Prepayments and Accruals | Adjusting Entries

in this video I'm going to give you an introduction to adjusting entries in accounting specifically prepayments and accruals I'm going to explain what they are and why we need them hey there welcome back to the channel I'm James this is accounting stuff and in today's video we're going to walk through adjusting entries in accounting I've had a bunch of requests from you guys in the comments to cover this topic so thanks for all of these it's great to know what content you're after if you haven't heard of adjusting entries before it's the name that we give to the journal entries that we post at the end of each accounting period in order to bring our books into alignment with the accrual basis of accounting sound complicated well it is kind of so I've decided to create a mini series devoted to unraveling the mystery of adjusting journal entries and this is video number 1 we'll start off by taking a look at the big picture of accounting and then we'll drill in to uncover the problems posed by the accrual basis and how adjusting journal entries can help us work around them all explain what the four types of adjusting entry are and how to identify them prepaid expenses deferred revenue accrued expenses and accrued revenue my plan is to follow this video up with full more will discuss how to record adjusting entries and go through worked examples for each type so subscribe and hit the bell to be notified when those come out I'll take all of these videos and put them into one playlist that you can find up here once it's done got it good let me know in the comments which kind of adjusting entry you're having the most problems with and don't forget to watch this one through to the end find out how all of this works let's get cracking I said that the justing entries of the journal entries that we post at the end of each accounting period to bring our books into alignment with your cool basis of accounting but what does that mean why would we do that I think we need to take a step back and look at the big picture of financial accounting financial accounting is the process of recording summarizing and analyzing and entity's financial transactions and reporting them in financial statements to it listing and potential investors lenders and creditors so ultimately as financial accountants our job is to produce financial statements to assist our key stakeholders with their decision-making but what are financial statements you can think of them as formal reports this summarize a business's financial performance position and cash flow collectively they give all of the interested parties an idea of the business's financial health when preparing financial statements there are some rules that we need to follow the specifics differs slightly from country to country but broadly speaking we follow the generally accepted accounting principles GAAP assured or the international financial reporting standards IFRS now both GAAP and IFRS have something in common they both require us to produce our financial statements in accordance with the accrual basis of accounting now the accrual basis of accounting is key to understanding adjusting entries so what is it in a call accounting revenue is recognized as it's earned and expenses are recorded as they are incurred regardless of when cash or an invoice changes hands I made a whole video explaining what this means and its pros and cons versus the easier cash method of accounting that you can find linked up here and down below in the comments but the key takeaway here is that payments and invoices shouldn't dictate when we recognize our revenues or expenses instead we need to think about the substance behind each transaction that's the real trigger but the problem is that this doesn't just happen naturally and that's when adjusting entries come in let me explain a normal business transaction involves two parties a buyer and a seller the seller provides goods or services to the buyer and sends them an invoice and in return the buyer with hays them in cash so there are three parts to this transaction we have the transfer of goods or services the invoice and the payment keep that in mind for a moment alongside all of this the financial statements we produce are designed to cover a range of time which we call an accounting period depending on the business's reporting requirements this could be anything from a ma to a quarter or even a full year if all three parts of this transaction happen in one accounting period then were all good no adjusting entries are necessary but when they fall into different counting periods then we've got a problem this is where adjusting entries come in there are two main types prepayments and accruals prepayments occur when goods or services have been paid for in advance whereas accruals happen when goods or services are to be invoiced in the future in a prepayment goods or services have been paid for in advance I'll show you how this works I think it's best if we think of this in terms of two accounting periods the past and the future with us being bang in the middle balancing on a tie rope in the present in a prepayment goods or services have been paid for in advance so that means that the payment happened back in the past the goods or services they're going to be delivered or consumed in the future the problem here is that normally the invoice and payment part of the transaction naturally triggers an accounting entry that recognizes the whole transaction in the past so if we were the buyer then we would have recognized an expense in the past and if we were the seller and we would have recognized the revenue in the past but we are accrual accounting so revenue should be recorded as it's earned and expenses should be recorded as they are incurred the goods or services are going to be provided in the future so the revenues or expenses should also be recognized in the future not the past so right now before the period closes we've still got a bit more time to make changes in the past we need to post an adjusting entry to reverse out those revenues or expenses from the income statement and hold them in the balance sheet where they don't impact our past financial performance then in the future accounting period we'll post another adjusting entry to release these from the balance sheet to the income statement so we've correctly recorded our revenue as it was earned or our expenses as they were incurred that's how pre payments work in general but really there are two types depending on where we fit in to the transaction we have prepaid expenses and prepaid revenue which is more commonly known as unearned or deferred revenue if we're the buyer in the transaction then we're dealing with prepaid expenses because we're the ones receiving or consuming the goods or services however if we're the seller then we're on the other side of the transaction and we're dealing with prepaid revenue because we're the ones providing the goods or services accruals occur when goods or services are to be invoiced in the future these are almost the opposite prepayments goods or services are delivered in a past accounting period whereas the invoice and eventual payment come later in the future again we have a problem the accrual basis of accounting is telling us that revenues or expenses should be recognized when they're earned or incurred in this case the substance of the transaction happened in the past because that's when the goods or services were delivered or consumed however the natural accounting trigger in this situation happens in the future when the invoice is raised by the seller and received by the buyer so as things currently stand the transaction is going to be recognized in the future income statement to correct this we need to post an adjusting entry into the past accounting period to accrue the revenues or expenses into the income statement and the other side of that journal will be to temporarily hold the core as an asset or liability in the balance sheet in the future once the invoice has been raised by the seller and given to the buyer we'll need to reverse this across so that we aren't recognizing this transaction twice that will release the original adjusting entry from both the income statement and the balance sheet again there are two categories of accrual accrued expenses and accrued revenue if we're the buyer in the transaction then we're dealing with accrued expenses because we're the ones receiving or consuming the goods or services however if we're the seller then we're on the other side and we're dealing with a crude revenue instead because we're the ones making the money by providing those goods or services so adjusting entries are required to bring our books in line with the accrual basis of accounting which is required under BOE GAAP and IFRS when producing financial statements adjusting entries are divided into two categories pre payments occur when goods or services have been paid for in advance whereas accruals occur when goods or services are to be invoiced in the future if you're on the buying side of the transaction then you prepay or accrue expenses depending on the timing of the payment or invoice however if you're on the selling side then you defer revenue when you've been paid in advance and accrue revenue when you've already provided goods or services and plan to invoice the customer in the future any questions let me know down below in the comments or message me directly on instagram at accounting stuff if you're still confused by adjusting entries I totally get it and that's why I'm going to release for new videos covering examples of each type in detail hit this circle to subscribe so you don't miss out on those and whole playlist will go over here once I finished something else interesting will go there in the meantime I promise you see ya you

Channel: Accounting Stuff

Views: 632,089

Keywords: adjusting entries, adjusting entry, adjusting journal, adjusting journal entries, what are adjusting entries, why are adjusting entries necessary, prepayments, accruals, prepaid, accrued, deferrals, deferred, prepaid expense, deferred revenue, accrued expense, accrued revenue, accounting basics, accounting, adjusting entries in accounting, what are adjusing entries, how to adjusting entries, accounting stuff, accounting tutorial, financial accounting, journal entries, accrual basis

Id: H0N7tvXuJlU

Length: 9min 57sec (597 seconds)

Published: Mon Jun 03 2019