Deferral Adjusting Entries: Prepaids and Unearned Revenue
Deferral adjusting entries are period-end entries for amounts paid or collected in advance. For a prepaid expense, you move the used-up portion from the asset to expense. For unearned revenue, you move the earned portion from the liability to revenue. Cash was already recorded, so the adjustment never touches Cash.
Watch Professor Farhat: This lesson covers all four types of adjusting entries. For deferrals, jump to 1:26 for the revenue deferral (a prepaid rent example) and 11:48 for the supplies example.
What Are Deferral Adjusting Entries?
The central question is simple: how much belongs to the current period? Paying cash does not create an expense by itself, and collecting cash does not create revenue by itself. If you skip the adjustment, both profit and the balance sheet can end up wrong.
An adjusting entry is a journal entry recorded at the end of an accounting period, before the financial statements are prepared, so revenue and expenses land in the period they belong to. Deferrals cover two of the four basic types of adjusting entries: prepaid expenses and unearned revenues. Accruals cover the other two.
These examples use the asset method for prepayments and the liability method for customer advances. In plain terms, a prepayment is first recorded as an asset, and a customer advance is first recorded as a liability. They are original hypothetical cases and assume the initial entries were recorded correctly.
Prepaid Expense vs. Unearned Revenue: What’s the Difference?
| Question | Prepaid expense | Unearned revenue |
|---|---|---|
| Who paid first? | The company paid a supplier | A customer paid the company |
| Initial balance | Asset: future benefit | Liability: remaining service obligation |
| Adjustment trigger | Benefit consumed or expired | Promised service provided |
| Period-end entry | Debit Expense; credit Prepaid Asset | Debit Unearned Revenue; credit Revenue |
| Remaining balance | Unused benefit | Unfulfilled obligation |
The same advance can appear differently to the two parties. A customer who prepays for future services may have a prepaid asset; the provider may have unearned revenue. Always identify whose books the question asks you to prepare.
For the recognition foundation, see revenue versus expense recognition. FASB’s revenue-recognition project overview explains the scope of the customer-contract model. Under ASC 606, Revenue from Contracts with Customers, revenue is recognized when (or as) the company satisfies a performance obligation, meaning a promise in the contract to deliver a distinct good or service to the customer.
For the complete five-step model, see the Revenue Recognition Principle lesson in the Intermediate Accounting course.
Supplies: record what was used
Hypothetical example: Cedar Studio has a $3,500 debit balance in Supplies immediately before adjustment. A count establishes that $900 remains. There were no unrecorded purchases or other changes.
Supplies used = unadjusted Supplies balance − supplies remaining = $3,500 − $900 = $2,600.
| Account | Debit | Credit |
|---|---|---|
| Supplies Expense | $2,600 | — |
| Supplies | — | $2,600 |
The $900 count is the required ending asset, not the expense. After the entry, the ledger shows $900 in Supplies. If you debit expense for $900 instead, you leave $2,600 as an asset even though that amount has been consumed.
If the ledger balance already includes beginning supplies and current purchases, do not add those purchases again. Reconcile the account first, then compare its balance on the unadjusted trial balance with the physical count.
Prepaid insurance: measure expired coverage
Cedar separately pays $3,600 on October 1 for a twelve-month insurance policy beginning that day. It debits Prepaid Insurance $3,600 and credits Cash $3,600. Assume coverage is provided evenly and no monthly adjustments have yet been made.
At December 31, three months have expired. Monthly cost is $3,600 ÷ 12 = $300. Expense is $300 × 3 = $900, leaving $2,700 of unexpired coverage.
| Account at December 31 | Debit | Credit |
|---|---|---|
| Insurance Expense | $900 | — |
| Prepaid Insurance | — | $900 |
If October and November had already been adjusted, the December-only adjustment would be $300. The required ending asset would still be $2,700. This illustrates why elapsed time and previously posted entries must both be considered.
Use the coverage start date, not automatically the payment date. A policy paid for in September but beginning in October does not create September insurance expense under these facts.
For a video walkthrough and exercise on prepaid expenses, see Deferral or Prepaid Expenses in the Financial Accounting course.
Unearned revenue: recognize the service provided
In another hypothetical case, Cedar receives $8,400 on November 1 for six identical monthly support services from November through April. Assume revenue is appropriately recognized evenly as each month of service is provided. Cedar initially credits Unearned Service Revenue $8,400.
