BA 211 Chapter 3-2 “Adjusting Entries (Deferral Transactions)”

>>Haitham: Hi, so
as mentioned earlier, the accrual basis accounting, it
has deferral and accrual bases. So, the example on
the deferral is for example the prepaid trend. We also have the supplies, as
well as the unearned revenue. Remember, the deferral means
that we got the cash in advance, or we paid the cash in
advance and the revenue, or the expense has been
deferred to the future. So, I’m going back to
some of the transactions that we recorded in
our previous videos for the first two chapters. Those three journals in
particular, the prepaid rent, and cash, and supplies
and unearned revenue. There’s one more. And what we need to,
to consider here. So, let’s say they were
recorded on January 1, 2016. Well, what would happen at
the end of January or end of February or end of any
month after January 1, what would happen to the
balance for the prepaid rent and the supplies and
unearned revenue? Is it going to remain the same? I mean, did we pay $1,200 and we considered it an
asset for prepaid rent? As knowing to continue to being
our asset for $1,200 forever? Of course not, the reason
we paid that money is to start consuming it over time. Okay? So, let’s say that the
$1,200 was prepaid for a year for the 2016 year starting
from January 1, until the end of the December 31
of the same year. So, if we just make a simple
math and consider that the cost for that, for the rent
is the same every month. Then we simply divide
$1,200 by 12, then that gives us
$100 per month. Okay? So, in other words, we
have to consume $100 every month out of the $1,200
of prepaid rent. Remember, prepaid
rent is, it’s an asset and that means its
money that we still own. Now, if I’m going to
consume $100 out of 1,200 that means I’m not going to own
$1,200 anymore for prepaid rent. I’m going to own less than that because I’m going
to consume $100. So, $100 has to be taken from
prepaid rent and we’re going to transfer it to
an expense account. That’s exactly what we’re going
to do in our adjusting entries. That’s an example
of an adjustment. So, what do we do here? At the end of January 31 we
have record an adjustment to the prepaid rent. When we consume $100, we
have to drop it down by $100 and that’s what we say, that’s
what we called an adjustment, adjusting the ending balance. That’s what it means. So, prepaid rent has
to decrease by $100. So, I’m going to credit prepaid
rent, but what about the, what about the debit side? Well, the debit side it’s
going to be an expense account. What’s the best name
for that expense account when it comes to prepaid rent? Well, rent expense. So, I’m going to
debit rent, expense. Remember, expenses always
increase with a debit. So, that expense is increasing. So, it’s increasing by how much? By $100. An expense
account, it’s not an asset, it’s an income statement
account, which we will, which I’m going to show
you in chapter 4 in how to prepare the income statement, which will have all the
revenues and expenses there. So, it’s not asset
it’s an expense account that goes to income statement. And then, your credit side
you will have the prepaid rent because it’s decreasing
and as we know, any asset decreases
with a credit. Okay? $100. So, after recording that,
what is my ending balance for the prepaid rent after
decreasing it by $100? Well, if you make a T
account, if we have a T account for prepaid rent, we
used to have $1,200, and now I’m crediting it by
$100, so that would make it, the ending balance at the end
of January 31, only $100 — $1,100 for the prepaid rent because I already
consumed the $100. And then I’m going to record
the exact same journal entry at the end of every month. End of February,
March, and so on, so that ending balance will keep
decreasing by $100 over time after every time we record
that same journal entry at the end of every month. Okay? And that’s
exactly what you do, because that amount
is decreasing. What we own from prepaid rent is
decreasing over time because we, just because time passes, that amount of money
will be consumed. So, that’s just one example. So, the second example
we have is the supplies. So, we recorded earlier
in the previous videos, we debited supplies that we
purchased and we have them on a shelf and they
have a value of $1,000. And the reason why we,
they still have value because we considered that,
we still did not use them. They’re still on the
shelf or in the warehouse. But then, what happens when
we start using those supplies? Are we going to continue
having value in them? Well, once you start using
those are pens and papers and clips maybe cleaning
supplies, they’re not going to have value in them
once we start using them. If they are still sealed
in the warehouse, then yes, they still have value. But once we start using them,
then we have consume them. We have record adjusting
entry for the amount of supplies that we consumed. Okay? So, at the end of
January, what we will do is, we’re going to go back and
found out how much left over supplies we
