Hello, I'm Professor Brian Buchet. Welcome back. In the next two videos, we're going to talk about adjusting entries.
These entries help to get the books in shape so that we can prepare financial statements. In this video, we'll talk about adjusting entries conceptually and go through some examples. And in the next video, get some practice to do these journal entries.
Let's get started. So far, we've looked at the part of the accounting cycle where a company is analyzing transactions, doing journal entries, and posting the tea accounts during the fiscal period. And at the end of the period, the company does an unadjusted trial balance to make sure that there are no mistakes made so far.
Now, we're going to move on and take a look at the next step in the cycle, which is adjusting entries. Adjusting entries are internal transactions that update account balances in accordance with acrruel accounting prior to the preparation of financial statements. By internal transactions, we mean that we're not doing any more transactions with outsiders.
This is just the accountant sitting at his or her desk doing journal entries to get accounts up to date to do financial statements. I guess the way to think about this is if a company's fiscal period ends December 31st, everyone else in the company is going to leave at 5:00 to go out for New Year's Eve parties, but the poor accountant has to stay behind and do these adjusting entries before the company can get ready to do its financial statements for the end of the year. There's two big categories these entries.
The first are called deferred revenues and expenses. In this case, we're updating some existing account balance to reflect its current accounting value. This happens when there's been some kind of cash flow in the past, but we need to record revenues or expenses.
Now, the other big category are acred revenues and expenses. Here, we have to create some new account balances to record some previously unrecorded assets or liabilities. This will be situations where we're going to record a revenue or expense now and there'll be some kind of cash flow in the future.
So, don't worry. I'm going to go through examples of each of these types of adjusting entries so you can see exactly what we mean by them. Do any of these adjusting entries involve recording cash?
Now, no. Adjusting entries never involve cash because these are purely internal transactions. We're not doing any transactions with anyone outside the business at this point.
So there's no more cash coming in and there's no more cash going out. The first category we're going to look at are deferred expenses. So as our poor accountant sits at his desk on New Year's Eve night and watches his colleagues from sales and marketing and operations and human resources happily leave the company to go celebrate New Year's Eve.
The accountant asks himself, "Are there any assets that have been used up this period and should be expensed? The accounts that we'll see here are generally called prepaid accounts, like prepaid rent or prepaid insurance. Depreciation and amortization are also examples of a deferred expense, but we'll talk more about those later in the video.
But let's think of something like prepaid rent. We've paid cash in advance of occupying the space. So, we create an asset called prepaid rent.
But then as time goes by and we've occupied the space, we have to recognize the cost of the rent for the time that we've occupied the space. So we're going to do an adjusting journal entry where we debit an expense to recognize the cost of the rent that's been used up over time. And we're going to credit the prepaid asset to reduce the balance to how much that's still prepaid, if any, at the end of the year.
Next, we have deferred revenues. So, as our accountant starts receiving all sorts of text messages from his friends saying, "Hey, when are you going to come out to the New Year's Eve party? It's getting late.
" The accountant has to put away his phone and think to himself, "Are there any liabilities that have been fulfilled by delivery of goods or services that should be recognized as revenue? " So, the accounts involved here will be things like unearned revenues or deferred revenues. So, what's happened in this case is we've received cash prior to providing goods or service.
Now that time has gone by and we've earned the revenue, the adjusting journal entry will say credit revenue to recognize the revenue that we've earned over time and debit the unearned revenue liability to reduce the obligation because we fulfilled part of the obligation by delivering the goods or services over the time period. Why would this be an adjusting entry? Wouldn't you know when you had delivered goods and then just record this entry then?
Yeah, if we had delivered some goods, we probably would have recognized revenue when we delivered the goods. But these examples are about providing some kind of service over time. And in this case, we just do an adjusting entry to recognize all the service provided over the period as opposed to doing an entry every month or week or day or hour or minute or second.
Next, we have acred expenses. So, as our poor accountant decides to turn on the TV to watch something like New Year's Rock and Eve so he can hear some of the music in the background that he's missing at all the parties, he he has to ask himself, have any expenses accumulated during the period that have not yet been recorded. These accounts are all going to be payable type accounts.
What's going on here is that we've incurred some expense over time, but we haven't yet paid for it in cash. So the adjusting journal entry we need to make is to debit an expense to recognize that expense and credit a payable liability to show that we have an obligation to pay for that expense. For example, if employees have worked for us, but we haven't paid them yet, we have to debit a salaries and wages expense to recognize the cost the employees working for us and then credit salary and wages payable to show the liability that we have to pay our employees some point in the future.
Finally, we have acred revenue. So, as our poor accountant looks at the TV to watch the ball drop at Times Square, he hurriedly asks himself, "Have any revenues accumulated during the period that have not yet been recorded? " So, he can do his one more set of adjusting journal entries.
The accounts we're talking about here are going to be receivable accounts like interest receivable or rent receivable. An example would be if we loaned someone else money, time has gone by, so now they owe us interest. We would do a journal entry to credit revenue for the interest that they owe us.
And then we would debit a receivable asset like interest receivable to show that we have an asset for the amount of cash that we're going to collect in the future. So this adjusting journal entry allows us to recognize revenue that we haven't recognized so far and then show that we have an asset for the cash that we expect to collect in the future. How can revenues be accumulated with you not knowing about it?
When revenues are earned and realized, you should record the entry. Why is this an adjusting entry? Again, these examples are about providing a service over time as opposed to delivering specific goods.
