Introduction to Adjusting Journal Entries and Prepaid Expenses
3. Accrual Accounting Concepts
Introduction to Adjusting Journal Entries and Prepaid Expenses - Video Tutorials & Practice Problems
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Adjusting journal entries are used to (you guessed it) adjust the balances in certain accounts due to the passage of time. Adjusting entries are made at the end of an accounting period.
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Introduction to Adjusting Journal Entries
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Alright, so now let's start our discussion of adjusting journal entries. These are a key feature of the accrual accounting system, Let's see how and when we're going to use them. So the whole idea behind adjusting journal entries is that accounts need to be updated for the passage of time. Some accounts need to be updated for the passage of time. Okay, So there's gonna be some balance in the account and time's gonna pass. And let's say the account balance is gonna be used up, right? We need to adjust that balance, it's going to be sitting at that balance until we make these journal entries to bring it to the correct balance. Okay. We're gonna see all types of adjusting entries and mostly they're gonna be deferrals and a Krul's, we're also going to discuss depreciation but we go into that way deeper later in the book. Okay, so let's start here with deferrals and accruals, let's define them. So a deferral, that's an adjustment for the payment of an item or receipt of cash in advance. Okay, So this is when the cash happens before the triggering event happens. Okay, So the cash is happening before the expense or before the revenue the cash is moving first. Okay, so that those are gonna be deferrals compare that to an accrual, which is the opposite of a deferral. This is when we're recording the revenue or expense before collecting cash. Okay, so this is where the revenue expense happens before the cash moves. Okay deferrals the cash moves and then the revenue or expense accruals We have the expense or the revenue and then the cash. Okay, so we're gonna kind of see how those go hand in hand last, but not least. We have depreciation. Okay, so depreciation. This is where we allocate the cost of a long term asset over its useful life. Okay? When I say long term asset, this is like a machine, right? If we buy a machine to produce our product, that's gonna last us a long time. Say that machine is going to last us 10 years. Well, we want to, we want to allocate the cost of the machine over the 10 years. We don't want to just say, Hey, we bought this really expensive machine right now. We just have to take all the expense right now. No, we take the expense. Little by little over time. Okay, so we'll see how that depreciation works. And just a quick note here, before we dive into our first type of adjusting entry, we're going to be studying these right here. Under deferrals, we've got these, the prepaid expenses, supplies and unearned revenue under Krul's. We're gonna learn about accrued expenses and accrued revenue. I've got quotations there, I'll talk about that a little more later and then last but not least our depreciation. We're gonna discuss depreciation expense and the associated accumulated depreciation. Alright, so let's take a quick pause here and then we'll start with prepaid expenses are first type of adjusting entry
Alright, so let's dive into prepaid expenses. So these are payment of an expense. And typically when we talk about prepaid expenses, we're talking about rent or insurance. So we pre pay some rent or pre pay for an insurance policy and this is when we pay in advance. Okay, So we're paying an expense in advance. So pop quiz real quick prepaid expenses are a expenses be liability, C assets or D revenue? What do you guys think? Prepaid expenses, yep. I heard 11 of you out there definitely see it's an asset. I know this is pretty tricky. A lot of students get tripped up with this at first because they see the word expense, right? And I did tell you when you see the word expense, it's generally going to be an expense. But one of our key words that tells us that it's not an expense is when we see prepaid anything that says prepaid expense. Prepaid rent. Prepaid insurance, anything like that, it's going to be an asset, Okay? And let me tell you why it's going to be an asset. So the idea here is that we're pre paying for something. So if we're paying for let's say a year of rent in advance, right? So we have a rent policy that's starting for the next year, we paid for the whole thing right now, right? We paid for 12 months of rent. Well we haven't earned, we haven't received any of the benefit from renting the place. Right? We paid for it, but we haven't occupied the space used it for our business, we haven't received any of the benefit. We just paid in advance. So what we did is by paying this cash we have this value saved up right we we create this asset which holds the value for all this rent that we're not going to have to pay in the future. Right. So let's go ahead and dive into these adjusting entries and see how this is an asset here. Okay So these prepaid expenses, they're gonna be assets. And let's think about a certain example here. Okay So when we're dealing with most adjusting entries we're gonna be dealing with two dates. Okay. One date is gonna be the date for the expense of the revenue and one date for the cash. Okay. So let's check this out for prepaid expenses. We're going to start with the expense payment date. Okay. We