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Journal Entry for a Prepaid Liability

written by: •edited by: Linda Richter•updated: 2/19/2016

One of several methods to recognize revenue uses the prepaid liability account. This article contains examples of a journal entry for a prepaid liability and how it’s used in different types of businesses. This will also thresh out the confusion between unearned income & prepaid liability accounts.

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    Accounting for Prepaid Liability

    710px-Economy 

    In understanding a transaction that calls for a journal entry for prepaid liability, we must initially establish the difference between an unearned income and a prepaid liability. Both accounts are used to record advance payments received from customers; hence they are often misconstrued as one and the same account. This is understandable, because the only differences between these two accounts are their timelines.

    At the end of the year, all advance payments under the unearned income account should be recognized as income to match the expenses incurred during the same accounting period. Otherwise, if the cost of goods sold or the cost of services rendered will extend to the succeeding year or accounting cycle, the money received in advance, or that portion corresponding to costs that will be incurred in the future, should be treated as prepaid liability and not unearned income.

    This means, therefore, that money received in advance to pay for goods or services related to income-generating transactions in which the income cannot be recognized as such for the year, whether in part or in whole, are treated and classified as prepaid liabilities. These advance payments are known in terms of business transactions as deposits or down-payments, paid as part of conditions to a contract, to perform a particular service, or to deliver an asset, which may include intangibles.

    Generally, prepaid liability is the accounting classification for customers’ deposits, and the accounting principle of "conservatism," aside from "matching principle," govern this accounting method of revenue recognition. Income should be properly matched with its corresponding expenses, but the principle of "conservatism" dictates that income should be recognized only if the transaction to which it is related has transpired or will transpire within the accounting year.

    The following sections present examples of business transactions involving the use of journal entry for prepaid liability:

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    Various Rental Businesses Including Real Property

    800px-Car rental-park 

    Businesses that let or rent out equipment, automobiles, costumes, and various recreational tools, gadgets, and devices observe a standard operating procedure of asking for the customer’s deposit. Usually, the deposit serves as a guarantee that the items will be returned safely to the business in the same condition as when they were issued or released. In the event that certain damages are sustained by the items or objects that were rented, the customer’s deposit can be applied as payment in part or in whole.

    Some customers who intend to rent again do not withdraw their deposit upon return of the item rented. It is only when the customer signifies his intention that he will cease from renting the goods of the business that the customer’s deposit account will be debited and applied as payment for the final transaction between customer and rental business owner.

    Journal entries for customer’s deposit in a rental business:

    (1) Received payment for the rental deposit required.

    Dr. Cash __________

    Cr. Customer’s Deposit Account __________

    (2) Customer returned the item with missing or damaged part; if the customer intends to rent again, this transaction will not affect the Customer’s Deposit Account.

    Dr. Cash __________

    Cr. Advance Payment for Repair of Damaged Goods __________

    (3) If the customer signifies his intention not to rent again after returning the damaged goods, the following journal entry for the prepaid liability will be recorded in the general ledger books.

    Dr. Cash __________

    Dr. Customer’s Deposit __________

    Cr. Advance Payment for Repair of Damaged Goods __________

    Cr. Rental Income __________

    Note: Businesses involved in leasing or renting out real estate property will basically follow the same format in the journal entry for prepaid liability.

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    Journal Entry for Earnest or Goodwill Money Received

    Some buyers willingly pay money in advance even if it is not the standard operating procedure of a business. This practice is usually done to signify a buyer's serious intention to purchase a particular commodity once the item, i.e. real estate property, is put up for sale in the market. In order to make sure that preemptive right will be awarded to him, the serious buyer pays a certain amount in advance as proof of his earnestness, which is aptly called “earnest or goodwill money". Since there is no specific period established when the sale will take place, which may or may not extend to future years, earnest or goodwill money is initially recorded as a prepaid liability. Below are the appropriate accounting entries to record the transactions.

