MODULE 7C

The Accounting Cycle of the Process - Summarizing Phase (Adjusting the Books)

PREPAID EXPENSES
▪ These are expenses already paid but not yet incurred at the end of the reporting period.
▪ The accounts affected are the following:
a) Expense account
b) Asset account, particularly prepaid expense which include the following:
1) Office Supplies
2) Prepaid Insurance
3) Prepaid Rent
4) Prepaid Interest on Notes Payable

▪ Two Methods of Recording Prepaid Expenses

Unlike accrued expenses, prepaid expenses are already recorded in accounting books upon payment of such expenses. The
recording of such expenses will depend on the company's accounting policies as follows:

1) Asset Method
▪ The expense item paid in advance is initially recorded as an asset using the account Prepaid Expense or similar
account like the word "Unused" or "On Hand" as in the case of supplies.

▪ This is also called the statement of financial position approach or the balance sheet approach.

▪ This is the proper or normal method of recording this item of expense because on payment date, these expenses are
only paid in advance but not yet incurred.

▪ As time passes by until the end of the accounting period, the portion of the amount of prepaid expense account are
already incurred like the following:
a) Certain supplies are already used in operation (expense) but still included in the prepaid expense account balance
(asset).
b) The portion of the prepaid rent balance is already expired because of the usage of the office space being rented
but such expired rental cost (expense) is still included in the prepaid rent balance (asset).
c) The portion of the prepaid insurance balance is already expired because of the application of insurance premiums
to number of months that have already passed, but such expired insurance cost (expense) is still included in the
prepaid insurance balance (asset).
d) The portion of the prepaid interest balance is already expired because of the application of interest on notes
payable paid in advance to number of months that have already passed, but such expired interest amount
(expense) is still included in the prepaid interest balance (asset).

▪ The adjusting entry at the end of the reporting period is to extract from the asset account balance (prepaid expense
account) the expired cost or expense portion. In effect, the prepaid account will decrease (credit) while the expense
account will increase (debit).

1. To record payment of expense Prepaid Expense (Asset) xxx

Cash or Appropriate account xxx

2. Adjusting entry at reporting date:

To record the expense portion of Expense xxx
of prepaid expense Prepaid Expense xxx

▪ Based on the above proforma entries, the following are noted:

ADJUSTMENT
Accounts affected Classification Before To adjust After
Prepaid expense Real account Overstated Credit Updated
Expense Nominal account Understated Debit Updated
 2) Expense Method
▪ The expense item paid in advance is initially recorded as an expense using the account related expense account or
similar account using the word "Used" as in the case of supplies or "Expired" as in the case of insurance premium or
rental payment.

▪ This is also called the income statement approach.

▪ This is the short cut method of recording the expense item because in the future, this item will become used,
consumed, or expired. To reduce the number of times the prepaid expense account balance will be transferred to
expense account, it is immediately recognized as expense on payment date.

▪ The adjusting entry at the end of the reporting period is to extract from the expense account balance the unexpired
cost or asset portion. In effect, the expense account will decrease (credit) while the prepaid account will increase
(debit).

1. To record payment of expense Expense xxx

Cash or Appropriate account xxx

2. Adjusting entry at reporting date:

To record the asset portion of Paid Expense xxx
of expense Expense xxx

ILLUSTRATION 1 - SUPPLIES

On December 15, 2022, Wax Company bought office supplies costing P 12,000. At December 31, 2022, the unused office supplies
on hand per physical count shows P 3,000. Record the transactions using the (a) asset method and the (b) expense method.

SOLUTION:
Date Asset Method Expense Method
2022
Dec. 1 Office Supplies 12,000 Supplies Expense 12,000
Cash 12,000 Cash 12,000
Bought office supplies Bought office supplies

Dec. 31 Supplies Expense 9,000 Office Supplies 3,000

Office Supplies 9,000 Supplies Expense 3000
Used portion of supplies Unused portion of supplies
at year end. expense at year end

Office Supplies Office Supplies

Dec. 1 Acquisition; unadjusted balance 12,000 Dec. 31 Unadjusted balance 0
31 AJE - Used portion 9,000 31 AJE - Used portion 3,000

31 Adjusted balance 3,000 31 Adjusted balance 3,000

Supplies Expense Supplies Expense

Dec. 31 Unadjusted balance 0 Dec. 1 Acquisition; unadjusted balance 12,000
31 AJE - Used portion 9,000 31 AJE - Used portion 3,000

31 Adjusted balance 9,000 31 Adjusted balance 9,000

NOTES:
1) Asset method
a) The asset account (Office Supplies) is debited on acquisition date.
b) At December 31 which is the reporting date, the expense portion of P 9,000 is extracted from the asset balance of P
12,000. The problem states that the office supplies on hand per physical count is P 3,000. Therefore, the used portion is
P 9,000 (P 12,000 unadjusted unused balance less P 9,000 adjusted unused balance).

