Mark Farber: Hi, I'm Mark Farber and this is Accounting Fundamentals, in our last video
we talked about the difference between cash accounting and accrual accounting.
Prior to that we've looked at a whole bunch of different transactions that a company does,
generally on a day to day basis, so selling revenue gets recorded at the moment that it's
sold.
Purchasing things gets recorded as you purchase them but there's a bunch of entries that have
to be done at the end of each accounting period, whether the period is a month, quarter or
a year, that are called adjusting entries.
Those are related to accruals.
In other words, what we're trying to do is balance off the payment of cash, against when
things actually occurred.
When we actually earned revenue or whether we actually incurred expenses.
We're going to in the next bunch of videos go through a bunch of different types of adjusting
entries, the first one we're going to look at it is something called prepaid expenses.
A prepaid expense is nothing more than an expense that a company incurs where they pay
for it in advance, we have an example over here.
ABC company purchased a one year insurance policy on January 1st and they paid $2400
cash for that policy.
So on January 1st if we were to record this using cash accounting, and remember cash accounting
we incur expenses and earn revenue only when cash changes hands and to the extent cash
changes hands.
If we were to use cash accounting to record this then on January 1st we would debit insurance
expense, I'll just abbreviate it as “insur.
exp.”
for $2400, the cost of the policy.
We would credit cash.
For $2400.
Then on the income statement in January, there would be $2400 of insurance expense listed
and for the remaining months of the year, February, March, April.
There'd be no insurance expense.
You'd have a huge spike in the first month of the year of expense, and then no insurance
expense there after.
In fact, that's not really what happens.
What happens is the company paid $2400 on January 1st but they are going to be getting
the benefit of this insurance policy over the next 12 months.
So we can very quickly do the math, if the cost was $2400 divided by 12 months, because
the policy is for one year.
Means that, in effect, the company is paying $200 per month for insurance.
There should be $200 of expense in every single month, to do that what we do under accrual
accounting, we'll just put those ... A few of them over here.
Is on January 1st, we have to record that we purchased the policy and that we paid cash,
because obviously $2400 of cash was paid to the insurance company.
Rather than debiting an expense, what we do is we debit prepaid insurance, let's just
do this, and it's going to be for $2400.
Sorry I'm running out of room here, and we credit cash.
$2400.
So essentially what we've done is we've created this new account called prepaid insurance
and it has $2400 in it.
Then, and that was on January 1st, I'll just move it over here a bit.
On January 31st at the end of the first month, the company has gotten the benefit of one
month of insurance, or $200 worth of insurance.
On January 31st, they make an adjusting entry.
At the end of the month they will debit insurance expense for $200, the amount that's incurred
each month, and they will credit, rather than crediting cash because they've already paid
the cash, they're going to credit this prepaid insurance account.
Prepaid insurance, is credited $200.
Again, debits equal credits always.
Now if you think about it, we had, think of a big bucket.
We filled it up, this is our prepaid insurance, we filled it up with $2400 of prepaid insurance.
There's a little spigot over here, we've now let out $200.
So we've let out $200, we now have $2200 left of prepaid insurance.
The $200 that we've let out has been expensed, so on the income statement in January, rather
than having $2400 of expense, for the month, we only have the $200 expensed, the actual
cost of the insurance for the month of January.
In February, we'll do the exact same thing.
I can change this date to February 28th, it will be the exact same entry, another $200
of expense.
At the end of March, March 31st, we'll do the exact same entry.
Another $200 of expense.
Each month, we'll keep letting out $200, $200, $200.
Until by the end of the year, we've incurred the entire $2400 of expense, all the prepaid
expense which is an asset that sits on the balance sheet, will have become an expense
on the income statement.
We'll spread it out over the year as opposed to recording it all in one shot.
That's what prepaid expenses are all about.
In our next video we'll take a look at the reverse to this, or essentially the reverse
to this which is unearned revenue.