start where the expenses actually paid for. Right We're talking about a deferral. The cash happens first and the expense happens later. So let's see this one. We're gonna pay for the expense in advance and create the prepaid expense account. So in our example on September one the company pays $12,000 for a full year of rent in advance. Okay? So they're paying $12,000 for a full year of rent but they haven't received any benefit from it yet. Right they paid for the whole upcoming year. But they that year hasn't happened yet. So what happened is we definitely paid money, right our cash left our pocket. So we're gonna be crediting cash. But we're going to debit, we're gonna create this asset for prepaid Rent, right? It could go into just a prepaid expenses broad category, but I'm gonna call it pre paid rent. Okay? And this prepaid rent is an asset, right? Because we have all this value stored up for rent that we aren't gonna have to pay in the future, right? We already paid for it and we're gonna be able to use that space over time without paying more cash. So we're going to debit or prepaid rent for the 12,000, right? So now we've had this asset worth $12,000 and we're going to credit cash for 12,000, right? This lowers our cash by 12,000 because we paid it out and now we have this value of 12,000 sitting in our books. Okay, notice I've got two columns here too. on the in the blue columns which we're gonna fill out. Now, this is where we're gonna deal with the very correct and accrual accounting way to do it. And in the red side we're gonna deal with a situation where maybe we started in the cash basis of accounting and then we have to transfer it into a cruel basis. Okay, So we'll see how that works. So here we go. We've got the pre paid rent for 12,000 and the cash for 12,000. So that's the first entry we would make when we actually paid for the cash uh paid for the rent. Okay? And then there's the second date and this is the date where we're updating the books, the adjusting date. So we're gonna adjust the prepaid expense account based on the time that's passed. So you can imagine time is gonna be passing, we're not going to be paying money for rent because we already paid it. And then as that time passes we're eventually gonna have to be taking the expense. Right? So now it's December 31 and the company's updating their books And they're adjusting the records for the passage of time. Okay. So remember at first they had 12,000 on their books for the pre paid rent. But months have passed by. We've used up some of that prepaid rent. Right? So how many months have passed by? That's the first thing we have to find out. So it started in September. So the month of September went by October November and December? It's been four months, right, So four months have passed. So we need to take four months of the expense. How do we find out what four months of the expense is going to be when we want to start by finding out what one month of the expense is. So if we had $12,000 for the full year, let's divide that by the 12 months and we'll find a monthly expense of $1,000 per month. Right? So now that it's December 31, we'll September past October November December, those were the four months, right? Times four that tells us That there should be $4,000 that we've used up. Right? So if we were paying for this rent monthly, if we were just paying it in cash every month, we would have paid $4,000 by now, right? We would have paid rent for September October November December and we would have paid 4000. So in the same sense, it's the same as if we had paid cash every month, we would have had the same total amount of expense. Right? So this is what we want to do at this point, we need a rent expense that that signifies that we've used up four months of rent, right? So our rent expense should be $4,000. So we're going to debit rent expense right? And we increase our expenses with debits. And that's why we're debating it here for the 4000, right? This this $4000 is the 4000 of expense we've used up, but we didn't pay cash in this situation, right? The cash was already paid up front. So what we need to do is we need to lower the value of our prepaid rent. Right? Because right now our prepaid rent account says that we have $12,000 in prepaid rent, But that's not true. We've used some of it up. So we need to lower the value down to the correct amount. And that's because and that would be the 4000 we've used up. Right? So we would want to credit it. Prepaid rent by 4000 to lower the value of prepaid rent by 4000, right? Because we no longer have that asset or that $4,000 worth of that asset. We've used that up. There's still some prepaid rent left for the remaining months but not the full 12,000. So what happened here are prepaid rent account started at 12,000? Right? I'm gonna put 12 K. K. For 1,012,000 minus 4000. Right? We've used up 4000 of it. So it's gonna be sitting at 8000. I will write that one out for the final number, 12,000 minus 4000 gets us to the 8000 balance. So and on december 31st, if we're going to show a balance sheet, the balance sheet would show $8000 in pre paid rent as an asset, right? And our rent expense would be $4000 right? The 4000 for the four months that have passed. And we made that journal entry in the second in the second box there. Cool. Alright. So let's pause here and then let's consider the same transactions from a cash basis and then we're gonna adjust it into an accrual basis of accounting. Okay. So we start in the cash basis and move to accrual basis. Let's check that out uh in the upcoming video.