By December 31, two months are complete. Monthly revenue is $8,400 ÷ 6 = $1,400. Revenue earned is $2,800; the remaining obligation is $5,600.
| Account | Debit | Credit |
|---|---|---|
| Unearned Service Revenue | $2,800 | — |
| Service Revenue | — | $2,800 |
The debit reduces a liability. It is not an expense. No receivable arises because the customer has already paid. Do not divide every advance evenly by months: use the contract’s actual service pattern. The equal monthly calculation is justified by the explicit facts in this example.
For a video walkthrough and exercise on this topic, see Unearned Revenues in the Financial Accounting course.
Where depreciation fits
Long-lived equipment also provides benefits after acquisition, but its periodic allocation normally credits Accumulated Depreciation rather than Equipment. The original cost stays visible, and accumulated depreciation collects the cost allocated to date.
This differs from reducing Prepaid Insurance directly. The adjusting-entries overview includes a simple straight-line example and explains why book value is not fair value. Advanced depreciation methods are outside this lesson.
For a full video lesson, see Depreciation Expense in the Financial Accounting course.
What If the Prepayment Was Recorded as an Expense First?
Some companies record an advance payment straight to an income statement account and fix it at period end. This is often called the expense method for prepayments and the revenue method (or income method) for customer advances. The adjusting entry flips direction, but the adjusted balances end up exactly the same.
Here are the same Cedar Studio facts under this approach. For supplies, assume Cedar debited Supplies Expense for all $3,500 of supplies it bought and had no beginning Supplies balance.
| Situation | Initial entry | December 31 adjusting entry | Adjusted balances |
|---|---|---|---|
| Supplies | Debit Supplies Expense $3,500; credit Cash $3,500 | Debit Supplies $900; credit Supplies Expense $900 | Supplies $900; Supplies Expense $2,600 |
| Insurance | Debit Insurance Expense $3,600; credit Cash $3,600 | Debit Prepaid Insurance $2,700; credit Insurance Expense $2,700 | Prepaid Insurance $2,700; Insurance Expense $900 |
| Customer advance | Debit Cash $8,400; credit Service Revenue $8,400 | Debit Service Revenue $5,600; credit Unearned Service Revenue $5,600 | Unearned Service Revenue $5,600; Service Revenue $2,800 |
Exam tip: under this method, the adjustment records what is left (the unused or unearned part), not what was used. Before you write any deferral entry, check how the prepayment was first recorded.
Common deferral mistakes
The most frequent error is confusing the amount used with the amount remaining. Another is treating a liability debit as an expense. Describe the economic change before choosing debit and credit accounts.
| If this adjustment is omitted | What is overstated? | What is understated? |
|---|---|---|
| Consumed prepaid asset | Assets and net income | Expense |
| Earned customer advance | Liabilities | Revenue and net income |
These effects assume the initial asset or liability method and ignore income taxes. Because net income closes to retained earnings, equity is misstated in the same direction as net income: overstated when a prepaid adjustment is skipped, understated when an unearned revenue adjustment is skipped. An advance that has not yet been earned should remain a liability; leaving that balance in place is not an error.
Key Takeaways
The entry patterns and omission effects below assume the asset method for prepaid expenses and the liability method for customer advances.
- A deferral starts with cash that has already moved. The adjusting entry never debits or credits Cash.
- Prepaid expense: debit the expense and credit the prepaid asset for the part used up or expired.
- Unearned revenue: debit the liability and credit revenue for the part you have now delivered.
- Supplies: expense equals the unadjusted balance minus the count. The count is the ending asset, not the expense.
- Time-based prepaids: start from the coverage or service start date, and subtract any adjustments already posted.
- Skipping a prepaid adjustment overstates assets and net income. Skipping an unearned revenue adjustment overstates liabilities and understates revenue and net income.
Interactive practice: deferral adjusting entries
Test your understanding of prepaid expenses, unearned revenues, and the effects of omitted deferral adjustments with this eight-question exercise. Choose one answer per question, select Check answers, and review the explanations before trying again.
Exercise assumptions: Use the asset method for prepaid expenses and the liability method for unearned revenues. For the supplies question, use the Cedar Studio facts from the Supplies section above.
Accounting practice · 8 questions
Adjusting Entries for Deferrals
What are deferrals? Deferrals are expenses or revenues recognized at a later date than the original cash exchange. The two types are prepaid expenses and unearned revenues.
Under the asset and liability methods used on this page, an adjusting entry for a deferral decreases a balance sheet account and increases an income statement account.
