Liability Method of Recording Unearned Revenue
Liability Method of Recording Unearned Revenue
Liability Method of Recording Unearned Revenue
We are simply separating the earned part from the unearned portion. Of the
$30,000 unearned revenue, $6,000 is recognized as income. In the entry above,
we removed $6,000 from the $30,000 liability. The balance of unearned revenue
is now at $24,000.
Income Method of Recording Unearned Revenue
Under the income method, the accountant records the entire collection under
an incomeaccount. Using the same transaction above, the initial entry for the
collection would be:
Jan 10 Cash 30,000.00
Service Income 30,000.00
If at the end of the year the company earned 20% of the entire $30,000, then
the adjusting entry would be:
Jan 31 Service Income 24,000.00
Unearned Income 24,000.00
By debiting Service Income for $24,000, we are decreasing the income initially
recorded. The balance of Service Income is now $6,000 ($30,000 - 24,000),
which is actually the 20% portion already earned. By crediting Unearned Income,
we are recording a liability for $24,000.
Notice that the resulting balances of the accounts under the two methods are
the same (Cash: $30,000; Service Income: $6,000; and Unearned Income:
$24,000).
Another Example
On December 1, 2016, DRG Company collected from TRM Corp. a total of
$60,000 as rental fee for three months starting December 1.
Under the liability method, the initial entry would be:
Dec 1 Cash 60,000.00
Unearned Rent Income 60,000.00
On December 31, 2016, the end of the accounting period, 1/3 of the rent
received has already been earned (prorated over 3 months).
Lesson5
In preparing the adjusting entry, our goal is to transfer the used part from the
asset initially recorded into expense – for us to arrive at the proper balances
shown in the illustration above.
The adjusting entry will include: (1) recognition of expense and (2) decrease in
the asset initially recorded (since some of it has already been used). The
adjusting entry would be:
Dec 31 Service Supplies Expense 900.00
Service Supplies 900.00
The "Service Supplies Expense" is an expense account while "Service Supplies" is
an asset. After making the entry, the balance of the unused Service Supplies is
now at $600 ($1,500 debit and $900 credit). Service Supplies Expense now has a
balance of $900. Now, we've achieved our goal.
Expense Method
Under the expense method, the accountant initially records the entire payment
as expense. If the expense method was used, the entry would have been:
Dec 7 Service Supplies Expense 1,500.00
Cash 1,500.00
Take note that the entire amount was initially expensed. If 60% was used, then
the adjusting entry at the end of the month would be:
Dec 31 Service Supplies 600.00
Service Supplies Expense 600.00
This time, Service Supplies is debited for $600 (the unused portion). And then,
Service Supplies Expense is credited thus decreasing its balance. Service Supplies
Expense is now at $900 ($1,500 debit and $600 credit).
Notice that the resulting balances of the accounts under the two methods are
the same (Cash paid: $1,500; Service Supplies Expense: $900; and Service
Supplies: $600).
Another Example
GVG Company acquired a six-month insurance coverage for its properties on
September 1, 2016 for a total of $6,000.
Under the asset method, the initial entry would be:
Sep 1 Prepaid Insurance 6,000.00
Cash 6,000.00
On December 31, 2016, the end of the accounting period, part of the prepaid
insurance already has expired (hence, expense is incurred). The expired part is
the insurance from September to December. Thus, we should make the following
adjusting entry:
Dec 31 Insurance Expense 4,000.00
Prepaid Insurance 4,000.00
Of the total six-month insurance amounting to $6,000 ($1,000 per month), the
insurance for 4 months has already expired. In the entry above, we are actually
transferring $4,000 from the asset to the expense account (i.e., from Prepaid
Insurance to Insurance Expense).
If the company made use of the expense method, the initial entry would be:
Sep 1 Insurance Expense 6,000.00
Cash 6,000.00
In this case, we must decrease Insurance Expense by $2,000 because that part
has not yet been incurred (not used/not expired). Insurance Expense shall then
have a balance of $4,000. The amount removed from the expense shall be
transferred to Prepaid Insurance. The adjusting entry would be:
Dec 31 Prepaid Insurance 2,000.00
Insurance Expense 2,000.00
Conclusion
What we are actually doing here is making sure that the incurred (used/expired)
portion is included in expense and the unused part into asset. The adjusting
entry will always depend upon the method used when the initial entry was made.
If you are having a hard time understanding this topic, I suggest you go over
and study the lesson again. Sometimes, it really takes a while to get the concept.
Preparing adjusting entries is one of the challenging (but important) topics for
beginners.
Lesson6
Notice that at the end of the useful life of the asset, the carrying value is equal
to the residual value.
Depreciation for Acquisitions Made Within the Period
The delivery van in the example above has been acquired at the beginning of
2012, i.e. January. Therefore, it is easy to calculate for the annual straight-line
depreciation. But what if the delivery van was acquired on April 1, 2012?
In this case we cannot apply the entire annual depreciation in the year 2012
because the van has been used only for 9 months (April to December). We need
to prorate.
For 2012, the depreciation expense would be: $6,000 x 9/12 = $4,500.
Years 2013 to 2016 will have $6,000 annual depreciation expense.
In 2017, the van will be used for 3 months only (January to March) since it has a
useful life of 5 years (i.e. April 1, 2012 to March 31, 2017).
The depreciation expense for 2017 would be: $6,000 x 3/12 = $1,500, and thus
completing the accumulated depreciation of $30,000.
2012 (April to December) $ 4,500
Allowance for Bad Debts (also often called Allowance for Doubtful Accounts)
represents the estimated portion of the Accounts Receivable that the company
will not be able to collect.
Take note that this amount is an estimate. There are several methods in
estimating doubtful accounts.The estimates are often based on the company's
past experiences.
To recognize doubtful accounts or bad debts, an adjusting entry must be made
at the end of the period. The adjusting entry for bad debts looks like this:
Dec 31 Bad Debts Expense xxx.xx
Allowance for Bad Debts xxx.xx
Bad Debts Expense a.k.a. Doubtful Accounts Expense: An expense account;
hence, it is presented in the income statement. It represents the estimated
uncollectible amount for credit sales/revenues made during the period.
Allowance for Bad Debts a.k.a. Allowance for Doubtful Accounts: A balance
sheet account that represents the total estimated amount that the company will
not be able to collect from its total Accounts Receivable.
What is the difference between Bad Debts Expense and Allowance for Bad
Debts?
Bad Debts Expense is an income statement account while the latter is a balance
sheet account. Bad Debts Expense represents the uncollectible amount for credit
sales made during the period. Allowance for Bad Debts, on the other hand, is the
uncollectible portion of the entire Accounts Receivable.
You can also use Doubtful Accounts Expense and Allowance for Doubtful
Accounts in lieu of Bad Debts Expense and Allowance for Bad Debts. However, it
is a good practice to use a uniform pair. Some say that Bad Debts have a higher
degree of uncollectibility that Doubtful Accounts. In actual practice, however, the
distinction is not really significant.
Here's an Example
Gray Electronic Repair Services estimates that $100.00 of its credit revenue for
the period will not be collected. The entry at the end of the period would be:
Dec 31 Bad Debts Expense 100.00
Allowance for Bad Debts 100.00
Again, you may use Doubtful Accounts. Just be sure to use a logical (and
uniform) pair every time. For example:
Dec 31 Doubtful Accounts Expense 100.00
Allowance for Doubtful
100.00
Accounts
If the company's Accounts Receivable amounts to $3,400 and its Allowance for
Bad Debts is $100, then the Accounts Receivable shall be presented in the
balance sheet at $3,300 – the net realizable value.
Accounts Receivable (Gross Amount) $ 3,400
Less: Allowance for Bad Debts 100
Accounts Receivable - Net Realizable Value $ 3,300
Lesson8
An adjusted trial balance is prepared after adjusting entries are made and posted
to the ledger.
This is the second trial balance prepared in the accounting cycle. Its purpose is
to test the equality between debits and credits after adjusting entries are entered
into the books of the company.
To illustrate how it works, here is a sample unadjusted trial balance:
Gray Electronic Repair Services
Cash $ 7,480.00
At the end of the period, the following adjusting entries were made:
Dec 31 Accounts Receivable 300.00
After posting the above entries, the values of some of the items in
the unadjusted trial balance will change. Take the first adjusting entry. Accounts
Receivable is debited hence is increased by $300. Service Revenue is credited for
$300.
The balance of Accounts Receivable is increased to $3,700, i.e. $3,400
unadjusted balance plus $300 adjustment. Service Revenue will now be $9,850
from the unadjusted balance of $9,550.
Next entry. Utilities Expense and Utilities Payable did not have any balance in the
unadjusted trial balance. After posting the above entries, they will now appear in
the adjusted trial balance.
Third. Service Supplies Expense is debited for $900. Service Supplies is credited
for $900. The Service Supplies account had a debit balance of $1,500. After
incorporating the $900 credit adjustment, the balance will now be $600 (debit).
And fourth. There were no Depreciation Expense and Accumulated Depreciation
in the unadjusted trial balance. Because of the adjusting entry, they will now
have a balance of $720 in the adjusted trial balance.
Adjusted Trial Balance Example
After incorporating the adjustments above, the adjusted trial balance would look
like this. Just like in the unadjusted trial balance, total debits and total credits
should be equal.
Gray Electronic Repair Services
Cash $ 7,480.00
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