>> Hello, I'm Professor Brian Bushee.
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 adjust 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 T 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.
By internal transactions,
we mean that we're not doing anymore transactions with outsiders.
This is just the accountant sitting at his or her desk,
doing journal entries to get account up to date to do financial statements.
I guess a 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 o'clock 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 for 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 accrued 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.
>> 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 Years Eve night and
watches his colleagues from sales and marketing and operations and
human resources happily leave the company to go and
celebrate New Years 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
lets think of something like prepaid rent.
We have paid cash in advance of occupying the space.
So, we create and asset called prepaid rent.
But then as time goes by and we have 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 Years 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?
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 has delivered some goods,
we probably would have recognized revenue when we delivered the goods,
b ut 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 accrued expenses.
So as our poor accountant decides to turn on the TV to watch something like
New Year's rocking eve, so he can hears some of the music in the background
that he's missing at all the parties.
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 salary and wages expense to recognize the cost of
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 accrued 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.
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.
>> Again, these examples are about providing a service over time as opposed
to delivering specific goods.
And so the only matter's 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 or minute.
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 a 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.
So 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.
There's 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 have 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 are taking depreciation on a truck,
you wouldn't deduct it from the truck account.
Instead, the depreciation is going to be recorded in a contra asset account
called the accumulated depreciation.
A contra asset is denoted by XA in parenthesis and 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 and
equipment on the balance to get something called Net Book 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 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 contra 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 T-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 the 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 shareholder's equity side of the balance sheet in retained
earnings, but they have a debit balance.
That means that 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 will become more intuitive to you.
>> 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 is going to be worth when you're
done using it.
So in the numerator, we're taking how much of the asset cost you're going to use up
and then the useful life is the number of periods you expect to use the asset.
>> 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
in later in its life which has much lower depreciation.
>> No, for financial reporting purposes,
there is no central government agency that dictates useful items 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 of 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 five years and
then sell it to someone else.
So when they choose their depreciation assumptions,
they're useful life is five 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, because you probably know who it is.
Their strategy if they bought a brand new plane would be to choose a useful life of
twenty years and they would have a low salvage value as a result.
So you get 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 tends
to use the planes not anything that has to do with the physical life of the plane.