[Kairos]

I understand that the company made a mistake in booking the entire amount for 90,000 and there are adjusting entries needed. How would the company correctly have journalized the two months of services? Thanks!

On October 31, year 1, a company with a calendar year end paid $90,000 for services that will be performed evenly over a six-month period from November 1, year 1, through April 30, year 2. The company expensed the $90,000 cash payment in October, year 1, to its services expense general ledger account. The company did not record any additional journal entries in year 1 that were related to the payment. What is the adjusting journal entry that the company should record to properly report the prepayment in its year 1 financial statements?

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Answer:

Correct! The company should have initially recorded the prepaid services as an asset, with the following journal entry:

Prepaid services $90,000

Cash $90,000

Then, for each month in the six-month period, the company would have recorded the use of the services with the following journal entry:

Services expense ($90,000 / 6 months) $15,000

Prepaid services $15,000

However, the company incorrectly expensed the entire cash payment in the month it was paid, which means $90,000 was debited to Services expense and credited to Cash. No prepaid asset was recorded. After two months (November and December), the books should show a remaining Prepaid expense balance of $60,000 and only $30,000 should have been expensed ($15,000 a month for two months; $90,000 / 6 = $15,000). The adjusting journal entry necessary to show these correct balances is a debit to Prepaid services of $60,000 and a credit to Services expense of $60,000.

[Missy]

I don't understand your question. The way it should have been done and the correction required are both part of the answer you listed above.

Licensed Massachusetts Non Reporting CPA since 2012
Finance/Admin/HR Manager

[Kairos]

I was having trouble seeing how the balances were affected by the $60,000.

ie: Why is prepaid services being debited by $60,000 when it was already debited for $90,000 in the beginning? Wouldnt that bring the balance to $150,000 instead of the $60,000 balance we want?

[spatel15]

Think of it all:

Company initially did this:

Expense 90K

Cr. Cash 90K

It's in the books, there's no going back now. How do you correct that at Year End?

Prepaid 60K

Expense 60K

Ending Balances:

Cash is down 90K

Prepaid is up 60K

Expense is up 30K (90K-60K)

[Missy]

Their actual entry:

DR service expense CR cash (nothing went to prepaid)

They should have:

Dr prepaid expense and cr cash

Then each month

DR service expense and CR prepaid

Licensed Massachusetts Non Reporting CPA since 2012
Finance/Admin/HR Manager

[Jim Deal]

The adjustment was:

DR: Prepaid Services $60,000

CR: Service Expense $60,000

To correct the original:

DR: Service Expense $90,000

CR: Cash $90,000

The $30,000 difference is left where it is because that much time has lapsed between the error being made and finding it (so it appropriately belongs in Service Expense and not Prepaid Services). In effect, the $30,000 for those two months doesn't require a journal entry because the net effect would be the same with $30,000 in Service Expense.

You subsequently asked: “Why is prepaid services being debited by $60,000 when it was already debited for $90,000 in the beginning?”

It wasn't. In the answer they were showing you how it should have been done from the beginning so that you would better understand what went wrong. They don't actually begin answering the question until they state: “However, the company incorrectly expensed the entire cash payment in the month it was paid, which means $90,000 was debited to Services expense and credited to Cash.”

You probably just need a break so that you can comprehend what you are reading better. My reading comprehension goes out the window when I'm stressed, tired, or distracted. I intermittently come here to get away from my MCQ's for a while when I've got 100+ to get through.

[JohnWayneIsGod]

When in doubt, draw up some t-accounts. It always comes out better when you can see it and manipulate it. Draw them up for what happened, and then draw them up for what should have happened. Then enter adjustments into the wrong t-accounts so that the end result is what should be the end result in Year 1. You'll see that the expenses were overstated by 60k, and that Prepaid is understated by 60k. Adjusting Entry is Dr: Prepaid 60k; Cr: Expense 60k.

FAR - 80

Courage is being scared to death, but saddling up anyway.

-John Wayne

[Author]

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