Mark Farber: Hi, I'm Mark Farber and this is Accounting Fundamentals.
In our last video, we started to talk about adjusting entries and we talked about prepaid
expenses.
Remember that a prepaid expense is nothing more than an expense that a company has paid
for in advance and then records the expense on a regular basis over the period of a number
of months or years or whatever.
Initially, the prepaid expense is an asset because the company is owed a certain service
or something.
As they accrue that over time, that asset becomes an expense on the income statement.
What happens in reverse?
What happens if a company sells something and gets paid in advance for it?
In our last example we used an insurance contract, and we said that a company purchased a one
year insurance contract and paid for it in advance on January 1st.
I thought we'd look at the opposite here.
Here we have the insurance company, XYZ Insurance Company, and they sell a one year insurance
policy on January 1st for $2,400 dollars cash.
Now remember, they're going to receive $2,400 of cash on January 1st, but we can't record
that as revenue because in order to have revenue, two things have to occur.
In the case of an insurance policy, you have to substantially complete the delivery of
the policy or provide the service and payment has to be reasonably assured.
Well, payment is reasonably assured, they've already been paid on January 1st, but they
haven't delivered anything on that date yet.
So they don't have revenue.
We're not going to do the cash accounting anymore because we don't care about that.
Let's jump right into the accrual accounting.
First of all, let's just remind ourselves since it's a 12 month policy and it's a $2,400
dollar policy divided by 12 months, the policy is worth $200 dollars per month.
If we do the journal entries for this transaction, on January 1st this company is going to debit
cash because they received the check, $2,400, and they're going to credit a liability account
called "unearned revenue".
It's kind of a strange name, but what it basically tells us is that there's revenue that's coming,
$2,400 dollars' worth of it, but it hasn't been earned yet according to the accounting
rules.
Again, they haven't provided the service yet.
On January 1st that's what they have.
They have cash has increased by this $2,400 dollars and this liability account, called
unearned revenue, has increased by $2,400.
Well, on January 31st ... I'm just going to keep moving this over to give myself some
more space ... On January 31st, they've now delivered one month of this 12 month contract.
They've completed one month, and therefore, they've earned one month of revenue.
One month again is equal to $200 dollars.
On January 31st what this company will do is it will debit this unearned revenue account.
Again, remember that, because unearned revenue is a liability, a credit increases the account
and a debit will decrease the account.
We're going to decrease the amount of insurance that is owed to people or revenue that has
not yet been earned, so we'll debit unearned revenue by $200 dollars, the amount that one
month is worth.
And we will credit revenue for $200 dollars.
At the end of January, the company has now earned $200 dollars of the $2,400 dollars
that it received on January 1st.
Same thing will happen then end of February, Feb. 28, they'll enter a new transaction.
Debit unearned revenue $200 dollars and credit revenue $200 dollars.
Again, at the end of each month, when the company's doing its adjusting entries, it
will put in an entry for recognizing $200 dollars' worth of revenue that it's now earned,
until the very end of the year, December 31st, they'll do this for the last time.
At that point, this insurance company will have earned the entire $2,400 dollars and
it will begin anew next year when they get a check for the next policy from this particular
customer.
That's unearned revenue.
Kind of the opposite of prepaids, or if you want the flip side to prepaids, kind of a
mirror image of it.
We'll go on in the next coming videos and we'll look at some more of the adjusting entries
that a company has to make at the end of each accounting cycle, in order to get ready for
preparing the financial statements.