Hello, I'm Professor Brian Bushee, welcome back. This video is part two of our look at adjusting journal entries. Hopefully this sequel will be an Empire Strikes Back-type sequel and not a Mannequin 2-type sequel. Anyway, let's get to it. Okay, let's do some practice with adjusting journal entries. I will give you a series of related transactions. Some of them will be cash transactions that happen during the regular operating period of the company. And then other times, we'll look at the fiscal year end, and then ask the question about whether there's an adjusting entry needed and, if so, what would it be? As always, the pause icon will appear if you want to pause the video and try to come up with a journal entry before I give it to you as the answer. So let's get started. On September 30 BOC loans $100,000 to an employee at a 12% interest rate. This is a cash transaction that's happening during the fiscal period. BOC is loaning $100,000 cash, cash is going down so we credit cash for 100,000. The debit here is going to be an asset called notes receivable. It's a receivable because the employee owes us 100,000 of cash in the future. We don't want to call it accounts receivable, because we only use that for customers, so we call it notes receivable. December 31, it's the end of the fiscal year and no principal or interest payments have yet been made. Do we need an adjusting entry, and if so, what would it be? We do need an adjusting entry in this case, because three months has gone by and we haven't gotten paid any interest, but we've earned interest revenue. We've earned interest revenue because we provided the service of having the money outstanding to the employee over the past three months. We have a contract where we're eventually going to get paid. So it meets both the earned and realized criteria. So we're going to recognize the interest revenue. We recognize revenue with a credit. We credit interest revenue for 3,000. The debit is again going to be a receivable and we're going to be specific here and call it interest receivable. Because the asset is that we're owed cash for interest. We don't want to call this notes receivable because we're only going to use that for the principal part. And of course we don't want to call it accounts receivable because we only use that for customers. >> How did you come up with $3,000 as the amount of interest revenue? >> Let me show you. We have 100,000 of principle and a 12% interest rate. Anytime you see an interest rate you should assume it's an annual rate unless it specifies otherwise. So 100,000 times 12% is 12,000 of interest per year. But it hasn't been a year yet. So we take 12,000 times 3 12ths because it's been three months. And we end up with $3,000 of interest for the three months. Now it's January 6th the employee sends a check for three months of interest on the loan. This is a cash transaction happening in the next fiscal year. We're receiving cash, so we're going to debit cash for 3000 because we're receiving the interest receivable that was owed before. And if we're receiving the interest receivable, it's no longer receivable, so we need to get rid of that account. So we credit interest receivable to reduce that asset by 3,000 since we've now received the check. Next set of transactions. So it's December 31st, it's the end of the fiscal year. During December employees earned $400,000 in salaries, but paychecks do not get issued until January 2nd. It's the end of the fiscal year so we have to ask ourselves whether we need an adjusting entry. We do in this case because we've had employees work for us even though they haven't been paid, we have to recognize an expense for the amount of salaries that they earned during December. So we're going to create an expense, and we create an expense with a debit. Debit salary expense for $400,000. We haven't paid them cash, but we owe cash. We have an obligation to pay them for the time they worked, that obligation sounds like a liability, and in fact it is, so we credit salaries payable liability for 400,000. >> What do you mean by earned salaries? I thought earned was one of the revenue recognition criteria. This is an expense. >> Yes, earned is one of the revenue recognition criteria. And from the perspective of the employee, the employee earned salary revenue. The employee provided a service, they have an agreement to get paid, so it's revenue for the employee. And what is revenue for the employee, is an expense for the employer which is why this is salary expense. Now it's January 2nd and the paychecks are sent to the employees. If we've sent checks that means we've paid cash, so we're going to credit cash for $400,000. By paying the cash, we've gotten rid of the obligation to pay their employees, so we have to reduce the liability. We reduce liabilities with a debit. So we debit salaries payable for 400,000. Next series of transactions. On November 20th, BOC pays $10,000 for December's rent. So BOC's paid cash. So their cash has gone down, so we need to credit cash for 10,000. The debit is going to be to an asset called prepaid rent. It's an asset because we're either going to get the benefit of occupying the space in the future or we're going to get our money back. So either way we create an asset called prepaid rent for 10,000 at this point. Now it's December 31st, it's the end of the fiscal year, do we need an adjusting entry? And if so, what would it be? We do need an adjusting entry, because December has gone by and we've occupied the space for the month of December. The prepaid rent is no longer prepaid, it's been used up. So we have to create an expense for the amount of rent that we've used up. We create an expense through debit. So we debit rent expense for 10,000. Our rent is no longer prepaid so we have to get rid of that asset. We get rid of an asset with a credit, so we credit prepaid rent for 10,000 which brings the balance down to zero. So in this example, BOC is a company that sells software. We've received $60,000 cash as BOC, so we need to debit cash for 60,000. But BOC hasn't delivered any of the software yet, so it can't recognize revenue. Instead, they have to create an obligation, or a liability for their responsibility to deliver the software over