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Adjusting Journal Entries:Prepaid Expenses (Cash Basis to Accrual Method)
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Alright, so here in the red boxes on the right, I want to do the cash basis to accrual basis. Okay? So I just want to write that up here that we're doing cash basis to a cruel Okay, so what would these entries look like from a cash basis? Alright, so the first entry On September one the company pays $12,000 for a full year of rent in advance. Okay? So if the company is paying cash, remember in a cash basis when the cash goes out, you take the expense regardless of when we use it up. So the cash basis right here would have taken a rent expense. We would have debited rent expense right now. Yeah, For $12,000 And we would credit cash, right? Because we need to lower our cash balance by $12,000. So notice what's happened in a cash basis of accounting regardless of us having used the space or not, we take the full expense for all the rent expense, right? And you can already see why that's not as correct as the accrual accounting basis, right? Um so if that is the first entry, we make the rent expense and the cash. Now we want to adjust to an accrual basis of accounting. Right now it's the end of the period. Say we keep our books in cash and then we adjust it to accrual basis. It happens sometimes. So what would we do? We have this entry where rent expenses sitting at $12,000, right? But based on the same logic Where we found our monthly expense of $1,000 to 12,000 total divided by the 12 months gave us 1000 a month and it's been four months, right September October November December. Well, our rent expense should be 4000, right? From an accrual basis of accounting, we should have 4000 in rent expense, but right now our rent expenses sitting at 12,000. Right? So how do we bring that rent expense down from 12,000 down to 4000. So if you think about it, I'm gonna do it right down here are rent expense t account? Right? Remember we've got our T accounts and our rent expense is sitting at $12,000 right here. Right, well, we want it to end at 4000. So how do we bring that debit balance of 12,000 down to 4000? We need to credit it by 8000. Right, A credit of 8000 would do 12,000 minus the credit of 8000. Bring it down to a final balance of 4000. Right? So this credit is what we need to take right now and that brings it down to the correct final balance. Okay. So that's the trick here is you want to think of what the rent expense should be, the rent expense in this case should be 4000. And what is it currently? It's currently 12,000. So we need to bring it down to 4000, we're gonna have a credit to rent expense. So I'm gonna indented already. I'm gonna do the credit entry first. I'm gonna do rent expense and for 8000 now what would be the debit in this transaction? Well there's $8000 right? There's this 8000 is rent that we still haven't received yet or rent that we still haven't used up yet. Right. So what we're gonna do is now we create the prepaid rent account for 8000. So notice in both cases what what is our prepaid rent account in the second case, what we only made the one entry for pre paid rent on the adjusting date where we created the pre paid rent for the eight months remaining. Right? So we have a pre paid rent balance of 8000 and our rent expense. Well it was 12 K. Right? We started with 12 K. And then we subtracted eight K. And it left us with 4000. Right? So notice in both cases are prepaid rent, final balance and our rent expense final balance are the same. Right? Because all we did was adjust the accounts to be the correct amount on the adjusting date. So the big trick here is to think about on the adjusting date what the rent expense should have been right regardless of how the cash was paid. And then we want to create our, we want to make sure our prepaid balance is correct and our rent expense balance is correct. Cool. Alright let's go ahead and move on to the next video.