    (1) Received cash to signify the buyer’s intention to acquire the goods or property or to maintain continuous exclusive trading privileges with the company.

    Dr. Cash

    Cr. Customer’s Deposit- Earnest/Goodwill Money Paid by Mr. XYC

    (2) Upon acquisition of the goods or property sold to the customer who paid the earnest money.

    Dr. Cash __________ (Net of the Earnest Money previously paid by the customer)

    Dr. Customer’s Deposit- Earnest/Goodwill Money Paid by Mr. XYC

    Cr. Sales __________

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    Businesses Engaged in Performing Professional Services that Require Down Payment

    800px-FEMA - 37468 - US Army Corps of Engineers in Iowa 

    There are entities who undertake services which may require the purchase of materials in order to launch the agreed scope of work and contract specifications. Due to the large scope of work involved which may extend to future accounting periods, companies require advance payment from customers to cover the completion of a certain percentage of a job or work under contract. Examples of these are the construction contracts entered into by house or building contractors with a property owner or real estate developer.

    The journal entries pertaining to the prepaid liability in this type of work is presented in another article entitled “Unearned Revenue: Examples & Explanations---Professional Work Based on Percentage of Completion".

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    Website Development and Software Programming Businesses

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    The reader may refer to another article entitled “A Survey of Accounting Revenue Recognition Methods -- Recognizing Revenue under Proportional Performance Method for a full explanation on how the amounts used in recognizing the journal entry for these types of businesses are calculated.

    Dr. Cash __________

    Cr. 1st Payment for Website Development of The Greenability __________ (Net of portion recognized as income related to the launching of the project.)

    Cr. Revenue Earned from Launching of The Greenability Website Development Project __________

    Please note the account titles used and how account-specific title descriptions were affixed in order to maintain proper monitoring and matching of income and expenses per project.

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    Businesses with Brokerage Agreement

    Brokers who undertake the task of purchasing goods that may require importation or license and expertise to facilitate the purchase of an item likewise require deposits from their customers. This is to defray at least in part the cost of purchasing the item. The customer's down payment may be applied to partially pay for the goods, including the shipping costs, with the broker shouldering some part of the costs, but all will depend on the agreed terms and conditions between the broker and his customer. See the second page of the previously referenced article, “A Survey of Accounting Revenue Recognition Methods --- Revenue Recognition under Brokerage Agreement.

    (1) Journal entry of the prepaid liability upon receipt of the required deposit payment.

    Dr. Cash __________

    Cr. Customer‘s Deposit under Brokerage Agreement __________

    (2) Upon purchase of the item under Brokerage Agreement

    Dr. Accounts Receivable – Ms. Xandrake __________ (This represents all costs and charges related to the purchase)

    Cr. Cash __________

    (3) Upon Collection of reimbursement for customer and release of title to the goods purchased

    Dr. Cash __________ (Net amount of customer’s deposit)

    Dr. Customer‘s Deposit under Brokerage Agreement __________

    Cr. Accounts Receivable – Ms. Xandrake __________

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    Summary:

    In recording transactions that make use of prepaid liability methods, it will help the accountancy learner to understand the nature of each transaction and determine at what point in time the prepaid liability will be recognized as income. This way the applicable method of recognizing revenue, which makes use of the journal entry for prepaid liability, will be presented in accordance with the accounting principle of conservatism.

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    Reference Materials and Image Credit Section

    .Reference Material:

    • Carrington, Glenn R. Tax Accounting in Mergers and Acquisitions (CCH, 2009) -- via Google Books

    Image Credits:

All About Journal Entries

Find tips and advice on how to record journal entries for all types of transactions along with free, downloadable forms you can use for a variety of accounting purposes.
  1. Importance of Adjusting Journal Entries
  2. Typical Examples of Journal Entries
  3. Making a Journal Entry for Anticipated Income
  4. Journal Entry for a Prepaid Liability
  5. A Guide to Job Costing Journal Entries