What are adjusting entries?

At the end of the period (whether it is a year, a quarter, or a month), we must follow some specific rules. There are transactions in the accounting cycle that expand beyond one period. For example, when we pay rent every 10th of the month, we live in an apartment from December 10th, 2021 to January 10th, 2022. We pay in 2021, but live in the apartment until 2022. This transaction expands in two periods. In the next video we will examine these transactions.

The end of the period is really important because that is when we prepare the financial statements of the company. Everything we say in there must be true. If something happened, but we didn't record it and we didn't show it to our investors, we will be in trouble.

Adjusting Entries - Video Explanation


As you can note from the video above, we have different types of these transactions that expand beyond two periods. Here, we are discussing about ACCRUALS and DEFERRALS. Let’s first understand what these words mean.

Deferrals

What are deferrals? To defer means to postpone or to put off until a later time. In our examples in the video above, the Cash transaction happened, and then, the earning of the revenue was deferred, or the occurrence of the expense was deferred. Examples of these are any Prepaid Expenses or any Unearned Revenues.

Prepaid Expenses

What are prepaid expenses? We call them Prepaid Expenses because they were paid for, but we haven’t used them yet. An example is supplies (e.g. paper, pens). When we buy supplies, we paid for it. It is something of value that we own (an asset). However, when we use these supplies (i.e. paper, pens, pencils), they lose their value and usefulness and we throw them away (they become an expense).
To sum up, we buy Supplies (asset), but we have not used it yet (not yet an expense). Once, we use it, it becomes an expense. Prepaid Expenses are not expenses. Prepaid Expenses are assets. We call them Prepaid Expenses because ultimately, they will become expenses.

Unearned Revenues

What are Unearned Revenues? We call them Unearned Revenues because we have not earned our revenue, even though we were paid. The best example is a singer. Imagine that a singer schedules a concert. All fans will buy tickets in advance. The singer will receive all the cash from the fans, but, however, the singer did not perform the concert yet. Therefore, the singer did not earn the revenue (did not have the concert yet). It is true, however, that the singer OWES his/her fans to perform at a concert. Therefore, the Unearned Revenues are classified as a Liability. When the singer performs at the concert, he/she will earn the revenue by singing all songs at the concert. When the concert finishes, the singer would have earned all revenue.
To sum up, the singer collects all the cash for a concert. This is an Unearned Revenue (a liability). Once he/she performs at the concert, he/she earned the revenue and does not owe anything to his/her fans. Unearned Revenue is not a Revenue account, it is a liability account. We call it Unearned Revenue because ultimately the singer will earn the revenue.

Deferrals - Video Explanation

Accruals

What are accruals? To accrue means to accumulate or to pile up over time. In our examples in the first video lecture, we noted that something happens first, and then, we are either being paid or we pay someone else. Or in accounting terms, we earn (accrue) the revenue first, and later we are paid for it. Or, we use some service first, and then we pay for it. Examples of these are Accrued Revenues and Accrued Expenses.

Accrued Expenses

What are Accrued Expenses? Accrued Expenses are simple. They truly are Expenses. Think of your workers in your company. They work for you for 2 weeks, let’s say, and at the end of the 2 weeks you pay them. This means that you accrued the Salary Expense for 2 weeks and paid them at the end. Another example of accrued expenses is electricity. You use the electricity in your office for a month, but you pay at the end of the month, when the bill arrives.

Accrued Expenses - Video Explanation

Accrued Revenues

What are Accrued Revenues? Accrued Revenues are also very simple. They truly are Revenues. Think that you are a contractor. You agreed to install a new kitchen for one of your customers. The customer will pay you once you complete the project. So, first you work and install the kitchen (earning your revenue), but once you are done, you will get paid.

Accrued Revenues - Video Explanation