The second adjustment to be considered here involves the handling of prepaid expenses. In the transactions that were recorded in the previous chapter, Journal Entry 10 reported a $4,000 payment made in advance for four months of rent to use a building.An asset—prepaid rent—was recorded through the normal accounting process. This account is listed on the trial balance in Figure 5.1 "Updated Trial Balance". Why might a year-end adjusting entry be needed in connection with a prepaid expense? Answer: During these four months, the Lawndale Company will use the rented facility to help generate revenue. Over that time, the future economic benefit established by the payment gradually becomes a past benefit. The asset literally changes into an expense day by day. For illustrative purposes, assume that one month has now passed since the original payment. This month of benefit provided by the rent ($1,000 or $4,000/four months) no longer exists; it has been consumed. As a preliminary step in preparing financial statements, an adjusting entry is needed to reclassify $1,000 from the asset into an expense account. This adjustment leaves $3,000 in the asset (for the remaining three months of rent on the building) while $1,000 is now reported as an expense (for the previous one month of rent).
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The basic purpose of adjusting entries is to take whatever amounts reside in the ledger and align them with the requirements of U.S. generally accepted accounting principles (U.S.). For this illustration, the original $4,000 payment was classified as a prepaid rent and the adjustment above was created in response to that initial entry. In recording transactions, some accounting systems mechanically handle events in a different manner than others. Thus, construction of an adjusting entry always depends on the recording that previously took place. To illustrate, assume that when this $4,000 payment was made, the company’s computer program had been designed to enter a debit to rent expense rather than to prepaid rent. All money spent for rent was automatically recorded as rent expense. This initial accounting has no impact on the final figures to be reported but does alter the adjustment process. An adjusting entry still needs to be prepared so that the expense appearing on the income statement is $1,000 (for the past one month) while the asset on the balance sheet is shown as $3,000 (for the next three months). If the entire cost of $4,000 is in rent expense, the following alternative is necessary to arrive at the proper balances. It shifts $3,000 out of the expense and into the asset.
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