings
Service revenue
Insurance expense
Rent expense
Salaries expense
Supplies expense
$ 16,600
26,000
80,000
40,000
4,020
7,800
59,900
5,900
$240,220
Credit
$ 14,820
44,000
60,000
121,400
$240,220
Analysis reveals the following additional data:
1. On February 1, 2021, the company purchased a one-year insurance policy.
2. The one-year, 5% note payable was issued on March 1, 2021. Interest and principal are payable on the
maturity date.
3. The equipment was purchased on March 2, 2021, and has an estimated useful life of eight years.
4. At December 31, 2021, there was $785 of supplies on hand.
5. At December 31, 2021, service revenue of $2,550 was unearned.
6. Service revenue earned but unbilled and unrecorded at December 31, 2021, totalled $1,275.
7. January 2022 rent of $600 was paid on December 31, 2021, and is included in Rent Expense.
Instructions
a. Journalize the adjusting entries at December 31, 2021. (Adjustments are recorded annually.)
b. Prepare an adjusted trial balance.
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Appendix 3A: Alternative Treatment of Prepaid Expenses and Unearned Revenues 3-7
Taking it Further If Winter Designs initially recorded all prepaid costs as assets and all revenue received in advance as a liability, would this result in different numbers in the adjusted trial balance than
in (b)? Explain.
Problems: Set B
P3.1B (SO 2, 5) AP Garrett Bass Co. began operations on January 1, 2021. Its fiscal year end is December 31. It prepares financial statements and adjusts its accounts annually. Selected transactions for 2021
follow:
Prepare and post transaction and
adjusting entries for prepayments.
1. On January 1, 2021, bought supplies for $1,250 cash. A physical count at December 31, 2021, revealed
$375 of supplies still on hand.
2. Bought a $2,820, one-year insurance policy for cash on February 1, 2021. The policy came into effect
on this date.
3. On December 1, Garrett received a $1,200 advance cash payment from four clients ($300 each) for
services expected to be provided in the future. As at December 31, services had been performed for
only one of the clients.
Instructions
a.Assume that Garrett Bass Co. records all prepaid costs as assets and all revenues collected in advance
as liabilities.
1. Prepare the journal entries for the original transactions.
2. Prepare the adjusting journal entries at December 31, 2021.
3. Post these journal entries to T accounts and calculate the balance in each account after adjustments. You do not need to post to the Cash account.
b.Assume instead that Garrett Bass Co. records all prepaid costs as expenses and all revenues collected
in advance as revenues.
1. Prepare the journal entries for the original transactions.
2. Prepare the adjusting journal entries at December 31, 2021.
3. Post these journal entries to T accounts and calculate the balance in each account after adjustments. You do not need to post to the Cash account.
Taking it Further Compare the balances in each account calculated under (a) above with those calculated in (b). Comment on your findings.
P3.2B (SO 3, 4, 5) AP Summer Design Company was organized on January 1, 2021, by Corine Burian.
Summer Design records all prepaid costs as expenses and all revenues received in advance as revenue. At
the end of the first year of operations, the trial balance had the following accounts:
Prepare adjusting entries and adjusted
trial balance using the alternative treatment of prepayments.
Summer Design Company
Trial Balance
December 31, 2021
Debit
Cash
Accounts receivable
Equipment
Accounts payable
Note payable
C. Burian, capital
C. Burian, drawings
Service revenue
Insurance expense
Interest expense
Rent expense
Salaries expense
Supplies expense
$ 8,790
12,970
45,900
16,800
1,980
1,485
8,125
28,800
5,350
$130,200
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Credit $ 5,500
32,400
28,000
64,300
$130,200
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C H A PT E R 3
Adjusting the Accounts
Analysis reveals the following additional information:
1. A one-year, 5% note payable was issued January 2, 2021. Interest is payable monthly on the first of
the month. Principal is payable at maturity.
2. Equipment was purchased on January 3, 2021, and has an estimated useful life of 12 years.
3. On April 1, 2021, the company purchased a one-year insurance policy.
4. During the year, Summer Designs collected $6,000 cash from customers before providing services to
them. At December 31, 2021, $4,500 of this amount has been earned.
5. A count at December 31, 2021, showed $445 of supplies on hand.
6. Salaries of $850 are owed at December 31, 2021.
7. January 2022 rent of $625 was paid on December 31, 2021, and is included in Rent Expense.
Instructions
a. Journalize the adjusting entries at December 31. (Adjustments are recorded annually.)
b. Prepare an adjusted trial balance.
Taking it Further If Summer Designs recorded all prepaid costs as assets and all revenue received in
advance as a liability, would this result in different numbers in the adjusted trial balance than in (b)?
Answers to Self-Study Questions
1. a 2. c.
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