2.8 Adjusting Journal Entries and Deferrals - Deferred Expenses Example

Adjusting Journal Entries and Deferrals

Deferred Expenses: Cash Paid Before Expense Incurred

• In deferrals, the original journal entry's recording location matters for adjusting journal entries.
• For deferred expenses, cash payment occurs before the expense is incurred.
• Accruals happen before cash, while deferrals occur after cash.

Example: Desert Company Prepays Rent

• On October 1, Desert Company prepays $18,000$ cash for eighteen months of rent.
• The bookkeeper initially recorded the entry to Prepaid Rent (a real/permanent account), indicating accrual accounting.
• Desert has a December 31 year-end.

Original Journal Entry:

• Debit Prepaid Rent: $18,000$
• Credit Cash: $18,000$

Timeline:

• $18,000$ paid for 18 months of rent = $1,000$ per month.
• Year 1 (October, November, December): 3 months * $1,000$ = $3,000$
• Year 2: 12 months * $1,000$ = $12,000$
• Year 3 (January, February, March): 3 months * $1,000$ = $3,000$

Adjusting Journal Entries

Year 1

• Original entry to Prepaid Rent (asset account).
• Three months' rent used: $3,000$
• Adjusting journal entry adjusts Prepaid Rent for the amount used.
• Credit Prepaid Rent to reduce its balance by $3,000$, resulting in an ending balance of $15,000$.
• Adjusting Journal Entry:
  • Debit Rent Expense: $3,000$
  • Credit Prepaid Rent: $3,000$

Year 2

• Twelve months used, totaling $12,000$.
• Adjusting Journal Entry:
  • Debit Rent Expense: $12,000$
  • Credit Prepaid Rent: $12,000$
• Remaining balance in Prepaid Rent: $3,000$

Year 3

• Three months used, totaling $3,000$.
• Adjusting Journal Entry:
  • Debit Rent Expense: $3,000$
  • Credit Prepaid Rent: $3,000$
• Prepaid Rent balance at the end is zero.

Check for Understanding: What If Adjusting Entries Were Forgotten?

• Assume the bookkeeper forgot to make any adjusting journal entries.
• The expense was recognized entirely at the end of the lease term.
• Analyze the effects on assets, liabilities, equity, and net income in each of the three years.

Scenario:

• Original journal entry: Debit to Prepaid Rent, credit to Cash (correct).
• Error: No adjusting journal entries at year-end X0, X1; all rent expense recorded at year-end X2.

Analysis

Prepaid Rent Account

• Established with a debit of $18,000$. The initial journal entry was correct.
• Year X0:
  • Error: Prepaid Rent remains at $18,000$. Reduction in prepaid rent not recorded.
  • Correct: Should have reduced by $3,000$, leaving $15,000$. Adjusting journal entry should have been made.
  • Asset Overstated by: $3,000$
• Year X1:
  • Error: Prepaid Rent remains at $18,000$.
  • Correct: Should have credited Prepaid Rent for $12,000$, leaving $3,000$.
  • Asset Overstated by: $15,000$
• Year X2:
  • Error: Credit to Prepaid Rent for $18,000$, resulting in a zero balance.
  • Correct: Credit to Prepaid Rent for $3,000$, resulting in a zero balance.
  • No Error. Balance of prepaid rent is zero.

Rent Expense Account

• Year X0:
  • Error: No rent expense recorded.
  • Correct: Should have recorded $3,000$.
  • Expenses Understated by: $3,000$
  • Net Income Overstated by: $3,000$ (inverse relationship).
• Year X1:
  • Error: No rent expense recorded.
  • Correct: Should have recorded $12,000$.
  • Expenses Understated by: $12,000$
  • Net Income Overstated by: $12,000$
• Year X2:
  • Error: Total $18,000$ rent expense recorded.
  • Correct: Should have recorded $3,000$.
  • Expenses Overstated by: $15,000$
  • Net Income Understated by: $15,000$

Overall Financial Statement Effects

Year X0

• Assets (Prepaid Rent) Overstated by: $3,000$
• No liability errors.
• Net Income Overstated by: $3,000$
• Equity Overstated by: $3,000$
• Balance sheet equation in balance.

Year X1

• Assets Overstated by (Prepaid Rent): $15,000$
• No liability errors.
• Net Income is Overstated by: $12,000$
• Retained Earnings is a Real Account, Cumulative Error Matters
  * Beginning Retained Earnings = last year's error
• Equity (Retained Earnings) Overstated by: $15,000$ ($3,000$ (prior year) + $12,000$ (this year)).
• Cumulative error of $3,000$ (from X0) + current overstatement of $12,000$
• Balance sheet equation in balance.

Year X2

• No error on assets
• No liabilities involved.
• Net Income Understated by: $15,000$
• Equity (Retained Earnings):
  • Beginning Retained Earnings is Overstated by: $15,000$
  • Net Effect: No Error ( $15,000$ (prior year) - $15,000$ (this year)).
• Balance sheet equation in balance.

Conclusion

• Errors affect both the balance sheet and income statement over time.
• Importance of reporting according to the expense recognition principle, ensuring accurate impacts on financial statements.
• Analyzing accounts individually helps organize errors and determine their overall effect on financial statements.