Accounts affected Classification Before AJE After

Office Supplies (Asset) Real account 12,000 overstated (9,000) 3,000
Supplies Expense (Expense) Nominal account 0 understated 9,000 9,000

2) Expense method
a) The expense account (Supplies Expense) is debited on acquisition date.
b) At December 31 which is the reporting date, the asset portion of P3,000 is extracted from the expense balance of P
12,000. The problem states already that the office supplies on hand per physical count is P 3,000. This is already the
asset portion.

Accounts affected Classification Before AJE After

Office Supplies (Asset) Real account 0 understated 3,000 3,000
Supplies Expense (Expense) Nominal account 12,000 overstated (3,000) 9,000

3) Both methods provides the same adjusted balances for asset (office supplies) account and expense (supplies expense)
account.

ILLUSTRATION 2 - PREPAID INSURANCE

One-year insurance premiums of P 54,000 was paid on Aug. 1 of the current year for a fire insurance coverage of P 1,200,000 on
property. Record the transactions using the (a) asset method and the (b) expense method.

Date Asset Method Expense Method

2022
Aug. 1 Prepaid insurance 54,000 Insurance Expense 54,000
Cash 54,000 Cash 54,000
One year fire insurance One year insurance premium
premium.

Dec. 31 Insurance Expense 22,500 Prepaid Insurance 31,500

Prepaid insurance 22,500 Insurance Expense 31,500
Expired insurance premium Unexpired insurance premium
at year end. at year end
(P 54,000 x 5/12 months) (P 54,000 x 7/12 months)

Prepaid Insurance Prepaid Insurance

Aug. 1 Payment; unadjusted balance 54,000 Dec. 31 Unadjusted balance 0
31 AJE - Expired insurance premium 22,500 31 AJE - Unexpired insurance 31,500

31 Adjusted balance 31,500 31 Adjusted balance 31,500

Insurance Expense Insurance Expense

Dec. 31 Unadjusted balance 0 Dec. 1 Payment; unadjusted balance 54,000
31 AJE - Expired insurance premium 22,500 31 AJE - Unexpired insurance 31,500

31 Adjusted balance 22,500 31 Adjusted balance 22,500

NOTES:
1) Asset method
a) The asset account (Prepaid Insurance) is debited on acquisition date.
b) At December 31 which is the reporting date, the expense portion of P 54,000 is extracted from the asset balance of P
54,000. The insurance premium is for one year from August 1, 2022 up to July 31, 2023. From August 1, 2022 to
December 31, 2022, the reporting date, is 5 months. Therefore, the expired cost of prepaid insurance is P 22,500
computed by allocating the P 54,000 to 5 months out of 12 months within a year (P 54,000 x 5/12).

Accounts affected Classification Before AJE After

Prepaid insurance (Asset) Real account 54,000 overstated (22,500) 31,500
Insurance Expense (Expense) Nominal account 0 understated 22,500 22,500

2) Expense method
a) The expense account (Insurance Expense) is debited on acquisition date.
b) At December 31 which is the reporting date, the asset portion out of P 54,000 is P 31,500 (P 54,000 x 7/12). The 7
months will be from January 1, 2023 to July 31, 2023. The expired portion of 5 months is from August 1 to December 31,
2022.

Accounts affected Classification Before AJE After

Prepaid insurance (Asset) Real account 0 understated 31,500 31,500
Insurance Expense (Expense) Nominal account 54,000 overstated (31,500) 22,500

3) Both methods provides the same adjusted balances for asset (prepaid insurance) account and expense (insurance expense)
account.

ILLUSTRATION 3 - PREPAID INTEREST EXPENSE

Discounted our own 90-20% promissory note for P 300,000 on November 1, 2022 of the current year. Interest was charged to
Prepaid Interest account. Record the transactions using the (a) asset method and the (b) expense method.

