Adjustment: Prepaid Expenses Video Lecture | SSC CGL Tier 2 - Study Material, Online Tests, Previous Year

[MUSIC PLAYING]
Hi.
Else here.
And today we'll be talking
about prepaid expense adjusting
entries, and their impact
on the accounting equation.
Before I get started, it's
important to understand
what prepaid expenses are.
Because they include the word
expense, a lot of students
feel that these are expenses
that should be recorded
on the income statement.
But that would be totally wrong.
They're not expenses at all.
Instead, prepaid
expenses are assets.
Why?
Well, say you purchase a
one year insurance policy
for $12,000 cash.
Your cash goes down.
So your assets go down.
But the insurance policy
has a future benefit
for the company
because they now have
insurance coverage for a year.
If anything has
future benefit, it's
got to be recorded as an asset.
So will the insurance
ever become an expense?
Absolutely.
When you use your coverage
to protect yourself
over the next few months, you'll
be using up your coverage.
And then it'll move from
being an asset on the balance
sheet to being an expense
on the income statement.
But this will only
happen over time.
Are there other
assets on the balance
sheet that are similar
to prepaid insurance?
I mean, there are going to be
prepaid expenses that start off
as assets and then
later become expenses?
Yes.
There's things like
prepaid rent, which
is when you pay rent in
advance, prepaid fees, which
could be things like
professional fees paid
in advance.
And then there's
prepaid subscriptions
when you pay for say, a
year's worth of magazines.
All of these prepaid
expenses are called prepaid,
and they have the
word prepaid in them
so you know it's prepaid.
Are there any assets which
are prepaid expenses which
don't include the word
prepaid in their name,
but they still have the
same characteristics
as prepaid expenses?
Yes, there are.
And often students
are fooled by them.
For instance, supplies
are on the balance sheet
under current assets.
They're an asset
because they benefit
the future of the company.
They'll be used up in the
future to help generate
revenue, which
means that they're
going to become an expense.
That's the same as prepaid rent.
You start off as an asset,
and then later on you
become an expense.
So supplies are really
a prepaid expense that
don't include the word prepaid.
Are there others?
Actually, many of the
accounts under property plant
and equipment are
prepaid expense accounts.
Let's look at equipment.
It's an asset because it has
future benefit for the company.
It's going to be
used in the future
to help generate revenue,
which means that it's
going to become an expense.
That's the same as
supplies and prepaid rent.
And so equipment is
also a prepaid expense
that doesn't include
the word prepaid.
Actually, a lot
of asset accounts
are prepared
expenses in disguise.
We need to review the asset
section of the balance sheet
to see how many there are.
Inventories
purchased in advance.
It has future benefit
for the company
because we're going to
sell it in the future
to generate revenue.
When we sell it, it becomes
an expense called cost
of goods sold or cost of sales.
So it matches the
characteristics
of a prepaid expense.
Prepaid insurance we
know is a prepaid expense
because it has the
word prepaid in it.
Remember, if you ever see
the word prepaid connected
to any account, you
need to recognize
that it must be recorded as
an asset until it is used up.
We already talked about how
supplies a prepaid expense.
So let's move on to
non-current assets.
Buildings are
purchased in advance.
They have future
benefit for the company
because we'll use them as a
location for our business.
This helps us to
generate revenue.
Therefore they're an asset.
When we use the building over
time, it becomes an expense.
So again, this is an asset that
is really a prepaid expense,
even though we don't
call it prepaid.
Notice that, as we recognize
the expense due to usage,
we record the total
or accumulated amount
of all usage in a
contra asset account
called accumulated depreciation.
Accumulated depreciation
is a total amount
of all depreciation
expense since the day
we purchase the asset.
We already talked
about equipment.
It's an asset because
we use it in the future
to help generate revenue.
Like buildings, as we recognize
the expense due to usage,
we record the total
or accumulated amount
of that usage in a
contra asset account
called accumulated depreciation.
Accumulated depreciation is
the total amount of an asset
that we have used up since
the day we purchase the asset.
Intangibles, which are
things like patents,
are also purchased in advance,
and have future benefit
for the company because we
use the patented process
in our production.
That will help us to generate
revenue in the future
so we record it as an asset.
As we use the patent over
time, it becomes an expense.
Why?
Because we're using it
to help generate revenue.
So this is an asset that is
really a prepaid expense,
even though we don't call
it a prepaid expense.
We can see that any asset that
we purchase before we need it,
and then use up later,
or consume over time
to generate revenue is
really a prepaid expense,
no matter if their name
is something like supplies
or prepaid insurance.
Let's summarize what we
know about prepaid expenses.
When we pay for a
prepaid expense,
we recorded as an
asset because it has
future benefit for the company.
Then, when we use or
consume the asset,
we'll need to move some
of the value of that asset
from the balance sheet over
to an expense in the income
statement.
This is because we've used
or consumed it in order
to help generate revenue.
