This is principlesofaccounting.com, Chapter 3.
This is the second video on adjusting entries and the adjusting process.
In the first video, we looked at a general introduction to the adjustment process.
In this video, we'll be looking at more specific examples that take us deeper into
the adjustment process.
In this first illustration of adjusting entries,
we're going to look at the supplies account.
Supplies is essentially a prepaid expense item.
We're buying supplies to be used in the future.
So in this particular example,
a company purchased 900 of supplies during the period.
And at the end of the period, $200 of supplies remained.
Meaning that $700 of supplies was used.
There was no beginning inventory in this case.
So let's look at the journal entries.
On December 8th, supplies were purchased for $900.
The entry to record the purchase of that asset, debit, supplies,
and credit cash for $900.
The adjusting entry, on December 31, entails a credit to supplies for $700
to reflect or reduce the asset account for the amount that's been used up.
And that is transferred to Supplies Expense.
That's the first year of operations for this business.
If we go to the next year, though,
assume that an additional $1,000 of supplies was purchased.
$300 of supplies remain on hand at the end of year.
Now I'm telling you that 900 is used up, but
it'll take a moment to see how that occurs.
But first, let's look at the journal entry.
Here we buy supplies throughout the year, debiting supplies, 1,000, and
crediting cash, $1,000.
At the end of the period, we record the expense, the portion used up,
by debiting supplies expense 900, and reducing the supplies account, 900.
Notice supplies went up during the period, 1,000, and down during the period, 900,
a net increase of 100.
Bear in mind, in the prior year,
there was $200 of supplies on hand at the end of the year.
So we had $200 of supplies when we started the year.
And we ended the year with $300 of supplies.
A net increase of $100 during the year.
Let's see how this works.
Our beginning balance of supplies is $200, 2 boxes full.
Then during the year, we buy 10 more boxes, or a $1,000 worth.
And that's reflected as purchases.
And so the beginning balance, $200, plus purchases, $1,000,
gives us the supplies available of $1,200.
The goods available for utilization, $1,200.
We go out at the end of the year and take inventory, assess what we have.
And we find there's $300 of supplies still on hand in a supply closet somewhere.
That's what's left over.
And so you can see that tells us that of the 1,200 available,
900 have been used up.
Hence, we know how much to record as a supplies expense,
how much to take out of the supplies account.
Let's next turn our attention to depreciation.
Depreciation is a process used to allocate the cost of a long-lived asset
to the accounting periods benefited.
It is not a process of valuation, it is a process of cost allocation.
And we're going to use, for now, the straight-line method.
In a later chapter, we'll introduce a number of other depreciation
methods that you might consider.
Under the straight-line method, as the name suggests,
an equal amount of asset cost is assigned to each year of service life.
So for example, assume we purchase a truck for $150,000, and
that truck has a 3-year life.
And we'll assume there is no salvage value,
that it will be completely worthless at the end of the 3-year period.
And so under the straight-line method, you would deduce that we would wanna record
$50,000 of expense each year for the 3-year period.
And so our journal entry each year, our adjusting journal entry, would reflect
a debit to depreciation expense and a credit to accumulated depreciation.
I'm not crediting the asset here, and I'll show you why here.
Accumulated depreciation is a contra asset account.
Now I'm introducing a new concept.
Contra accounts, in general, deduct from or subtract from another account.
And so they have the opposite balance, as well.
Where equipment would have a debit balance,
accumulated depreciation on the equipment would have a credit balance.
It's an account that's subtracted from another account.
And if we look at a balance sheet, we'll see how this operates.
On the income statement, the depreciation expense of 50,000 appears,
as we saw from the journal entry debiting depreciation expense a moment ago.
But on the balance sheet,
we'll show accumulated depreciation as a deduct from the truck's cost of $150,000.
We use the accumulated depreciation account rather
than simply reducing the truck directly.
So that when one looks at the balance sheet,
they'll know the full cost of our equipment.
And how much of that cost has been allocated.
To some degree,
how much of that asset has been consumed in the operation of the business.
The asset account continues to be carried at its original cost.
It's reduced by the ever-growing accumulated depreciation account.
If you want a more complete example of this,
I would encourage you to look at the textbook.
Where this very example is carried forward for several years.
So you can see how each year's income statement
includes the depreciation expense of 50,000.
And each year's balance sheet is changed to reflect the growing amount of
accumulated depreciation.
Take note that the asset cost minus accumulated depreciation
is frequently called the book value or net book value of the asset.
Turning our attention to yet
another item that requires adjustment, unearned revenue.
Unearned revenue is revenue that has been collected in advance for
providing goods and services in the future.
Until we provide those goods or services, we have an obligation or
a duty to either return the money or provide the service or goods.
And so we reflect that obligation as a liability.
Let's look at a journal entry for recording an unearned revenue transaction.
Here we sold a 1-year software license for $1,200 on April 1 of year 1.
Notice we're crediting unearned revenue of $1,200.
That's the liability account.
Although it has the name revenue within the account, it's not revenue for
the income statement.
It's unearned revenue,
and there's a liability to be carried on the balance sheet until it's earned.
So let's assume that 9 months pass.
Our adjusting entry at December 31 will reflect the reduction of the unearned
revenue account and crediting revenue for the $900.
So we're reducing the liability, and
moving that amount into the revenue account as it is earned.
Accruals are another typical item that requires adjustments.
We have accrued revenues and accrued expenses that relate
to items that gradually accumulate through a particular period.
Accrued expenses relate to things such as salaries, interest, rents, utilities.
Think about the utilities, perhaps, on where you're living.
You use the electricity on a daily basis.
You use the heating services on a daily basis, perhaps.
Anyway, the utility cost is being consumed.
And it needs to be recorded as expense at the end of the time period,
even though we may not have received the utility bill, yet.
Accrued revenues, if we're doing work for a client, for an attorney,
or a lawn service, or an accounting firm.
As they do work for a client, they're earning the right to receive payment.
Even though we may not yet have billed the client.
And so let's look at an example of how this would be recorded.
We're going to accrued rent cost, here.
So we've leased office space, and
the terms of the lease agreements stipulate that rent will be paid within 10
days after the end of each month at $400 per month.
So our adjusting entry would entail, on December 31, the accrual of
the rent cost for December, debit rent expense and credit rent payable.
We know we're gonna get the bill and have to pay the amount shortly.
But we've already received, in this case, the benefit of the service.
We didn't prepay it.
We're paying it in arrears, in this particular case.
When the rent is actually paid then,
notice in the second journal entry, we'll debit rent payable.
And credit cash to reflect the payment of that cost.
Accrued revenue operates in a similar fashion.
Money has been earned during a month,
even though it won't be billed until the following month.
We need to record the revenue since it's been earned.
We have the unequivocal right to receive payment.
So at December 31, we accrue that revenue.
We debit accounts receivable, the assets being increased.
And we credit revenue to reflect that the earnings process is complete.
Eventually when we collect those amounts, we would debit cash and
credit accounts receivable.
Earlier we talked about a trial balance.
And we indicated that it may not be a sufficient basis for
preparation of financial statements.
If adjustments were necessary, we would prepare those adjustments.
And then we would be in a position to prepare financial statements.
Probably preceded by the preparation of an adjusted trial balance to check and
make sure that we maintained the equality of debits and credits.
The adjusted trial balance provides an excellent tool from which
financial statements can actually be prepared that are deemed to be correct,
and up to date, and complete.