Adjusting Entries for Deferrals

Unearned revenue is deferred revenue and can be an advance payment for goods or services on the balance sheet. It is a liability and therefore has not been earned. This is because the business owes the customer for goods or services since the customer has paid for them but has not received them. Unearned revenue can be items such as rent or subscriptions. If the unearned revenue is not reported as a liability on the balance sheet and claimed as revenue immediately, the matching principle of GAAP would be violated. So, a deferral entry is needed. Once the products are delivered, the deferred, or unearned, revenue then becomes earned revenue.

For example, regarding unearned or deferred revenue, Global Air receives $5,000 cash in ticket sales on July 1. Half of the flights occur in July, and the balance will occur in August.

Global Air will need to book flights from the $5,000 cash received from its customers on July 1; it has an obligation (a liability) to provide services at a future date. Since the services (flights) will take place partly in July and partly in August, only half of this amount is July revenue. The balance after the July revenue is deducted will include unearned revenue, or deferred revenue. The adjusting entry affects both an income statement account and a balance sheet account.

Global Air recognizes a portion of the unearned revenue as an adjusting entry.

As the name suggests, prepaid expenses are exactly that—prepaid, or paid in advance of services being rendered or goods being delivered. Because the expense is prepaid, it is deferred, and an adjusting entry needs to be made. A prepaid expense often happens in the case of purchasing insurance coverage.

For example, Global Air pays $6,000 for insurance coverage for 6 months (July through December) on July 1. Global Air will decrease cash (credit Cash) and increase asset (the Prepaid Expense account) on July 1. At month-end, one month's worth of insurance coverage has been provided, or used up, meaning $1,000, or $1/6\;\text{x}\;\$6\text{,}000$, is no longer prepaid and needs to be recognized as an expense for the month of July. Therefore, the adjusting entry on July 31 is a debit to Insurance Expense (increase) and credit to Prepaid Expense (decrease) for $1,000. The adjusting entry affects both an income statement account and a balance sheet account.

Global Air recognizes the expense for July by adjusting or reducing the prepaid expense account.