Adjusting what was paid or received in advance¶
Say your apartment complex bills you for a full year of renter's insurance every January, paid all at once. By February, has the insurance company earned any of that money, or is it still holding all of it? Its books have to answer that question every single month, and getting it wrong overstates or understates how much the company actually earned. The same fix applies any time cash moves before the expense or revenue it's tied to actually happens. Here you'll learn to write that fix for two common situations: cash paid in advance, and cash collected in advance.
Why some entries wait until period end¶
An adjusting entry is a journal entry made at the end of a period to move an amount from one account to another so revenues and expenses land in the period they belong to. It never touches Cash. Cash was already recorded when it moved, days or months earlier; the adjusting entry only fixes the timing of the expense or the revenue side, using accounts you've already met.
Common mistake: adjusting entries move cash
No cash changes hands at period end. It already moved when the prepayment was made or the deposit was collected. An adjusting entry only reclassifies an amount between an asset or liability and an expense or revenue account.
Prepaid expenses: from asset to expense as it's used up¶
A prepaid expense adjustment recognizes the part of a prepayment that's been used up. When cash goes out for something that will benefit future periods, rent, insurance, or supplies, it buys an asset first, not an expense. Only the sliver already consumed becomes an expense at period end.
Peachtree Bike Repair: prepaid rent
Peachtree Bike Repair pays $6,000 cash on July 1 for 12 months of rent in advance. That's 1/12 of the year gone by July 31, so $500 of it is used up.
| Date | Account | Debit | Credit |
|---|---|---|---|
| Jul 31 | Rent Expense | 500 | |
| Prepaid Rent | 500 |
The remaining $5,500 stays in Prepaid Rent because it still covers 11 months no one has used yet.
The same logic covers any prepayment. Cobalt Tutoring pays $2,400 on March 1 for a 12-month insurance policy; by March 31, one month of coverage, $200, has expired.
| Date | Account | Debit | Credit |
|---|---|---|---|
| Mar 31 | Insurance Expense | 200 | |
| Prepaid Insurance | 200 |
Supplies work the same way, just measured by counting what's left instead of counting months. Foothill Fitness Coaching starts a period with no supplies, buys $900 worth, and counts $150 still on the shelf at period end. The $750 difference was used up, so it moves to Supplies Expense.
Common mistake: paying cash means the whole amount is expensed
Paying $6,000 doesn't create a $6,000 expense today. An expense is recorded as it's incurred, one month, or one supply, at a time. The unused part stays an asset until a later adjusting entry catches up with it.
Depreciation: spreading a big cost over its useful life¶
Equipment is a prepayment too, just a much bigger and longer one. Depreciation spreads an asset's cost over the years it helps the business earn revenue, using the same logic as prepaid rent: a chunk of the cost becomes an expense each period, and the rest stays an asset. The simplest way to spread it is straight-line depreciation: an equal amount every period.
Annual depreciation = (cost minus salvage value) divided by useful life. Salvage value is what the asset is expected to be worth when the company is done with it; dividing the annual amount by 12 gives the monthly figure.
Northstar Moving: depreciating a delivery van
Northstar Moving buys a van for $21,000, expects to sell it for \(3,000 after its useful life, and plans to use it for 6 years. Annual depreciation is (\)21,000 - $3,000) / 6 = $3,000, so monthly depreciation is $3,000 / 12 = $250.
| Date | Account | Debit | Credit |
|---|---|---|---|
| Month-end | Depreciation Expense | 250 | |
| Accumulated Depreciation | 250 |
Accumulated Depreciation is a contra asset: it has a credit normal balance and it reduces the van's reported value, but it's a separate account from Equipment, not a reduction typed directly into it. The van's book value, cost minus Accumulated Depreciation, is now $21,000 - $250 = $20,750. Equipment itself still shows the full $21,000 it cost.
Common mistake: depreciation tracks market value
Depreciation allocates cost to the periods an asset helps generate revenue. It says nothing about what the van could actually sell for today. Book value and market value can be, and usually are, different numbers.
Common mistake: Accumulated Depreciation is cash set aside
No cash is set aside anywhere by this entry. Accumulated Depreciation just records how much of the van's cost has been expensed so far. Saving cash to replace the van someday is a separate decision the company hasn't made here.
Common mistake: crediting Equipment for depreciation
Equipment stays on the books at its original cost for as long as the company owns it. The credit goes to Accumulated Depreciation instead, so both the original cost and the used-up portion stay visible side by side.
Deferred revenue: earning what you already collected¶
Cash can also arrive before the work is done. Deferred Revenue (some people still call it unearned revenue) is a liability for work owed, not yet an asset the company has earned. A deferred revenue adjustment moves only the part actually earned into Service Revenue.
Summit Drone Photography: earning a deposit
Summit Drone Photography collects $1,200 in advance for two photo shoots. By month end, it has completed one shoot, worth $600.
| Date | Account | Debit | Credit |
|---|---|---|---|
| Month-end | Deferred Revenue | 600 | |
| Service Revenue | 600 |
The other $600 stays in Deferred Revenue. Summit still owes a second shoot, so that part isn't earned yet no matter how long ago the cash arrived.
Common mistake: collecting cash means revenue is earned
Cash in the door doesn't mean the work is done. Revenue is recorded only as it's earned. Money collected for work not yet performed stays a liability, Deferred Revenue, until it is.
Two more situations can throw off the timing: an expense incurred before it's paid, and revenue earned before it's billed. Section 03 covers both.
Pause and work¶
Watch Copperleaf Catering close its books for a full month using everything above: prepaid rent, prepaid insurance, supplies, depreciation, and deferred revenue, all in one closing. Then pick the right account for each of Marlow Landscaping's year-end adjustments. Finally, close a fresh company's books yourself.