This is principlesofaccounting.com, Chapter 3.
In this particular module, we will begin to at adjusting entries and
the adjusting process.
This is the first of two modules on this subject.
Let's look closer at the reason for adjustments.
Multi-period items is one example.
Some revenue and expense items may relate to more than one accounting period.
Prior to preparing financial statements,
it's necessary to apportion those items to the appropriate accounting periods.
Other items are said to be accrued items.
Revenues or expenses may have been earned or incurred in a given period but
not yet entered in the accounting periods, what's commonly called accruals.
Let's give further consideration to the adjusting process.
Recognize that there's no way to catalog every potential adjustment
that a business may need to make.
Therefore, before one can prepare adjusting entries for
a particular business, it's very necessary to understand business operations.
Typical adjustments can relate to a variety of items.
Here I have a couple of tables that talk about multi-period items such as prepaid
insurance or prepaid rent, or accounting for adjusting for supplies,
depreciation or the recording of unearned revenue.
The accrued type items relate to things such as accrued salaries,
accrued interest, accrued rent or accrued revenues.
Now the textbook illustrates each of these in turn.
We're going to look in this video at just a few examples.
First, looking at prepaid expenses, prepaid expenses represent amounts
that have future economic benefit but as time passes the asset is diminished.
Therefore adjustments are needed to reduce the asset and
transfer the asset's consumption to an expense account.
Let's look at a very simple illustration of prepaid expenses.
Imagine you have a home and in front of that home you have a lawn.
And you contract at the beginning of June to have the lawn mowed the entire summer.
And you prepay for that full summer's benefit for $300,
essentially paying $100 a month for the lawn mowing service.
As each month passes, $100 of the benefit is consumed.
The lawn is mowed or maintained for that period of time.
And so that will require an adjustment at the end of each
month to reflect the consumption of the $300 prepaid asset.
So let's look at an illustration.
First of all, in June, we see that we have mowing expense of $100 for
June's income statement.
July's income statement would also include $100 of mowing expense.
And if we prepared another income statement for
August, it would include $100 of mowing expense.
If we look at the balance sheet, on June 1,
you see that we got $300 representing our prepaid service.
However, at the end of June, 100 of that has been consumed and expensed, so
our balance sheet would only reflect $200 at the end of July.
Only one month's service remains prepaid so
only $100 would be in the asset account.
And then at the end of August,
at the end the summer, all of the service has been received.
All of the cost of the service has been transferred to expense and
the balance sheet would include zero for the prepaid mowing.
Let's look at prepaid rent and start thinking about journal entries.
In this case, we have a two-month lease that's entered into on March 1,
and we're paying $3,000 for a two-month lease.
At the inception of the lease on March 1,
we would need to debit an asset, prepaid rent, for $3,000.
At March 31, if we were then to prepare financial statements,
we would want them to be up to date, and so an adjusting entry would be needed.
And notice then that the adjusting entry includes a credit to prepaid rent.
Half of the $3,000 has now been consumed, the service has been received.
And that amount has transferred to rent expense.
At the end of March, still $1,500 of the original 3,000 would
still remain in the prepaid account, and that would become April's expense.
How frequently should adjustments be recorded?
The very short answer to that is, every time financial statements are prepared,
they need to be up-to-date and correct.
So adjustments need to be recorded at least at each financial statement datey
to reflect the current amount of revenue and expense.
So think about the goal of adjustments.
The goal of adjustments is to correctly assign the appropriate amount of expense
to the time period in question, leaving the remainder in a balance sheet account
to carry over to the next time period.
This concludes the first module on adjusting entries.
There's a second module or video on adjusting entries and
we'll look at additional examples in far more detail within that video.