Adjusting entries to convert assets to expenses are necessary when a company makes payments for goods or services in advance that benefit more than one accounting period. These payments are recorded as assets initially but need to be expensed as they are used.
Initial Recording as Asset: When the expenditure occurs, the payment is recorded by debiting an asset account (such as Prepaid Expenses) and crediting Cash.
Adjusting the Entry: At the end of each period, a portion of the asset is transferred to an expense account to reflect its use during that period.
Entry: Debit the relevant expense account (like Insurance Expense or Supplies Expense) and credit the asset account (such as Prepaid Insurance or Supplies).
Purpose: This process ensures that the cost is matched with the revenue it helps generate, providing a more accurate reflection of income for the period.
Prepaid Insurance: If 12 months of insurance is paid in advance, it is recorded as a prepaid asset. Each month, an adjusting entry allocates one month’s cost to Insurance Expense.
Shop Supplies: Supplies purchased are initially recorded as an asset. At the end of the period, the used portion of supplies is transferred to Supplies Expense based on the estimated remaining supplies.