Illustration of Prepaid Rent
Assume a two-month lease is entered and rent paid in advance on March 1, 20x1, for $3,000. The following entry would be needed to record the transaction on March 1:
By March 31, 20x1, half of the rental period has lapsed. If financial statements were to be prepared at the end of March, an adjusting entry to record rent expense and reduce prepaid rent would be needed on that financial statement date:
As a result of the preceding entries, the income statement for March would report rent expense of $1,500, and the balance sheet at March 31, would report prepaid rent of $1,500 ($3,000 debit less $1,500 credit). The remaining $1,500 prepaid amount would be expensed in April.
I'm a Bit Confused - Exactly When do I Adjust?
In the illustration for insurance, the adjustment was applied at the end of December, but the rent adjustment occurred at the end of March. What's the difference? What was not stated in the first illustration was an assumption that financial statements were only being prepared at the end of the year, in which case the adjustments were only needed at that time. In the second illustration, it was explicitly stated that financial statements were to be prepared at the end of March, and that necessitated an end of March adjustment. There is a moral to this: adjustments should be made every time financial statements are prepared, and the goal of the adjustments is to correctly assign the appropriate amount of expense to the time period in question (leaving the remainder in a balance sheet account to carry over to the next time period(s)). Every situation will be somewhat unique, and careful analysis and thoughtful consideration must be brought to bear to determine the correct amount of adjustment.
To extend your understanding of this concept, return to the facts of the insurance illustration, but assume monthly financial statements were prepared. What adjusting entry would be needed each month? The answer is that every month would require an adjusting entry to remove (credit) an additional $250 from prepaid insurance ($9,000/36 months during the 3-year period = $250 per month), and charge (i.e., debit) insurance expense. This would be done in lieu of the annual entry.
Illustration of Supplies
The initial purchase of supplies is recorded by debiting Supplies and crediting Cash. Supplies Expense should subsequently be debited and Supplies should be credited for the amount used. This results in supplies expense on the income statement being equal to the amount of supplies used, while the remaining balance of supplies on hand is reported as an asset on the balance sheet. The following illustrates the purchase of $900 of supplies. Subsequently, $700 of this amount is used, leaving $200 of supplies on hand in the Supplies account:
The above example is probably not too difficult for you. So, let's dig a little deeper, and think about how these numbers would be produced. Obviously, the $900 purchase of supplies would be traced to a specific transaction. In all likelihood, the supplies were placed in a designated supply room (like cabinet, closet, or chest). Perhaps the storage room has a person "in charge" to make sure that supplies are only issued for legitimate purposes to authorized personnel (a log book may be maintained). Each time someone withdraws supplies, a journal entry to record expense could be initiated; but, of course, this would be time consuming and costly (you might say that the record keeping cost would exceed the benefit). Instead, it is more likely that supplies accounting records will only be updated at the end of an accounting period.
To determine the amount of adjustment, one might "back in" to the calculation: Supplies in the storage room are physically counted at the end of the period (assumed to be $200); since the account has a $900 balance from the December 8 entry, one "backs in" to the $700 adjustment on December 31. In other words, since $900 of supplies was purchased, but only $200 was left over, then $700 must have been used.
The following year becomes slightly more challenging. If an additional $1,000 of supplies is purchased during 20x2, and the ending balance at December 31, 20x2, is physically counted at $300, then these entries would be needed:
The $1,000 amount is clear enough, but what about the $900 of expense? You must take into account that you started 20x2 with a $200 beginning balance (last year's "leftovers"), purchased an additional $1,000 (giving you total "available" for the period at $1,200), and ended with only $300 of supplies. Thus, $900 was "used up" during the period: