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Accrued rent is the opposite of the prepaid rent discussed earlier. Recall that prepaid rent accounting related to rent that was paid in advance. In contrast, accrued rent relates to rent that has not yet been paid - but the utilization of the asset has already occurred. For example, assume that office space is leased, and the terms of the agreement stipulate that rent will be paid within 10 days after the end of each month at the rate of $400 per month. During December of 20x1, Cabul Company occupied the lease space, and the appropriate adjusting entry for December follows:
When the rent is paid on January 10, 20x2, this entry would be needed:
Many businesses provide services to clients under an understanding that they will be periodically billed for the hours (or other units) of service provided. For example, an accounting firm may track hours worked on various projects for their clients. These hours are likely accumulated and billed each month, with the periodic billing occurring in the month following the month in which the service is provided. As a result, money has been "earned" during a month, even though it won't be billed until the following month. Accrual accounting concepts dictate that such revenues be recorded when "earned." The following entry would be needed at the end of December to accrue revenue for services rendered to date (even though the physical billing of the client may not occur until January):
Recap of Adjustments
The preceding discussion of adjustments has been presented in great detail because it is imperative to grasp the underlying income measurement principles. Perhaps the single most important element of accounting judgment is to develop an appreciation for the correct measurement of revenues and expenses. These processes can be fairly straight-forward, as in the above illustrations. At other times, the measurements can grow very complex. A business process rarely starts and stops at the beginning and end of a month, quarter or year - yet the accounting process necessarily divides that flowing business process into measurement periods. And, the adjusting process is all about getting it right; to assign costs and revenues to each period in a proper fashion.
The Adjusted Trial Balance
Keep in mind that the trial balance introduced in the previous chapter was prepared before considering adjusting entries. Subsequent to the adjustment process, another trial balance can be prepared. This adjusted trial balance demonstrates the equality of debits and credits after recording adjusting entries. The adjusted trial balance would look the same as the trial balance, except that all accounts would be updated for the impact of each of the adjusting entries. Therefore, correct financial statements can be prepared directly from the adjusted trial balance. The next chapter looks at the adjusted trial balance in detail.
Alternative Procedures for Certain Adjustments
In accounting, as in life, there is often more than one approach to the same end result. The mechanics of accounting for prepaid expenses and unearned revenues can be carried out in several ways. No matter which method is employed, the resulting financial statements should be identical.
As an example, recall the illustration of accounting for prepaid insurance - Prepaid Insurance was debited and Cash was credited at the time of purchase. This is referred to as a "balance sheet approach" because the expenditure was initially recorded into a prepaid account on the balance sheet. However, an alternative approach is the "income statement approach." With this approach, the Expense account is debited at the time of purchase. The appropriate end-of-period adjusting entry "establishes" the Prepaid Expense account with a debit for the amount relating to future periods. The off setting credit reduces the expense account to an amount equal to the amount consumed during the period. Review the following comparison, noting in particular that Insurance Expense and Prepaid Insurance accounts have identical balances at December 31 under either approach:
Accounting for unearned revenue can also follow a balance sheet or income statement approach. The balance sheet approach for unearned revenue was presented earlier in this chapter, and is represented at left below. At right is the income statement approach for the same facts. Under the income statement approach, the initial receipt is recorded entirely to a Revenue account. Subsequent end-of-period adjusting entries reduce Revenue by the amount not yet earned and increase unearned revenue. As you can see, both approaches produce the same financial statements.
The balance sheet and income statement methods result in identical financial statements. Notice that the income statement approach does have an advantage if the entire prepaid item or unearned revenue is fully consumed or earned by the end of an accounting period. No adjusting entry is needed because the expense or revenue was fully recorded at the date of the original transaction.