Which one of the following will be the adjustment journal entry if the rent received in advance is ₹ 2,000 ?

Correct — B, (b) Debit rent received account and Credit rent received in advance account. Rent received in advance is income the business has collected but not yet earned, and the adjustment entry has to take it out of income and put it into liabilities.

During the year the whole receipt was credited to the rent received account, which is a nominal account and would otherwise be carried in full to the credit of the profit and loss account. At the year end ₹ 2,000 of it turns out to relate to the FOLLOWING period. Two things must happen:

the income of this year must be reduced by ₹ 2,000, which means DEBITING the rent received account, because a nominal income account is reduced by a debit; and a liability must be created for ₹ 2,000, because the business owes the tenant the use of the property for a period it has already been paid for — which means CREDITING a rent received in advance account.

Hence: Rent Received A/c Dr. ₹ 2,000; To Rent Received in Advance A/c ₹ 2,000. That is option (b).

The accrual concept is what compels the entry. Income belongs to the period in which it is earned, not the period in which the money arrives, so an amount received for next year must be excluded from this year's revenue however clearly it has been banked. Rent received in advance — also called unearned income or income received in advance — is a representative personal account under the traditional classification, standing for the tenant to whom the obligation is owed, and it appears on the liabilities side of the balance sheet.

In the following year the entry is reversed — Rent Received in Advance A/c Dr., To Rent Received A/c — so that the ₹ 2,000 becomes income of the year to which it belongs. That reverse entry is exactly the wording of option (c), which is why the two must not be read carelessly.

Why the others are wrong

• (a)Debit profit and loss account and Credit rent account — Neither half of this entry is right for the transaction. Debiting the profit and loss account would treat the ₹ 2,000 as an EXPENSE of the year, when it is not an expense at all — it is income of the next year. Crediting a 'rent account' compounds the confusion: rent PAID and rent RECEIVED are different accounts, one an expense and the other an income, and this option's second half suggests the rent the business pays out. The correct treatment touches income and liabilities, not expenses. The only sense in which the profit and loss account is involved at all is indirect: because ₹ 2,000 has been removed from the rent received account, the amount eventually carried to the credit side of the profit and loss account is ₹ 2,000 smaller.
• (c)Debit rent received in advance account and Credit rent received account — These are the right two accounts with the debit and the credit the wrong way round, and the reason it is tempting is that it IS a correct entry — just for a different moment. Debit rent received in advance and credit rent received is the entry made at the BEGINNING OF THE FOLLOWING YEAR, when the liability created at the last year end is discharged and the ₹ 2,000 becomes income of the period to which it belongs. Made at the end of THIS year, it would do the opposite of what is required: it would increase the current year's income by ₹ 2,000 and create a debit balance in the advance account, so the same rent would be counted twice over the two years. When two options offer the same two accounts with the sides exchanged, fix the direction from first principles — income down, liability up.
• (d)Debit rent account and Credit profit and loss account — Both halves are wrong. Debiting a rent account would, if the account meant is rent received, indeed reduce the income — but crediting the profit and loss account would then put the ₹ 2,000 straight back into the current year's profit, leaving the year's result unchanged and creating no liability at all. Nothing would have been achieved. And if the rent account meant is rent paid, the entry would reduce an expense the business has never incurred on this transaction. An adjustment for income received in advance must leave a balance standing on the balance sheet at the year end; an entry whose second leg is the profit and loss account leaves nothing behind, which is enough to reject it.

Year-end adjustment entries exist because the accrual concept requires each period to carry its own revenues and its own costs, whatever the timing of the cash. Four adjustments recur and are best learned as two symmetrical pairs. INCOME RECEIVED IN ADVANCE, or unearned income: cash already received for a service not yet given. Entry — Income A/c Dr., To Income Received in Advance A/c; the credit balance is a liability. ACCRUED INCOME, or income earned but not received: entry — Accrued Income A/c Dr., To Income A/c; the debit balance is an asset. PREPAID EXPENSE, or expense paid in advance: entry — Prepaid Expense A/c Dr., To Expense A/c; the debit balance is an asset. OUTSTANDING EXPENSE, or expense incurred but not paid: entry — Expense A/c Dr., To Outstanding Expense A/c; the credit balance is a liability. The pattern is easier to hold than the four entries separately: in every case the nominal account is adjusted so that only the current period's amount survives in it, and the difference is parked in a representative personal account that becomes an asset or a liability according to whether the business is owed or owes. At the start of the next period each of the four is reversed, which is why the reversing entry is always available as a plausible wrong option in a question of this kind. The same logic explains where each appears: the adjusted nominal balance goes to the trading or profit and loss account, and the representative personal balance to the balance sheet.

Key facts

• Rent received in advance is income received but not earned; the adjustment entry is Rent Received A/c Dr., To Rent Received in Advance A/c.
• The rent received in advance account carries a credit balance and appears on the liabilities side of the balance sheet.
• In the following period the entry is reversed — Rent Received in Advance A/c Dr., To Rent Received A/c — so the income falls into the year in which it is earned.
• The accrual concept requires revenue to be recognised in the period in which it is earned, not the period in which cash is received.
• Income received in advance is a representative personal account under the traditional classification.
• Accrued income: Accrued Income A/c Dr., To Income A/c; the balance is an asset.
• Prepaid expense: Prepaid Expense A/c Dr., To Expense A/c; the balance is an asset.
• Outstanding expense: Expense A/c Dr., To Outstanding Expense A/c; the balance is a liability.
• In every one of the four adjustments the nominal account is corrected to the current period's amount and the balance is parked in a personal account.

Common traps

• Choosing the reversing entry. Debit rent received in advance and credit rent received belongs to the start of the next year.
• Involving the profit and loss account directly. The adjustment must leave a balance on the balance sheet.
• Confusing rent received with rent paid. One is income, the other an expense.
• Treating income received in advance as an asset. It is a liability, since the service is still owed.

• practice — not a real PYQ

  Commission of ₹ 3,000 has been earned during the year but not yet received. The adjustment entry at the year end is :

  • (a)Debit commission received account and Credit accrued commission account
  • (b)Debit accrued commission account and Credit commission received account
  • (c)Debit profit and loss account and Credit commission received account
  • (d)Debit commission received account and Credit profit and loss account

  Answer(b) Debit accrued commission account and Credit commission received account

• practice — not a real PYQ

  Rent received in advance appears in the balance sheet as :

  • (a)An asset, being cash already received
  • (b)A liability, being income not yet earned
  • (c)A part of capital
  • (d)A contingent liability disclosed by way of note

  Answer(b) A liability, being income not yet earned