In this video I'm going to give you an introduction to
adjusting entries in accounting. Specifically prepayments and accruals.
I'm going to explain what they are and why we need them.
[Music]
Hey there
welcome back to the channel! I'm James, this is Accounting Stuff
and in today's video we're going to walkthrough adjusting entries in accounting.
I've had a bunch of requests from you guys in the comments to cover this topic.
So thanks for all of these. It's great to know what content you're after.
If you haven't heard of adjusting entries before
it's the name that we give to the journal entries
that we post at the end of each accounting period.
In order to bring our books into alignment with the accrual basis of accounting.
Sound complicated? Well it is kind of.
So I've decided to create a mini series devoted to unraveling the mystery
of adjusting journal entries and this is video number 1.
We'll start off by taking a look at the big picture of accounting
and then we'll drill in to uncover the problems posed by the accrual basis
and how adjusting journal entries can help us work around them.
I’ll explain what the four types of adjusting entry are
and how to identify them. Prepaid expenses,
deferred revenue, accrued expenses
and accrued revenue. My plan is to follow this video up
with four more where we’ll discuss how to record adjusting entries
and go through worked examples for each type.
So subscribe and hit the bell to be notified when those come out.
I'll take all of these videos and pop them into
one playlist that you can find up here. Once it's done.
Got it? Good.
Let me know in the comments which kind of adjusting entry you're
having the most problems with. And don't forget to watch this one
through to the end find out how all of this works.
Let's get cracking!
I said that adjusting entries are the
journal entries that we post at the end of each accounting period
to bring our books into alignment with the accrual basis of accounting.
But what does that mean? Why would we do that?
I think we need to take a step back and look at the big picture
of financial accounting. Financial accounting is the process
of recording, summarising and analysing an entity's financial transactions
and reporting them in financial statements to it’s existing and potential
investors, lenders and creditors. So ultimately as financial accountants
our job is to produce financial statements to assist our key stakeholders with their
decision-making. But what are financial statements?
You can think of them as formal reports that summarise a business's financial
performance, position and cash flow. Collectively, they give all of the
interested parties an idea of the business's financial health.
When preparing financial statements there are some rules that we need to follow.
The specifics differ slightly from country to country.
But broadly speaking we follow the Generally Accepted Accounting Principles
GAAP for short or the International Financial Reporting Standards
IFRS. Now both GAAP and IFRS have
something in common. They both require us to produce our
financial statements in accordance with the accrual basis of accounting.
Now the accrual basis of accounting is key to
understanding adjusting entries. So what is it?
In accrual accounting, revenue is recognised as it's earned
and expenses are recorded as they are incurred. Regardless of when cash, or an invoice
changes hands. I made a whole video explaining what this
means and its pros and cons versus the easier
cash method of accounting. That you can find linked up here
and down below in the comments. But the key takeaway here is that
payments and invoices shouldn't dictate when we recognise our revenues or expenses.
Instead we need to think about the substance behind each transaction.
That's the real trigger. But the problem is that this
doesn't just happen naturally. And that's when adjusting entries come in.
Let me explain… A normal business transaction
involves two parties a buyer and a seller.
The seller provides goods or services to the buyer and sends them an invoice
and in return the buyer repays them in cash. So there are three parts to this transaction.
We have the transfer of goods or services, the invoice and the payment.
Keep that in mind for a moment. Alongside all of this the
financial statements we produce are designed to
cover a range of time which we call an
accounting period. Depending on the business's reporting
requirements this could be anything from a month to a quarter or even a full year.
If all three parts of this transaction happen in one accounting period.
Then were all good, no adjusting entries are necessary.
But when they fall into different accounting periods.
Then we've got a problem. This is where adjusting entries come in.
There are two main types: Prepayments and accruals.
Prepayments occur when goods or services have been paid for in advance.
Whereas accruals happen when goods or services are to be invoiced in the
future. In a prepayment
goods or services have been paid for in advance. I'll show you how this works.
I think it's best if we think of this in terms of two accounting periods.
The past and the future. With us being bang in the middle
balancing on a tight rope in the present.
In a prepayment goods or services have been paid for in advance.
So that means that the payment happened back in the past
for goods or services that are going to be delivered or consumed in the future.
The problem here is that normally the invoice and payment part of the transaction
naturally triggers an accounting entry that recognises the whole transaction in the
past. So if we were the buyer
then we would have recognised an expense in the past
and if we were the seller then we would have recognised the revenue
in the past. But we are accrual accounting.
So revenue should be recorded as it's earned and expenses should be recorded
as they are incurred. The goods or services are going
to be provided in the future so the revenues or expenses should also be
recognised in the future not the past.
So right now before the period closes
we've still got a bit more time to make changes in the past.
We need to post an adjusting entry to reverse out those revenues or expenses
from the income statement and hold them in the balance sheet
where they don't impact our past financial performance.
Then in the future accounting period we'll post another adjusting entry
to release these from the balance sheet to the income statement.
So we've correctly recorded our revenue as it was earned
or our expenses as they were incurred. That's how prepayments work in general.
But really there are two types depending on where we fit in to the transaction.
We have prepaid expenses and prepaid revenue which is more commonly known as
unearned or deferred revenue. If we're the buyer in the transaction
then we're dealing with prepaid expenses because we're the ones
receiving or consuming the goods or services.
However if we're the seller then we're on the other side of the transaction
and we're dealing with prepaid revenue because we're the ones
providing the goods or services. Accruals occur when goods or services
are to be invoiced in the future. These are almost the opposite of prepayments.
Goods or services are delivered in a past accounting period.
Whereas the invoice and eventual payment come later in the future.
Again we have a problem. The accrual basis of accounting is telling
us that revenues or expenses should be recognised when they're
earned or incurred. In this case the substance of the transaction
happened in the past because that's when the goods or services
were delivered or consumed. However the natural accounting trigger
in this situation happens in the future when the invoice is raised by the seller
and received by the buyer. So as things currently stand
the transaction is going to be recognised in the future income statement.
To correct this we need to post an adjusting entry into
the past accounting period to accrue the revenues or expenses
into the income statement and the other side of that journal
will be to temporarily hold the accrual as an asset or liability in the balance sheet.
In the future once the invoice has been raised by the seller and given to the buyer.
We'll need to reverse this accrual so that we aren't recognising this
transaction twice. That will release the original adjusting entry
from both the income statement and the balance sheet.
Again there are two categories of accrual. Accrued expenses and accrued revenue.
If we're the buyer in the transaction then we're dealing with accrued expenses
because we're the ones receiving or consuming the goods or services.
However if we're the seller then we're on the other side
and we're dealing with accrued revenue instead because we're the ones making the money
by providing those goods or services. So adjusting entries are required to bring
our books in line with the accrual basis of accounting
which is required under both GAAP and IFRS when producing financial statements.
Adjusting entries are divided into two categories…
Prepayments occur when goods or services have been paid for in advance.
Whereas accruals occur when goods or services are to be invoiced
in the future. If you're on the buying side of
the transaction then you prepay or accrue expenses
depending on the timing of the payment or invoice
however if you're on the selling side then you defer revenue
when you've been paid in advance and accrue revenue when you've
already provided goods or services and plan to invoice the customer
in the future. Any questions let me know down
below in the comments or message me directly on instagram
@accountingstuff if you're still confused by
adjusting entries I totally get it and that's why I'm going to release
four new videos covering examples of each type in detail.
Hit this circle to subscribe so you don't miss out on those
and whole playlist will go over here once I’ve finished.
Something else interesting will go there in the meantime I promise you.
cya