The basic accounting equation explains how assets equal liabilities plus equity. The accounts that make up these assets, liabilities and equity are detailed on the company’s Balance Sheet. Income (or loss) is a part of the Equity section, and this information is detailed on the Income Statement. Revenues and expenses from a specific period of time are on the Income statement.
So what are expenses and revenues? Expenses are costs of doing business during a set period of time, usually a month. These can vary from rent to payroll. Revenues are earned during the same period of time. Depending on if the company is cash or accrual based, these revenues can be real or accrued, meaning that either cash or a receivable respectively is associated with them.
Income Statements Show Profits and Loss
In order for these expenses and revenues to impact only the reporting period, sometimes they must be posted as assets or liabilities. Let’s say that Business A pays their rent every month and receives cash receipts immediately upon service rendered. This company can post their rent and cash received as current expenses and revenues.
On the other hand, Business B pays their rent six months in advance and receives cash to pay for three months of services not yet rendered. While one month of the rent is a current expense, the remaining five months are now Prepaid Rent and considered an asset. For the next five months, it will be accrued to a rent expense until the prepaid asset account is depleted.
Balance Sheets Show What Is Owned and Owed
The revenue is also paid ahead, but it is now a liability, since the company owes services to this customer. The Unearned Revenue account is considered a liability and will be recognized as revenue over the next three months until the liability is depleted.
Another way to look at it is to remember that expenses and assets are debits where as revenues and liabilities are credits. Since expenses and assets are both debits, they can swap roles, and since revenues and liabilities are credits, they can as well. In other words a prepaid rent account will never be a liability, since that is a credit account. Rent expense is always a debit, so it can only change to another debit account; in this case the asset Prepaid Rent.
Bookkeeping Is all About the Debits and Credits
If there is ever a doubt about which account to code the prepaid expense or unearned revenue, simply do the journal entry as if the amount were an expense and/or revenue. Once it is determined whether the account is a debit (asset) or a credit (liability), the appropriate account can then be used.