and now we're finally going to get a clear answer to the question what are adjustments they are
actions we take to correct our financial records specifically for the passage of time adjustments
our journal entries that we make periodically to correct our financial records for the passage of
time it also helps us prepare for financial reporting by acknowledging the cutoff dates
of certain amounts we also make adjustments to correct for mistakes and we usually make
them monthly or immediately before reporting our financial statements to someone because we
want to adjust our general ledger to make sure our financial statements are accurate the idea behind
this is that assets and expenses are really the same thing think about the definition of expense
it's when you pay for something after you use the value of whatever service that you're paying
for things like salary expense repair expense utilities expense delivery expense usually you
pay for them before you use them and of course we always think of them as expenses but assets
are something you pay for before you use the value for example a car usually you buy the car before
you can drive it and use the value of the car so we always think of car as an asset what about
furniture usually you buy the furniture you don't sit on it for five years and then when it breaks
you pay the person you took it from usually you pay for it first which means assets are paid for
before you use up the value of whatever you need them for but what about things like rent insurance
and supplies we usually think of these things as expenses and they are but these things we
usually pay for them before we use them so even though we think of them as expenses technically
at the moment we pay for them they are assets and they become expenses as we use them so therefore
if at the moment you pay for something it still has value you can use into the future you just
paid for an asset but if at the moment you pay for something you have already used the value or
you could say you have already expended the value then at that moment you have an expense and if it
was an asset don't worry wait a little while and you will finish using the value and the amount you
use let's say the amount you expend will become the amount you record as the expense for example
supplies you always pay for them before you finish using them then over time you use some
supplies and the amount of supplies you have used the amount of supplies you have expended then gets
recorded as supplies expense now this idea is also the same for paying office rent you usually pay
office rent in advance of staying in the office so technically at the moment you pay the rent
you have an asset you have something of value that you can use into the future you have the ability
to stay in the office but over time as you stay in the office the amount of time that you've used or
expended becomes your real rent expense and that's the amount you record on your income statement for
that month as rent expense insurance is the same thing you always pay insurance in advance of the
time in which they protect you then over time you're using the coverage and your coverage is
elapsing after you've used a certain amount of time during the policy the amount of time of
the policy that has elapsed is your insurance expense and the remaining amount still stays
on your books as an asset so let's see how this would work let's imagine on January 1 Holden the
owner of the company paid staples seven hundred dollars for supplies well on January 1 we did not
finish using the supplies so we cannot record this into supplies expense On January 1 we have a new
asset and just like we did in previous videos we make a debit to the asset for the amount that we
paid of course cash is credit if we paid cash but we're not really focusing on cash right now we're
just focusing on the asset that we bought that we will use into the future now the most important
date is January 31 let's imagine it's one month later and we physically count the supplies and
we see we only have three hundred dollars worth of supplies left well the first question is how much
of supplies did we use obviously we used 400 you could also say we expended 400 dollars worth of
supplies during January and that means supplies expense should be debited 400 dollars for the
amount that we actually used during January and that 400 dollars will go on the income statement
profit and loss as supplies expense for the month of January now of course if we made a debit to
supplies for 400 we have to make a credit of 400 we credit the asset if the value is going down and
of course it is correct to credit supplies for the 400 so that the ending balance of supplies
at the end of the month truly reflects what we physically have we physically have 300 dollars
worth of supplies and as you can see that's the new ending balance the supplies expense account
is an expense so that will get closed at the end of the month so that you can measure more
starting from zero how much supplies you used in the next month so you will see in the following
videos expenses become zero after each period so that you can start counting fresh what you used in
the next month but this 300 remaining in supplies goes up top as the beginning balance on February 1
for the asset account supplies now that idea will help you understand a special type of asset called
prepaid expenses these are time-based expenses things that we use just because of the passage
of time time-based expenses are things like rent when we pay office rent or insurance something we
pay that we will use in the future but we would normally consider it an expense for example let's
imagine on January 1 Holden the owner paid farmers insurance $1,200 for the whole year's office
insurance now we know that the office insurance is only really $100 per month we're really only
using the value of what we paid at the rate of a hundred dollars per month now you can put the
whole twelve hundred into the insurance expense account if you only report once a year so if you
don't need to show anyone your financial records until December 31 it really wouldn't matter if you
put this into insurance expense at the beginning however if you need to report monthly financial
statements you must put the twelve hundred into an asset called prepaid insurance and then adjust
at each month just the way you saw in the previous example with supplies prepaid insurance is another
current asset type of account so what's the difference why can't I just put insurance and
insurance expense when I pay or rent into rent expense when I pay well let's think about it if
you recorded this the wrong way and it all goes into insurance expense when you write the check
that means January's income statement is going to list insurance expense as one thousand two hundred
dollars because that's what you paid in insurance for January in February you didn't pay anything
for insurance so on February's income statement insurance expense will be listed as zero Marches
income statement insurance expense will be listed as zero and so on do you think you can fairly and
reasonably compare your operations between January and February by comparing January's
income statement to February's income statement of course not you cannot compare them in a fair way
because you recorded all of the year's insurance as an expense for January and none for February so
January and February profit and loss statement cannot be compared in an accurate and fair way
but if you do it the right way and adjust it the way I'm about to show you then January's insurance
expense will be only what you used during January and February insurance expense will be only what
you used during February and so on this way you can properly compare January's income statement
to February's income statement and make a fair and clear judgment about the difference in how
well you did each month because now it shows the real amount of insurance expense that
your company is using each month so how do you actually do this so it comes out correct well
when you pay the insurance put the money into the account called prepaid insurance which is
another current asset like supplies then make a journal entry to adjust at the end of each month
decrease the prepaid insurance for what you did use and put it into insurance expense to reflect
that it was used during that month so it's going to look very similar to what we did a moment ago
with supplies let's imagine on January 1 hold and paid farmers insurance 1200 for the whole year's
office insurance well we did not use the value or we did not finish using the value on January 1 so
we do not have an expense on January 1 on January 1 we have an asset debit the asset and of course
credit cash but we're not examining cash so just believe me cash will be credit now the interesting
part happens at the end of the month what should the numbers be well you know that this 1200 is not
accurate as of January 31 it was accurate back on January 1 before the insurance company protected
and covered us during January but on January 31 they are finished protecting us they are finished
covering us for January so we have actually used $100 worth of insurance during the month how do we
record this in our records to reflect this well insurance expenses debit for the amount that we
actually used during January and of course we have to credit $100 the asset to bring the value down
to what it really is as of January 31 there are only 11 months left on the policy so on January 31
the balance of this asset is $1,100 now of course the hundred dollars an insurance expense will go
on January's income statement to show that during January we used $100 of insurance and then of
course that gets closed and becomes zero so we can start measuring March's insurance expense fresh at
the beginning of the next month and of course the $1,100 goes as the balance on the balance sheet
as of January 31 to show what we had in prepaid insurance going forward at the end of January