And since it only matters that the revenues show up in the books when we put together financial statements, it's just easier to do the adjusting entry once at the end of the period instead of doing it every month or week or hour, minute or you get the idea. Finally, we're going to talk about depreciation and amortization, which are just examples of deferred expenses, but there's a lot more to them, so I wanted to give them their own couple of slides. The goal of depreciation and amortization is to allocate the original cost of long-lived asset over its useful life.
What we want to do is match the total cost of the asset to the revenues it generates over its period of use. If you remember back in the introductory video, we looked at Dave's car transport service. Dave had bought a truck that he intended to use for 48 months.
Instead of recognizing the cost of that truck as an expense in the first month, we spread the cost out over 48 months through depreciation to try to match the cost of the truck to the revenue we think it will generate in the future. Now, some terminology here. Tangible assets, which are physical assets like buildings or equipment or truck, we're going to call this process depreciation.
For intangible assets, which are abstract assets like trademarks or customer lists which we've acquired in an acquisition, we're going to call this process amortization, but the process is going to be very similar even though the terminology is different. Now, let's talk about the accounting procedure for depreciation amortization. Starting with depreciation, depreciation is not deducted from the tangible asset account.
So in other words, if you were taking depreciation on a truck, you wouldn't deduct it from the truck account. Instead, the depreciation is going to be recorded in a contraasset account called accumulated depreciation. A contra asset is denoted by XA in parenthesis and it has a credit balance which means that contra assets go up with credits and down with debits.
I think contra is a Latin word which means something like it has the balance on the opposite side of where you'd expect the balance to be based on where it is on the balance sheet. In other words, assets normally have debit balances. So, they're increased with debits.
A contra asset would have a credit balance and be increased with a credit because essentially a contra asset is keeping track of reductions in a companion asset account. Then what we'll see is when we put together the financial statements, the accumulated depreciation will be subtracted from property, plant, equipment on the balance sheet to get something called netbook value. Amortization is often deducted directly from the intangible account.
So if you were amortizing a trademark, you would deduct it directly from the trademark account. However, nowadays there are companies that have fairly large intangible assets and they've started to use accumulated amortization accounts as well. So that's just another type of contra asset where the accounting works just like accumulated depreciation.
But I think the most common treatment you see is that the amortization just comes directly out of the intangible asset account. Where do Kentra assets fit into the balance sheet equation? Why do they have a credit balance if they are assets?
I admit that it's hard to get your head around this notion of a contra account. Let me pull up the super tea account to show you where a contra asset sits on the balance sheet. So, the contra asset is on the asset side of the balance sheet, but it has a credit balance.
That means an increase in a contra asset would reduce total assets. The way to think about it is a contra account is keeping track of the decreases or reductions in a specific asset account. It's almost like an expense.
Expenses sit on the shareholders equity side of the balance sheet in retained earnings, but they have a debit balance. That means an increase in expense reduces retained earnings. And in fact, an expense is just a contra shareholders equity account.
So, you've actually seen this before and you're going to see a lot of it again. And as you see it over and over, I think it'll become more intuitive to you. And why not just abduct depreciation from the regular asset account?
Excellent question. When we get to the video where we put together a balance sheet, we'll see that the common format for reporting property plan equipment is to show the original cost of the property plan equipment separate from how much it's been depreciated over time. And in order to provide that format, we have to keep track of this accumulated depreciation in a separate account.
To calculate the amount of depreciation expense every year, almost every company uses a method called straight line depreciation. Under this method, the depreciation expense is equal to the original cost of the asset minus its salvage value, all divided by its useful life. The salvage value is what you think the asset's going to be worth when you're done using it.
So in the numerator, we're taking how much of the asset's cost you're going to use up. And then the useful life is the number of periods you expect to use the asset. So under straight line depreciation, the amount of the depreciation expense is going to be the same for each year of the asset's life.
Are there other methods of depreciation? Why do almost all companies use straight line for their financial statements? Yes, there are accelerated methods of depreciation where you recognize higher depreciation in the early years of an asset's life and then much less depreciation in later years of an asset's life.
These methods are used for tax purposes, which we're going to talk about much later in the course. My conjecture is that most managers like to use straight line depreciation because it produces nice smooth earnings. If you use accelerated depreciation, then your earnings will be more volatile depending on whether you have a lot of new equipment which is got high depreciation or a lot of equipment which is later in it life which has much lower depreciation.
Who determines the useful life and the salvage value? Is it a central government agency? No.
For financial reporting purposes, there is no central government agency that dictates useful life and salvage value. Managers are supposed to choose the useful life based on how long they intend to use the asset and then the salvage value will be a function of how long they intend to use it. So to see how this works, let's talk about a couple airlines.
There's a major international airline which has a strategy of only flying pretty new state-of-the-art planes. They'll buy a brand new plane, fly it for 5 years, and then sell it to someone else. So when they choose their depreciation assumptions, their useful life is 5 years and they have a very high salvage value.
Now there's a major domestic airline that tends to fly their planes for 20, 30, 40 years. I'm not going to mention the name, but you probably know who it is. Their strategy, if they bought a brand new plane, would be to choose a useful life of 20 years, and then they would have a low salvage value as a result.
So, you can have two airlines buy the same plane and have different depreciation assumptions, but that's okay because the depreciation assumptions are supposed to match how the manager intends to use the plane, not anything that has to do with the physical life of the plane. So, I think I've probably fully depreciated your energy at this point. So, why don't we wrap up here?
Uh, I'll see you next video where we'll do some more practice with adjusting journal entries. See you then. See you next video.