Date Asset Method Expense Method

2022
Aug. 1 Prepaid Interest 15,000 Interest Expense 15,000
Cash 15,000 Cash 15,000
120-days interest paid One year insurance premium
in advance.
(P 300,000 x 20% x 90/360)

Dec. 31 Interest Expense 10,000 Prepaid Interest 5,000

Prepaid Interest 10,000 Interest Expense 5,000
Expired insurance premium Unexpired insurance premium
at year end. at year end
(P 300,000 x 20% x 60/360) (P 300,000 x 20% x 30/360)

Prepaid Interest Prepaid Interest

Aug. 1 Payment; unadjusted balance 15,000 Dec. 31 Unadjusted balance 0
31 AJE - Expired interest expense 10,000 31 AJE - Unexpired interest expense 5,000

31 Adjusted balance 5,000 31 Adjusted balance 5,000

Interest Expense Interest Expense

Dec. 31 Unadjusted balance 0 Dec. 1 Payment; unadjusted balance 15,000
31 AJE - Expired interest expense 10,000 31 AJE - Unexpired interest expense 5,000

31 Adjusted balance 10,000 31 Adjusted balance 10,000

NOTES:
1) Asset method
a) The asset account (Prepaid Interest) is debited on acquisition date.
b) At December 31 which is the reporting date, the expense portion of P 10,000 is extracted from the asset balance of P
15,000. The prepaid interest is for 90 days from November 1, 2022 up to January 30, 2023. At December 31, 2022, the
reporting date, the expired cost of prepaid interest is P 10,000 computed as P 300,000 x 20% x 60 days or by allocating
the P 15,000 to 60 days out of 90 days.

Accounts affected Classification Before AJE After

Prepaid interest (Asset) Real account 15,000 overstated (10,000) 5,000
Interest Expense (Expense) Nominal account 0 understated 10,000 10,000

2) Expense method
a) The expense account (Interest Expense) is debited on acquisition date.
b) At December 31 which is the reporting date, the asset portion out of P 15,000 is P 5,000 (P 300,000 x 20% x 30/360).
The expired portion of 60 days is from November 2 to December 31, 2022.

Accounts affected Classification Before AJE After

Prepaid interest (Asset) Real account 0 understated 5,000 5,000
Interest Expense (Expense) Nominal account 15,000 overstated (5,000) 10,000

3) Both methods provides the same adjusted balances for asset (prepaid interest) account and expense (interest expense)
account.

ILLUSTRATION 4 - PREPAID EXPENSE ADJUSTMENT USING TRIAL BALANCE

The partial trial balance of JB Laundry Services at December 31, 2022, the end of the accounting period, and the data needed to
determine year-end adjustments are presented below:

Debit Credit
Cash 50,000
Accounts Receivable 65,000
Laundry Supplies 10,000
Prepaid Rent 20,000
Notes Payable 18,000
Laundry revenue 150,000
Advertising Expense 5,000
Interest Expense 600

Adjustment data:
1) Inventory of laundry supplies at December 31, 2022 is P 4,000.
2) A quarter of advertising cost is applied during the current year.
3) Four months rental of office space was paid on December 1, 2022, its effectivity date.
4) Notes Payable consists of PN No. 1 which is a 120-days, 12% note with a face amount of P 15,000 dated December 1, 2022
while PN No. 2 is a 90-days note with a face amount of P 3,000 dated December 16, 2022.

Required:
Prepare the necessary adjusting journal entries at December 31, 2022.
SOLUTION:
Date Account Names Debit Credit EXPLANATION
2022
Dec. 31 Laundry Supplies Expense 6,000 Asset method is used because the
Laundry Supplies 6,000 account debited in the trial balance is
Used portion of laundry supplies. the Laundy Supplies account. To
adjust, remove from the asset
balance the expense portion at year
end (P 10,000 - P 4,000 on hand).

Dec. 31 Prepaid Advertising 3,750 Expense method is used because the

Advertising Expense 3,750 account debited in the trial balance is
Unexpiredportion of advertising cost. the Advertising Expense account. To
adjust, remove from the expense
balance the asset portion applicable
to the next accounting period year
2023 (P 5,000 x 3/4).

Dec. 31 Rent Expense 5,000 Asset method is used because the

Prepaid rent 5,000 accounts debited is Prepaid Rent
Expired portion of rental payment. account. To adjust, remove from the
asset balance the expired portion of
the rental paid in advance which is P
5,000 applicable in December 2022 (P
20,000 x 1/4).

Dec. 31 Prepaid Interest 450

Expense method is used because the
Interest Expense 450
account debited in the trial balance is
Unexpired portion of interest.
the Interest Expense account. To
adjust, remove from the expense
balance the unexpired portion of
interest for 90 days applicable next
accounting period year 2023 (P
15,000 x 12% x 90/360). The expired
portion is 30 days for P 150 which is
from December 1 to 31, 2022.
 EXERCISES

EXERCISE 1
Concept of Prepaid Expenses
State whether the following statements are TRUE or FALSE. Write your answer on the space provided before each number. Use
only CAPITAL LETTERS.

