by Tess Boardman

Created on: July 26, 2010

Under GAAP, or the generally accepted accounting principles, financial statements must be prepared on an accrual basis. This allows users of the financial reports to see a clear picture of a company’s resources, income, liabilities, and expenses that occurred in the time period that the statements are for. To meet the revenue recognition principle and the matching principle, a company needs to make adjusting entries to account for transactions that have not fully transpired. Two types of adjusting entries are made: prepayments and accruals.

*Adjusting entries for prepayments

Prepayments consist of items where cash has been disbursed or received before used, consumed, expired, or earned. It is often not cost effective to record these items on a daily basis, so adjusting entries are made at the end of the period recognize or expense the actual amount used within the period. Common prepayments include inventory, insurance, and rent. Other assets that require an adjusting entry under the prepayments are fixed assets that depreciate over time.

-When supplies are purchased, the transaction is recorded as asset, such as Office Supplies with a debit entry, and Cash is reduced with a credit entry. At the end of the period, the supplies remaining are counted and the actual expense is figured. Then, that expense is recorded at the end of the month as Office Supplies Expense, reducing the asset account Office Supplies with a credit entry, and increasing the expense account Office Supplies Expense with a debit entry.

-If a company purchases an insurance policy for the year and prepays the entire cost of the policy, it is recorded as an asset. The Prepaid Insurance account would record a debit entry, increasing the account, while Cash would be credited, decreasing the account. As costs expire, Insurance Expense would be debited, and Prepaid Insurance would be credited in the month the expense was for.

-Depreciation is used to assign the cost of plant, property or equipment that is recorded as an asset. For example, if a new computer system is purchased, the Office Computers account would be debited. Cash or liability accounts would be credited to record the purchase. Sine the computers are used to generate revenue in future periods, the expense of the computers over those time periods is spread over their useful lives. The depreciation amount is recorded as a credit in a contra-account to the asset account Accrued Depreciation-Office Computers, and a debit in an expense

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