Hi, Else here.
And today we'll be talking about accrued expense
adjusting entries and their impact
on the accounting equation.
What are accrued expenses?
Well, accrue means to increase, gather together, or pile up.
Expense means a cost you've had to get something or go
somewhere.
So when accrued expense means to gather together
the costs in the business, which we have not as yet recorded
or pay period end.
So at period end, what are we going to do about these costs
that we've incurred, but not recorded or paid?
Costs incurred means we consumed or used something,
so we have to expense it.
Not pay paid means we owe somebody,
so that's a liability.
At every period end, we'll recognize
the expense that is incurred, but not recorded,
and the liability that is owed because we consumed something
without paying for it yet.
Let's do an example to solidify our understanding
and actually see the entries that
impact the accounting equation.
ABC Company earned income before taxes of $55,000 this year.
The company has charged a tax rate of 20% of their income.
ABC Company records their adjusting entries at year end
and their year end is December 31.
No taxes have been recorded or paid this year.
On February 28 of the following year,
the company pays their outstanding income taxes.
What entry, if any, do we have to make December 31?
What did we incur on December 31?
We incurred a cost, because taxes
are a cost of earning income.
Incurring a cost means we have to record an expense.
So how much of a cost did we incur?
Well, 55,000 times 20% is $11,000.
So we have to record an expense of $11,000 at December 31.
Why?
Because we've incurred a cost.
This cost is unpaid.
So do we owe someone?
Yes, we owe Revenue Canada for the taxes we've incurred
on our income , but not paid.
That means our liabilities increased by $11,000
under the account called income taxes payable.
Note, is this an adjusting entry?
Yes, it is.
How do we know that?
Well, this is an internal transaction.
Revenue Canada didn't send us a bill
and they didn't come knocking at our door.
We have to record a liability, because we know we owe it.
And to make sure our liabilities are properly
stated at the period end or the year end,
we have to record what we owe, but have not as yet paid.
It's an adjusting entry, because it's
made by the company to recognize that something
has been consumed, used, or incurred, but not yet paid.
Now, let's fast forward to February 28
of the following year.
We're standing in February 28, that date.
What are we going to do?
Well, we're going to pay our taxes.
How much?
We know that we have to pay $11,000 in cash,
so cash goes down by that amount, because we've paid it.
Now, what's the other side of the entry?
A lot of students say that because we paid cash,
the other side of the entry should be an expense,
but that would be totally wrong.
Why?
Because we did not incur more expenses than we
have already recognized of December 31.
Remember, last year at December 31,
we recognized income tax expense of $11,000 already.
We did not incur in other costs, so we can't record that expense
again.
So what's the other side of the entry?
Remember that of December 31, we recorded an income tax
payable--
a liability of $11,000.
That liability is still sitting in the account.
We've paid our obligation at February 28.
So do we still have a liability?
No, we do not.
And so we have to recognize that we paid our obligations
and we have to get rid of the liability,
because it's being settled and we no longer owe anything.
The other side of the entry is therefore
a reduction in the liability account
called income taxes payable to recognize
that we've paid it off.
What type of entry is this?
It's a transactional entry, because it's
an exchange between two parties, plus it involves cash.
And we know that whenever cash changes hands,
it's a transactional entry.
It's also an external transaction,
because it's an exchange between two parties involving cash.
External transactions are always transactional entries.
Now, let's look at both entries together.
Remember that the first entry is an adjusting
entry made at the end of the period or year.
It's an internal transaction recording the fact
that the company incurred a cost that they have not as yet paid.
So they have to record an expense,
because we incurred a cost and a liability,
because we owe cash in the future.
In the following year, when we actually pay cash,
we have to do a transactional entry.
Remember that this is an external transaction,
because we paid cash to an outside party and our liability
decreases, because we don't owe anyone anything anymore.
What's interesting about accrued expense adjusting entries
compared to prepaid expense adjusting entries?
Well, prepaid expense adjusting start
with a transactional entry sometime during the year
and then they do an adjusting entry at the end of the year
to recognize something has been used or consumed.
Now, accrued expense adjusting entries
do an adjusting entry at the end of the year
to recognize something that has been
incurred, but not as yet paid.
Then, we recorded transactional entry after the year end
to recognize paying off our obligations.
Let's see that different side by side.
Prepaid expenses starting as assets
going in and out using a transactional entry
and they end with an adjusting entry recognizing an expense.
Accrued expenses recognize an expense and a liability
using an adjusting entry and then have a transactional entry
in the following year to get rid of the obligation
and flow out the cash.
Both of these have transactional entries and adjusting entries.
Both adjusting entries happen at year end,
but the prepaid has a transactional entry first,
whereas the accrued expense has a transactional entry last
in the year following the adjusting entry.
Keep this in mind when you're working
on adjusting entries and trying to decide
what entries to make first.
So that's it right now for accrued expense adjusting
entry.
In our next video, we'll be focusing on accrued revenue
adjusting entries.