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Step-by-Step Process for Prepaid Expenses
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So as I was noting before, I just want to have it here and writing one time when dealing with prepaid expenses, it's best to consider what the final balance in each account would be. Right, just like we consider what should the balance in rent expense be or what should the balance and prepaid rent be? Right? So you want to think about that, what the final balance would be. And we're generally gonna do something like this where we first find a monthly expense. We take the total payment. In that case it was $12,000 for the full year and we divide it By the number of months covered in that case it was 12 months. Right? So that gives us the monthly expense and then we want to find what, well, we know what the monthly expense was going to be. We need to know what the final amount total of expense would be. Right. So we need to know how many months went by. So we take the monthly expense and we multiplied by the number of months that have actually passed right. In our case, it was four months that had passed. So we multiplied the $1000 monthly expense times the four months and last. We want to think about the final balance in the prepaid expense account. And that's gonna be the total payment. All the cash. Right? The total cash payment, Which in our case was the $12,000 payment minus The final expense balance, which was the 4000. Right? So the final prepaid expense balance in our case, that was where we took the total cash we paid minus the amount we used up. All right. Excuse me. So let's go ahead and do this example here and then you guys can try a practice problem. So on September one, a company paid 24,000 for the next 12 months of rent at this time the company included the entire amount in the pre paid rent account. The adjusting entry necessary when preparing the December 31 year end financial statements would include. So let's go ahead and think about the entry that the company did make already. Okay, so the company paid 24,000 for 12 months of rent. Right. And it says that at this time when they paid the company included the entire amount in prepaid rent. So let's think about the entry that they made. They must have made an entry that included it all in pre paid rent. They created the asset. So they debited prepaid rent For 24,000. Right? The total amount and they credited. What do you think they credited? Well, they paid 24,000 they paid it in cash. Right. So we got to credit our cash for 24,000. That's the entry that they made on the purchase date. Right on september 1st. So now we're thinking what happened? It's now december 31st four months later. Right, september october november december have passed. So we've used up some of that prepaid rent. Now we gotta think about how much did we use up. So first let's think about the monthly expense. 24,000 divided by 12 months. Well that gives us $2,000 a month. Right? So $2,000 a month times the four months that have passed. Right, Jane? Excuse Me? September October November December. That tells us that $8,000 should be our rent expense. Okay, so our rent expense should be 8000 to do that. We need to debit rent expense for 8000. What about the other side of the entry? Well, we got a credit or prepaid rent right? We no longer have as much pre paid rent. We've used some of it, some of it up. So we got to lower the balance of pre paid rent with a credit. So there we go. That's what our entry would look like. This is our adjusting entry here and where is that? In the answers? Let's see. It looks like it's answer. B Debit rent, expense, Credit, prepaid rent. 8000. Cool. Alright, let's move on to the next one.
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Problem
On January 1, a company purchased a two-year insurance policy at $2,400 per year in cash. At this time, the company included the entire value of the policy in Prepaid Insurance. The coverage began immediately. The adjusting entry necessary when preparing the June 30 financial statements would include:
On January 1, a company signed a two-year rental agreement policy at $4,800 per year in cash. At this time, the company included the payment of the lease in Rent Expense. The lease began immediately. The adjusting entry necessary when preparing the June 30 financial statements would include:
The prepaid insurance balance on December 31, 2017 was correctly shown as $900. On April 1, 2018 an additional premium of $600 was paid by the company. The balance sheet at December 31, 2018 showed the appropriate amount of prepaid insurance as $500. The correct amount of insurance expense for 2018 would be: