Adjusting entries: prepayments and unearned revenue

Under the accrual basis — the basis the Conceptual Framework and IAS 1 require for everything except cash flows — income and expenses belong to the period in which they are earned and incurred, not the period in which cash moves. Adjusting entries at the end of each period make the ledger reflect that. They never involve cash: the cash moved earlier (deferrals) or will move later (accruals).

A deferral arises when cash moves before the expense is incurred or the revenue earned. At the end of each period you adjust the balance for the part that has now been used or earned.

Prepaid expenses. Lumen pays 2,400 on 1 April for 12 months of insurance. On 1 April the whole amount is an asset — cover still to come. By 30 April one month has been used: 200 becomes an expense and 2,200 remains prepaid. The same logic applies to rent paid in advance, software subscriptions and service contracts: work out the used fraction by time (months used ÷ months covered).

Supplies. Supplies are recorded as an asset when bought. Nobody records each pen used, so at period end you count what's left; the difference between the account balance and the count is supplies used, and becomes the expense.

Unearned revenue. Cash received before the work is done is a liability: the business owes the customer either the work or the money back. As the work is performed, the liability is reduced and revenue recognised — by time for a retainer, by sessions or milestones for a course or project.

Two ways of recording the original payment. Most businesses debit the asset (or credit the liability) when cash moves — the balance-sheet method used above. Some debit the expense (or credit revenue) straight away and adjust the unused part back at period end — the income-statement method. Both reach the same adjusted balances; the adjustment just looks different. Always check how the original entry was recorded before writing the adjustment.

A missed adjustment misstates two places at once: for a prepayment, assets are overstated and expenses understated (so profit is overstated); for unearned revenue, liabilities are overstated and revenue understated.