Summary
Highlights
Adjusting entries are journal entries posted at the end of each accounting period to align a business's books with the accrual method of accounting. This video will cover four main types: prepaid expenses, deferred revenue, accrued expenses, and accrued revenue. Financial statements are formal reports summarizing financial performance, position, and cash flow, guided by GAAP or IFRS, which mandate the accrual basis of accounting.
In accrual accounting, revenue is recognized when earned and expenses when incurred, regardless of cash or invoice timing. A typical business transaction involves goods/services, an invoice, and payment. Adjusting entries are necessary when these three parts fall into different accounting periods. Two main types are prepayments (paid in advance) and accruals (to be invoiced in the future).
Prepayments occur when goods or services are paid for in advance. The payment happens in the past, but the delivery/consumption occurs in the future. An adjusting entry reverses initial recognition from the income statement, holding it as an asset/liability on the balance sheet until the future accounting period when it's released to the income statement. This ensures revenue/expenses are recognized as earned/incurred. Prepayments include prepaid expenses (buyer) and deferred revenue (seller).
Accruals happen when goods or services are delivered in the past, but the invoice and payment come in the future. An adjusting entry is posted in the past accounting period to accrue the revenue or expense into the income statement, temporarily holding the accrual as an asset or liability on the balance sheet. This accrual is reversed in the future once the invoice is raised. Accruals include accrued expenses (buyer) and accrued revenue (seller).
A prepaid expense is a future expense paid in advance. For example, car insurance paid in December 2018 for coverage in 2019. Initially, the full amount is debited to insurance expense. An adjusting entry is then made in December 2018 to credit insurance expense for the full amount and debit prepaid expenses (an asset) by the same amount. Each month in 2019, 1/12th of the prepaid expense is recognized as insurance expense, reducing the prepaid expense asset.
Deferred revenue (also known as prepaid or unearned revenue) is payment received in advance for goods/services not yet delivered. Using a flight ticket example, if a customer pays in June for flights in July and August, the airline initially debits cash and credits deferred revenue (a liability). In July, half the service is performed, so deferred revenue is debited and revenue credited for half the amount. In August, the remaining deferred revenue is recognized as revenue, aligning with the accrual basis.
An accrued expense is a past expense not yet recorded or paid. For monthly water bills paid quarterly, without an invoice, an estimated expense needs to be accrued. For November and December, a debit to utilities expense and a credit to accrued expenses (a liability) for $50 each month recognizes the incurred expense. In January, when the invoice is received and recorded, the accrued expenses are reversed by debiting accrued expenses and crediting utilities expense to avoid overstating the expense and liability.
Accrued revenue is revenue earned but not yet invoiced. As a web developer, if a website is completed in June but invoiced in July, an adjusting entry in June is needed. Revenue is credited, and accrued revenue (an asset) is debited for $500. In July, when the invoice is raised, accounts receivable is debited, and accrued revenue is credited to transfer the asset. Finally, when payment is received, cash is debited and accounts receivable is credited.