by Leigh Goessl

Created on: November 18, 2009

Adjusting entries are an essential part of accrual based accounting. Adjusting entries are made so records can be accurate and reflect the true balances on a given financial accounting period. There are two categories for adjusting entries and these are known as prepayments and accruals.

Here is a basic rundown of what prepayments and accruals are and how they are necessary to make adjusting entries:

*Prepayments

Prepayments are prepaid expenses and unearned revenues that have occurred in the accounting period. One is classified as an asset the other a liability.

>Prepaid expenses

A prepaid expense is an expenditure that is already paid for and recorded as an asset. It is owned by the organization, but hasn't yet been used.

An example of prepaid expenses is insurance policies. Money is paid upfront in exchange for several months to a year of coverage. Since the dates the coverage provides for has not occurred yet, this means the insurance policy theoretically hasn't been used. As time passes on the policy, eventually it will deplete and will cease to being an asset once the insurance policy's time frame for coverage expires.

>Unearned Revenues

Unearned revenues are monies that are received but the organization still has to provide the service or deliver the product to complete their end of the transaction. This is classified as a liability because there is still an obligation to be met even though money has been collected.

An example of unearned revenue would be a company that takes prepayment for a service. Say an oil company requires upfront payment in order to guarantee a customer to lock in a lower price for winter fuel, and they purchase 1,000 gallons of fuel. The customer has paid for both the oil and the delivery, but the fuel and delivery has not yet taken place, thus it is unearned even though money has exchanged hands.

This kind of accounting event would be recorded in an accounted worded along the lines of "unearned revenue" and each month a portion of it would flip over to earned income after each delivery is made. For instance if the company makes a $300 delivery, than this amount would turn into earned income and be adjusted accordingly at the end of each accounting period.

*Accruals

Accruals are categorized as accrued revenues and expenses. When money has been earned but not yet recorded in the same accounting time frame or expenses have been made, but the bill to pay these has not yet been reconciled, then the company still has a financial obligation, or an accrued expense.

For example if you take your car to a mechanic and they allow you to be billed instead of paid on delivery of services, this is revenue that has been earned, but the money has not yet been received. An accrued expense for a company would be items such as taxes, salaries or interest. For instance, employees have worked the hours to earn the pay, but since they are only paid on the last day of each month, the salary expense is considered accrued until payday occurs.

Prepayments and accruals are necessary accounting adjusting entries in accrual accounting. Without making these adjustments, than an organization's financial records would not be accurate and it would be difficult to assess certain financial aspects of the company during any given financial period.

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