have, we still have on the shelf or int
he warehouse. And what we say in
accounting is, the leftover supplies we
call them supplies on hand. Okay? So, let’s say that our
supplies on hand at the end of the month, they
were about $700, that means we consumed $300 of
supplies, because we started with 1,000, we still have 700
at the end, so we consumed 300, which is 1,000 minus 700. So, what happens with that $300
of supplies that we consumed? Well, we’re going to transfer
it to an expense account. What is the name of
that expense account? Supplies expense. Okay? So, there’s
a huge difference between supplies
expense and supplies. Supplies expense, it’s
an expense account. Supplies account is an asset. Okay? Supplies expense does
what we, we show the amount of supplies we consumed. Supplies we will show the amount
that we still have available and it still have
some value in it. Okay? Because it’s an asset, that’s an expense the
other one is an asset. So, debit to an expense
we’re going to call it supplies expense. And remember we have to
record not the leftover, we have to record
what we consume. Remember, journal entries
we record the changes in the balances for
the accounts. So, what changed, what changes
happened to the $1,000 supplies? It decreased by $300. So, I’m going to record
$300 in my journal entry. We do not record the ending
balance in the journal entries, we record the changes
in the balances. Okay? Be careful about that. So, credit, supplies. $300 because supplies are
decreasing, it’s an asset, so it goes down with a credit. It’s decreasing but $300,
where’s that $300 going? It goes to an expense account. Another example, which
is the unearned revenue, that’s the amount of money
that we received in advance if you still remember. We get $200 in advance for,
let’s say it was 200 — $2,000 for services that we
will provide to a customer in two different sessions. So, let’s say that first
session will be within January, the second session will
be within February. So, at the end of January, we
already performed a service for $1,000, for example,
$1,000 for that customer. So, half of the $2,000
has been earned already by the end of January. We still have to provide him a
service worth $1,000 next month, which is February. So, we still have to keep
$1,000 in the unearned revenue. So, for now, end of
January we earned $1,000 of, out of the $2,000
unearned revenue. They became a revenue. We’re going to take it
from unearned revenue and transfer it to
a revenue account. So, unearned revenue
has to decrease and then the revenue
will increase. So, we’re not liable as
much as we used to be, because now $1,000 out of 2,000
became officially a revenue. So, we’re less liable now and
then our revenue is increasing. So, we’re going to debit
the unearned revenue, because it’s a liability account
and it decreases with a debit. Okay, remember, if a liability
goes up with a credit, that means it goes
down with a debit. So, unearned revenue. For $1,000. Remember, we only
record the changes. So, we’re transferring the
$1,000 from unearned revenue to a service revenue account, which is an income
statement account. So, revenue it’s an
income statement account, unearned revenue it’s a
balance sheet account. It’s under liabilities. Okay? $1,000 of service revenue. Okay, because service revenue
it’s, it goes up with a credit. It’s increasing, so
that will be a credit. The last example I have, which
is a little bit different from the other ones, it’s
the, it’s the equipment. Okay? Now, when we buy
equipment and we start using it, I mean it’s like a car. When you buy a car, it’s not
going to hold the value forever. If you buy a car today
for $20,000 it’s going to start depreciating over time. It will depreciate. It will lose value. Depreciation means losing value. You buy today for 20,000, after
a year it’s not going to be, it’s not going to
worth 20,000 anymore, it will drop maybe
let’s say $4,000. So, after a year, it will be,
it’s going to worth $16,000. And then, every year
it will drop. Same thing with equipment. In companies we have to adjust
the equipment account at the end of every month or every year. Depends on how much
value it’s decreasing. Okay? How much drop
in the value? We call it depreciation. So, when it comes to
equipment we can record a depreciation expense. That amount, the loss in value
we call it depreciation expense. So, here’s an example on that
equipment that we purchased. It was $20,000. Here’s a note about it. The equipment has a
5-years, use for life, and $4,000 residual value, which sometimes they call
it salvage value as well. And then, we’re going to
use the straight line method to calculate the
depreciation expense. Okay? So, it’s $20,000
for 5 years, and the residual value means
at the end of the useful, at the end of the life of that
equipment there will be still some value in it, that we
think that we can still sell it for that price which is
$4,000 in our example. So, how much total
depreciation are we going to record over the 5 years? So, that will be 20,000