the next three years. So we create a liability with a credit, credit unearned software revenue for $60,000. It's now December 31st, it's the end of the fiscal year. Is an adjusting entry needed? And if so, what is it? We do need an adjusting entry. Because six months of that three years has gone by. And as time goes by we get to recognize revenue for the amount of time that's passed. So we're going to credit software revenue for 10,000 to recognize six months worth of revenue. This in turn, has to reduce the liability. We reduce the liability with a debit. Debit unearned software revenue for 10,000. So after this transaction, the balance in unearned software revenue would be 50,000. Which is our obligation to deliver software over the next two and a half years. >> I know why the answer is $10,000. But maybe you should explain it for the other viewers. >> Sure, I'm happy to explain how to get 10,000 for the other viewers. BOC's going to earn $60,000 of revenue over three years. Assuming they earn it on a straight line basis, that's 20,000 per year. It hasn't been a year, it's only been six months. So 20,000 x one half is 10,000 and BOC get to book 10,000 of revenue for the six months. Next series of transactions, it's June 30th BOC purchases a building for $500,000. The expected life of the building is 20 years and its expected salvage value is $100,000 At this point we have to account for purchasing the building, but we're not going to do any depreciation yet because we just bought the building. We paid $500,000 cash so we credit cash $500,000. We received a building, a building's an asset so we debit building for $500,000. Now it's December 31, it's the end of fiscal year, is an adjusting entry needed and if so, what is it? We do need an adjusting entry to recognize the depreciation for six months. The format of the depreciation expense journal entry always looks like this. We debit depreciation expense to create the expense and then we credit accumulated depreciation. Remember accumulated depreciation is a contra asset account. That's where we're going to store up the depreciation over time. We're not going to directly deduct it from the building account, but instead we're going to put it in this contra asset called accumulated depreciation. Because it's a contra asset, a credit increases the account, increases the contra asset, which in turn is reducing total assets. Now we did 10,000 as the number where did we get that from? I've got that one on the slide. So the building originally cost 500,000 and the salvage value was 100,000. So we're using up 400,000 of value over time. We're doing it over 20 years, so that's 20,000 of depreciation per year. But it's only been six months, so we need to take the 20,000 divided by 2 to get $10,000 of expense for the six months. >> What if your salvage value or useful life estimates are wrong? How can you possibly know what a building will be worth in 20 years? Or even that you will use it for 20 years? >> Both the useful life and salvage value are managers' best estimates, at the time they buy the building, of how long the building will last and how much it will be worth when they are done with it. Like all estimates, they will almost certainly be incorrect. But at any point if the manager gets better information, they can revise their estimates. So if they think they're going to to use it longer or shorter than they originally thought, they can extend or reduce the useful life and then just change the depreciation expense going forward. And then when they decide to sell the building, if it's not worth the salvage value then we'll just book a gain or loss when we sell it. And we'll see this play out more later in the course. Okay, last set of transactions. It's December 31st, BOC still has an outstanding order for $300,000 of products that will be delivered and billed in January. Do we need an adjusting entry at this point? We do not need an adjusting entry at this point. We haven't earned any revenue because we haven't delivered any goods or services this year. We haven't collected any cash so we don't have to account for any cash that we've received. So basically there's no transaction yet. Everything's going to happen in the future so there's no adjusting entry needed at this point. >> Okay, so we can't record revenue yet. But, is there any way that we can let people know about this order? >> Yes, companies can always voluntarily disclose additional information that they're not allowed to recognize in the financial statements. For example, companies often disclose the order backlog in their annual report. The order backlog is a disclosure of the number of outstanding orders the company has that haven't got to the point yet where the company could book revenue from them. So the investors can use this disclosure to find out about upcoming orders even though they haven't yet shown up on the balance sheet or the income statement. Here's a quick graphical overview of adjusting entries before we wrap up the video. Think about a timeline where we have cash transactions that happen at different times than we recognize revenues or expenses. The deferred revenue and deferred expense occur when we have a cash transaction before we recognize a revenue or expense. So if we receive cash before we can book revenue, we need a liability, an unearned revenue liability, to bridge the gap. Or if we pay cash before we record an expense, we need an asset, a prepaid asset, to bridge the gap. For accrued expenses and accrued revenue, now the expense and revenue recognition is happening before the cash transaction. If we have to recognize an expense before we pay cash, we need a liability to bridge the gap. And that liability it's going to be a payable. If we book revenue before we receive cash, then we need an asset to bridge the gap and that asset is going to be a receivable. So all the adjusting entries that we talk about are going to fit into one of these four categories. Now that we've done examples of all the possible types of adjusting journal entries, I can't think of anything better to do then, do more practice with them. And that's what we'll do on the next video when we continue the Relics Spotter case. I'll see you then. >> See you next video.
