Adjusting Journal Entries (Prepayment type)

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So when we think of adjusting journal entries, there's really a couple types.

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So one is we've got prepayment, related adjusting journal entries, and then we also have accrual related adjusting journal
entries.

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In this video we're gonna talk about those of the prepayment variety.

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So what are we talking about when we look at prepayment adjusting journal entry.

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We've really got a couple types, so now, we got some subcategories here, we've got prepaid expenses, right?

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Something like insurance, you pay in advance for your insurance and you use it up as time passes.

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And then we've got things, like unearned revenue, where there's prepayment going on.

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But it's actually prepayment on the part of your customer and you haven't earned the revenue again.

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So let's just talk a little bit about what is going on here.

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So when we think of these, why an adjusting journal entry would need to be made with these prepayments type entries.

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What we've got is the accountant in question is basically expiring over time.

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Just slowly over time and it's not something that you would record on a daily basis, or it's just something that's this kind of
expiring as it's used up.

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Expire as used up like supplies or something like that.

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And again, you're not going to go every single second and make some kind of entry, you just look at the end of the period
and see what's been used up.

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So let's go ahead and take a look here and see an example.

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And we're gonna start with a prepaid expense, okay, that type of prepayment.

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We're gonna take a look at one of those and just see how it will play out in natural practice.

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So let's take for our example that you purchase 12-month insurance policy, 12-month policy for $12,000.
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Okay, let's just assume you pay cash, you pay $12,000 for some insurance policy for your business.

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So what's our initial entry gonna look like?

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Well, let's say that you do this on January 1st, 2015, so what's gonna happen?

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Well, you're getting an asset, right?

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So you're getting prepaid insurance, you're gonna debit that, that's an asset account.

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You're gonna debit that for $12,000, right now, we're assuming here that you pay cash.

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So you're going to credit cash for $12,000, but then your boss says, let's say it's the end of the month, it's January 31st
2015.

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And your boss says, look, I want you to go ahead and I want you to make some adjusting journal entries.

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We're gonna put together an adjusted trial balance and we need to make some changes.

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So now, you have to say, okay, look we bought a 12 month policy, right?

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Now, we see that one month has gone by, so well, what's one way of thinking about that?

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Well, one way to think about is we've used up one-twelfth of our asset, right?

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This $12,000 asset is not really a $12,000 asset anymore, now, we should multiply it by this one-twelfth, all right?

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And say, okay, how much of this asset have we used up, right?

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So ultimately, we're gonna say, okay, well we've got this 12,000 divided by the 12 months, right?

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So 12 [UNKNOWN] so that tells you this is $1,000 a month, is the rate at which we use up this asset.

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Now, what happens when you use up an asset, well, let's say you have an expense, right, and in this case, we'll call it
insurance expense.

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All right, because we've used up this insurance asset and insurance expense is gonna be $1,000, right?

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Just 1,000 a month, it's been one month, so that's pretty simple, now, what do we credit, right?
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Because we need to make this balance, well, we're gonna credit prepaid insurance, right?

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Because we can't keep the assets on the books at 12,000 anymore, because we know it's not worth 12,000, now, it's
worth 11,000.

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So what do we have to do?

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We have to deduct 1,000 for, we have to credit this asset and crediting an asset reduces the asset, so we credited it for
1,000.

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So now, we've made an adjusting journal entry to reflect the fact that we've basically, we've used up some of our policy.

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Some of our 12 month policy, we've used up one month and now, we've adjusted for that fact that the end of the month,
okay.

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So that's the type of, when we're talking about a prepayment, we're looking at a prepaid expense, right?

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But also, you can have kind of this prepayment issue with unearned revenue.

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Now, if you're not quite sure what unearned revenue is, I'll just briefly explain here.

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You're going to, I'm going to have example not exp, so for this example, we're gonna do unearned revenue.

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And unearned revenue is basically the customer has sent you some money, but you haven't actually done the act in
question that would entitle you to recognize this is revenue.

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We have another video on revenue recognition, so you can watch that if you're not quite sure what I mean.

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But let me give you an example that will make it a little bit easier to understand.

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So this unearned revenue, let's say that you sell a two year magazine subscription, to one of your customers, two of your
magazine subscription.

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Now, what happens when you have a magazine subscription?

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While the customer typically send you the money up front, so let's say that in this case it's $240, right?

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So the customer sends the money up front and now, what you have is you have this money, this $240, but you haven't
delivered the magazines yet.

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So it's not revenue yet, but you got the cash.
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So now, we need to make an entry to reflect this, and then I'll show you what the adjusting entry would be as time goes
on.

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So let's say that this is January 1st, 2016, is when you sell this policy, okay?

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So what is gonna happen as you're getting cash of $240, right?

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That's pretty simple to figure out, and then we're gonna match that with this unearned revenue.

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That's gonna make this balance this unearned revenue $240 is not earned yet, cuz you haven't delivered the magazines
yet, right?

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So now, it's let's say the end of the quarter, right, so it's March 31st, 2016.

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And your boss says, look, it's the end of the quarter and now we have to go ahead and we have to make some kinda entry
to reflect the fact that now three months have gone by.

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And this was a 2 year subscription, so that's 24 months, so 3 of those 24 months have gone by.

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So now, we have delivered 3 months of magazines and now, we can go ahead and start recognizing the sum of this
unearned revenue has become earned.

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And now, we're coming out with our quarterly report and we wanna go ahead, and we wanna make an adjusted journal
entry to reflect this three months that's happened here, okay?

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So what we're gonna do is we're gonna say, okay, look, there's 24 months, right, 2 years times 12 months in a year.

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So we're looking at 24 months and ultimately, this is a $240 subscription.

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So we can just say if we're, what if 240 divided by 24 months, right?

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So that's going to be $10 a month, that's ultimately what we recognize every month.

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But what's happened here, we've got three months that have gone by, this isn't just one month.

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So we're recognized this at a rate of $10 a month, but we haven't recognized it yet, and it's been three months.

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So we multiply the 10 a month, right, times 3 and that gives us that we that we need to make an adjustment for $30, right?

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So how do we do that?
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Well we need to say, okay, look $30 of this this on earned revenue of $30 has now been earned.

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So we're going to say, well we need to reduce the unearned revenue, we need to make an adjusting journal entry.

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This an adjusting journal entry here, we're reducing unearned revenue by 30, right?

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Now, we credit revenue, cuz we've earned this of $30.

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So what we're basically doing is saying okay look, so let's assume that we had, let's just say we had a T account for
unearned revenue.

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Right, so we have this T account, it's a liability, so it has a credit balance.

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So the beginning balance, before we made the adjusting journal entry here, before we did that, the unearned revenue
would have had a balance of 240, all right?

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But we made this adjusting journal entry here to reflect the fact that time has gone by, right time.

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Time is passing by and now, we've actually can record 30 of this as revenue, because we've delivered three month's worth
of magazines.

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So now, we go and we say now we're gonna adjust this unearned revenue account, right?

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We're gonna have a debit to it of 30, and then now, it's gonna be, if we had our adjusted trial balance, right?

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So you start with the trial balance that would have the 240, will be on the trial balance.

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But now, we make the adjusting journal entry over here.

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And then we've got the adjusted trial balance would show 210 in unearned revenue.

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