FALSE 1. Prepaid expenses are expenses already incurred but not yet paid.
FALSE 2. Like accrued expenses, prepaid expenses are not recorded in accounting books at the end of the accounting
period.
TRUE 3. Prepaid expense is an asset account.
TRUE 4. The normal method of recording prepaid expense is the asset method.
TRUE 5. The short cut method of recording prepaid expense is the asset method.
FALSE 6. Prior to adjusting entry for prepaid expenses using the asset method, the asset account is understated.
FALSE 7. Prior to adjusting entry for prepaid expenses using the asset method, the expense account is overstated.
TRUE 8. The adjusting entry for prepaid expense using the asset method is to debit expense and to credit asset.
TRUE 9. The amount of the adjusting entry for prepaid expense using the asset method is the adjusted amount of the
expense account.
TRUE 10. Prior to adjusting entry for prepaid expenses using the expense method, the asset account is understated.
TRUE 11. Prior to adjusting entry for prepaid expenses using the expense method, the expense account is overstated.
FALSE 12. The adjusting entry for prepaid expense using the expenset method is to debit expense and to credit asset.
TRUE 13. The amount of the adjusting entry for prepaid expense using the expense method is the adjusted amount of the
asset account.
TRUE 14. The asset method of recording prepaid expense is also called the statement of financial position approach.
TRUE 15. The expense method of recording prepaid expense is also called the income statement approach.

EXERCISE 2
Adjusting Entry for Supplies
(Source: Principles of Accounting 2nd Edition by Weygant, Chlamers, et. al)

Profile Advertising's trial balance as at December 31, 2022 shows Advertising Supplies P 67,000 and Advertising Supplies Expense
P 0.00. On December 31, there are P 17,000 of supplies on hand. Prepare the adjusting entry as at December 31 and, using T-
account, enter the balances in the accounts, post the adjusting entry and indicate the adjusted balance in each account.

EXERCISE 3
Determining the Missing amounts
(Source: Financial Accounting 6th Edition by Larson and Miller)
Determine the missing amounts in each of these four independent situations:

(a) (b) (c) (d)

Supplies on Hand, January 1 10,000 8,000 6,800 ?
Supplies purchased during the year 7,000 27,000 ? 120,000
Supplies on Hand, December 31 2,500 ? 9,200 16,000
Supplies Expense for the year ? 6,500 48,000 131,500

EXERCISE 4
Adjusting Entry for Prepaid Insurance
(Source: Principles of Accounting 2nd Edition by Weygant, Chlamers, et. al)
On July 1, 2022, Orlow Ltd. Pays P 120,000 to HNH Insurance Ltd for a 3-year insurance contract. Both companies have reporting
periods ending 31 December. For Orlow Ltd., journalize and post the entry on July 1 and the adjusting entry on December 31. Use
both approaches in recording prepaid expenses.
EXERCISE 5
Determining the Missing amounts
Determine the missing amounts for each year:

Year 2021 Year 2022 Year 2023

Prepaid Advertising, January 1 200,000 ? ?
Advertising paid in advance during the year 140,000 200,000 ?
Prepaid Advertising, December 31 50,000 ? 184,000
Advertising Expense for the year ? 130,000 48,000

EXERCISE 6
Preparing Adjusting Journal Entries for Prepaid Expenses
The partial trial balance of Mighty Man General Services at December 31, 2022, the end of the accounting period, and the data
needed to determine year-end adjustments are presented below:

Debit Credit
Cash 250,000
Notes Receivable 100,000
Prepaid Advertising 120,000
Prepaid Interest 2,500
Supplies 12,000
Notes Payable 70,000
Service revenue 450,000
Insurance Expense 120,000
Rent Expense 180,000

Adjustment data:
1) Inventory of supplies at December 31, 2022 is P 8,000.
2) Two-thirds of advertising cost paid in advance are applicable to the next accounting period.
3) One-year rental of office space was paid on October 1, 2022.
4) Notes Payable consists of PN No. 1 which is a 90-days note with a face amount of P 20,000 dated November 11, 2022. The
balance is PN No. 2 which is a 180-days, 10% note dated December 1, 2022.
5) Prepaid insurance in force at December 31, 2022 is P 40,000.

Required:
Prepare the necessary adjusting journal entries at December 31, 2022. Round off your answers to the nearest peso.