Discussion: Adjusting Entries

Scenario 5:Capstone Lawnmowers operates in the beautiful pacific northwest. One of the services it offers its residential customers is an annual subscription service whose fee is paid annually in advance. The service is based on the size of the yard to be serviced. One customer, Lerriuqs Tunaepeht, paid $6,000 on June 1, 2016, for one year service beginning on that date. The services are provided evenly every month. Capstones fiscal year ends on December 31.

1. What journal entry should be made on June 1, 2016?
2. How much revenue will the company have earned by Dec 31, 2016?
3. What adjusting entry should be made on December 31, 2016?

   Sample Answer

   Scenario 1: Prepaid Expenses

   Prepaid expenses refer to those expenses that are paid for in advance; that is, cash is paid before the expenses are incurred. As such, prepaid expenses are recorded by debiting asset accounts. When Ajuja Enterprises paid its twelve-month insurance premium, Prepaid Insurance was debited for $5,400. The complete journal entry would have been:

   DATE	DESCRIPTION	DEBIT	CREDIT
   6/30/2017	Prepaid Insurance	5,400
   	Cash		5,400
   	To record prepaid insurance for twelve months

   Since the insurance was prepaid for twelve (12) months, this equates to $450 per month. Ajuja's fiscal year ends on December 31, representing 6 months of used (expired insurance); thus, $2,700 of insurance has expired by December 31, 2017.

   According to the matching principle, expenses should be recognized in the period incurred, and not necessarily in the period paid. Since $2,700 of the prepaid insurance was used in fiscal year 2017, this amount should be transferred to the insurance expense account by completing the following journal entry.

   DATE	DESCRIPTION	DEBIT	CREDIT
   12/31/2017	Insurance Expense	2, 700
   	Prepaid Insurance		2,700
   	To record expired insurance

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