Choose one answer for each question, then select Check answers to see your score and explanations.
0 of 8 answered
Answer key and explanations
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What does “to defer” mean?
Answer: To postpone or delay. To defer means to postpone or delay.
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When are deferred expenses or revenues recognized?
Answer: At a later date than the original cash exchange. Deferrals involve expenses or revenues recognized after the point when cash was originally exchanged.
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What are the two types of deferrals?
Answer: Prepaid expenses and unearned revenues. The two types of deferrals are prepaid expenses and unearned revenues.
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If a required prepaid expense adjustment is omitted, how are the related balances misstated?
Answer: The asset is overstated and the expense is understated. Without the required adjustment, the asset remains too high and the related expense remains too low.
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If a required unearned revenue adjustment is omitted, how are the related balances misstated?
Answer: The liability is overstated and revenue is understated. Without the required adjustment, the liability remains too high and the related revenue remains too low.
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Before adjustment, Cedar Studio’s Supplies account shows $3,500. What does that balance represent?
Answer: All supplies available for use: any beginning supplies plus purchases. Before adjustment, the Supplies account holds everything Cedar had available during the period. It has not yet been reduced for the $2,600 of supplies used, which is why the adjusting entry is needed.
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Why is Supplies Expense understated when supplies have been used but no adjustment has been made?
Answer: The cost of supplies used has not been recognized. Supplies Expense is understated because the cost of supplies used during the period has not been recognized.
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Under the asset and liability methods, what is the overall effect of an adjusting entry for a deferral?
Answer: It decreases a balance sheet account and increases an income statement account. Under the asset and liability methods, a deferral adjustment decreases a balance sheet account (the prepaid asset or unearned revenue) and increases an income statement account (the expense or revenue). Under the expense or revenue method, the direction reverses.
Need a refresher? Review the prepaid expense and unearned revenue comparison or the effects of omitted adjustments, then continue to the worked practice questions.
Practice questions with explained answers
1. Supplies has a $1,900 balance; $450 remains. What amount is expensed?
Answer: $1,450. Debit Supplies Expense and credit Supplies for $1,900 − $450. The adjusted asset equals the count.
2. A $2,400 policy covers twelve months beginning July 1. No adjustments have been recorded by September 30. What is the entry?
Answer: Debit Insurance Expense $600 and credit Prepaid Insurance $600: $2,400 ÷ 12 × 3 months. The remaining asset is $1,800.
3. A $5,000 advance includes $1,750 of services now completed. What remains unearned?
Answer: $3,250. Debit Unearned Revenue $1,750 and credit Revenue $1,750; the balance represents services still owed.
Frequently asked questions
Is a prepaid expense initially an expense?
Answer: Under the asset method used here, it is initially an asset. It becomes expense as the benefit is used up. Some companies use the expense method instead, which records the full payment as expense first and moves the unused part back to an asset at period end.
How is a deferral different from an accrual?
Answer: In a deferral, cash moves first and the revenue or expense is recognized later. In an accrual, the revenue is earned or the expense is incurred first, and cash is settled later. See the accrual examples for worked entries.
Where do the adjusted balances go?
Answer: They enter the adjusted trial balance. Keep the remaining asset or liability separate from the period’s expense or revenue. From there, the balances are used in preparing financial statements, and the revenue and expense accounts are later reset through closing entries.
What Are the Two Types of Deferral Adjusting Entries?
Answer: Prepaid expenses (also called deferred expenses) and unearned revenues (also called deferred revenues). Supplies, prepaid insurance, and prepaid rent are common prepaid expenses. Customer deposits, subscriptions paid in advance, and retainers are common sources of unearned revenue.
Does a Deferral Adjusting Entry Ever Affect Cash?
Answer: No. Cash was recorded when the company paid or collected in advance. The adjusting entry only moves amounts between a balance sheet account (the prepaid asset or unearned revenue) and an income statement account (the expense or revenue).
What If the Prepayment Was First Recorded as an Expense or Revenue?
Answer: Then the adjusting entry runs the other way. You move the unused or unearned portion back to the balance sheet. For example, if Cedar had debited Supplies Expense for all $3,500 and $900 remains, the entry is debit Supplies $900 and credit Supplies Expense $900. The adjusted balances match the asset method.
About the Author
Mansour Farhat, CPA, CIA, DBA, is the professor behind Farhat Lectures. He teaches the video lessons on this site for CPA, CMA, and EA candidates and accounting students. Learn more about Professor Farhat.
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