minus the residual value which is $4,000 and that
would equal $16,000. So, the total depreciation over
the 5 years will be $16,000. Okay? Now, what we need to calculate here is how much
is the depreciation per month during those 5 years. The 16 is for the entire
5 years, so $16,000 divide that by — so, 5 years
every year has 12 months, so multiple 5 by 12,
that will be 60 months. So, divide the 16,000
over 60 months to find out how much your depreciation
expense per month is going to be. How much, how much are you going
to lose in value every month? So, 16,000 divided by 60, it
will be approximately 266.67. So, I’m going to
just round it to 267. You don’t really
need to round it. It depends on the company,
every company is different. So, in our example we’re
just going consider that it’s okay to round. So, $267 a month, that will be
the depreciation for a month. So, the equipment for 267. Now, the name of the expense
account is depreciation expense. So, I’m going to increase
depreciation expense by 267,000. And then the credit, now, someone might think we’re
going to, I mean it’s logically to credit the equipment account. I totally agree with anyone
who would think this way, because that’s what
we did with supplies. We credited supplies
to decrease it. We, did the same thing
with prepaid rent, we credited prepaid
rent to decrease. So, someone might think, well we
should also credit the equipment because it’s also decreasing. Now here’s the thing. Yes, we’re going to decrease the
net equipment, but we’re going to come up with a new
account and we’re going to use that account for crediting
instead of the equipment, and that’s just for
one reason, because, if I credit equipment
for $20,000. That means my ending balance
would be less than $20,000 and then there’s no way for
us to come at a specific point and just look at the balance,
the value for that equipment at a specific point
in time and find out how much was the
historical value. There’s no way you can find
out that it used to be $20,000. Now because equipment it’s
different from supplies, and prepaid — it’s more
important, it’s more expensive, it’s more investors or owners
of this company, they’re more – they’re going to more curious
about knowing how much it used to be initially and how
much it’s worth today. So, we don’t want to change the
$20,000 just because we want to keep showing up, we want to keep showing the
historical value. So, we will create a new
account which is going to be a contra-asset,
we call it contra, contra-asset, or
contra equipment. Contra accounts normally
have opposite balances. So, for example, if every
asset has a debit balance, a contra asset will
have a credit balance. Just like the account that I’m
going to show you right now, which is accumulated
depreciation. It’s a contra asset so
it has a credit balance. Okay? IT’s opposite the
normal balance of assets. And that will be $267 as well. Now, what happens
with that account? Where do we see that account? So, equipment. Nothing’s going to
change to the $20,000. Okay? That’s the
historical value, but then in our statements, under the equipment we will show
the accumulated depreciation immediately after the equipment. It will show in the
same statement, the same place under the assets. For $267 it has a
credit balance. So, credit and assets
mean negative. Okay? So, that will be negative. And then in accounting
usually we put the amounts between parentheses if they
have a negative balance. Okay? So, 267 between
parentheses and then we subtract
20 minus 267 and that will be
our net equipment. And that would be after
subtracted that would $19,733. Okay. So, our net
equipment is less than 20,000 because we depreciation
some of the 20,000. And over time, every time you
record the same journal injury at the end of every month for
depreciating the equipment. Every time we’re going to record if we’re using straight
line method, we’re going to use
the same amount. Because straight line
method means we’re going to, the amount of the depreciation
will be the same every month. That’s what straight
lines means straight. Same amount every month. So, we’re going to
record the same journal at the end of every month. That means your accumulated
depreciation balance will keep increasing, it’s accumulated
so it keeps accumulating. So, 267 and then the following
much it will be the 267, plus another 267 which will
make it higher than that, which would make our less
equipment less than the 19,733. So, the more you depreciate,
the higher than amount would be, the lower your net
equipment would be. And that’s true, because over
time your net equipment has to decrease between
your depreciating it because you’re using it. All right? So, those are the four
different examples. There are more examples of where
adjustment, adjusting entries and those are just the main,
the most important ones you need to know for deferral
transactions. In our next video, we’ll
talk about The accrual. Some examples on
accrual transactions.

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