Let's do an example to
solidify our understanding
and actually see
the entries that
impact the accounting equation.
ABC Company rents a new
location on January 1st.
The rent is $2000 per
month, and they pay
six months of rent in advance.
Six times 2,000
means they've spent
$12,000 cash on January 1st.
The company has to report to
the public quarterly, which
means they produce financial
statements on March 31st.
Let's look at January 1st and
see what needs to be made.
Whenever we look
at a transaction,
we need to ask ourselves,
what did we give up?
What did we get, if anything?
What did we use or consume?
What did we earn?
What do we owe?
The first two questions
are key questions,
and the last three help
to clarify our thinking.
So what did we give up?
We gave up cash of $12,000.
That means that assets
decreased by 12,000.
Did we consume or use anything?
When we pay cash for
things, students often
assume that we have an
expense on the other side.
The question is, did we
use or consume anything?
Not whether we paid cash.
In this case, the answer
is no, we have not.
And because we have not,
we can't record an expense.
So expenses are off the table.
What did we get?
Well, we got the right to use
the space for the next six
months.
Does that have a benefit?
Yes it does.
It has a future benefit for the
company and, because of that,
we record it as an
asset, prepaid rent,
under the element assets.
Remember, this is because it has
future benefit for the company.
What kind of
transaction is this?
It's an external
transaction because it's
measurable and realized.
Realized meaning that
it happened in the past.
It is external because
we exchange something
with an outside party, someone
who is external to the company.
Entries that are
external transactions
are called
transactional entries.
Sometimes you'll see a textbook
call it an original entry.
But I actually prefer the
name transactional entry,
indicating the transaction
occurred with a third party,
and there was likely
a paper trail,
such as an invoice or receipt.
Now, let's fast
forward three months.
We're now standing
in March 31st.
We know the company is going to
produce financial statements.
So we have to be sure that all
the assets on our balance sheet
have future economic benefits
equal to the value that we've
recorded on the statements.
If not, we have to make
an entry to recognize
the use of the asset.
If we look at our
prepaid rent account,
the last time we did
anything with this account
was on January 1st.
So on March 31st, we still
have our January 1st balance.
We know that this account
was an asset because it had
future benefit for the company.
But is that future benefit
still worth $12,000?
And the answer is
no, not anymore.
We've been using this phase
for the last three months.
So we have to recognize that
some of the asset is now gone,
and the value has been
used up, and therefore
has to be moved to
an expense account.
We said we used the
asset for three months,
and we know that rent
was $2000 per month.
So that means we've used up
$6,000 over the last three
months.
We have to reduce the asset
account by this amount
because the value
has been used up.
This means our ending balance
in the prepaid rent account
has to be updated
to be $6,000, which
is our original $12,000 less
the $6,000 of rent that was used
over the last three months.
We still have three months
of rent left for the future.
That's why there's still
$6,000 left in prepaid rent
at the end of March 31st.
In order to reflect
that use, what entry
do we have to make to
our accounting equation?
Well, we've used
three months of rent.
And that means we need to
recognize that use as a rent
expense of $6,000.
Students often then use cash
as the other side of the entry.
Is that correct?
Well, we haven't paid
any more money for rent.
So cash is not impacted, and
you should leave it alone.
Actually, adjusting
entries never involve cash.
So for making an
adjusting entry,
don't touch the cash account.
Instead, what did we use?
We used up three
months of prepaid rent.
So we should reduce the
asset account by that amount.
We would record a
reduction in assets
under the prepaid rent account
of $6,000 for what we used up.
Most transactions are triggered
by something, a paper trail,
a bill, an invoice.
There's actually an
exchange between the company
and a third party.
But adjusting entries
are internal entries.
There is no paper trail,
nothing to tell us
that we have to make an entry.
Instead, it's an entry
made by the company
to recognize that they
used or consumed something
that had value before--
and so it was an asset--
but it no longer has
any value because it's
being used or consumed.
It has to be moved
to an expense.
The entry is
triggered by the fact
that we have to report
to external parties.
And so we need to make sure
that only those assets that
still have future
benefit remain as assets.
All the assets that have
been used or consumed
have to be moved to an
expense account, which
is exactly what we have
done in this entry.
Let's look at both of
the entries together.
Remember that the first entry
is a transactional entry
because it's an exchange
with a third party
and it includes a paper
trail, like an invoice.
This is an external transaction.
The second entry is
an adjusting entry
because it is just c
accounts before we publish
the financial statements.
It's an internal
entry because we
adjust our records internally.
There is no paper trail to
tell us we have to do this.
Instead, we do it to
recognize use or consumption.
What would show up
on the balance sheet?
Well, only the balance at March
31st, which will be $6,000,
would show up on the balance
sheet under current assets.
Remember that there are
many other accounts that
will need to be adjusted
every reporting period.
I've listed a few here.
They all need to be
adjusted for whatever
has been used or consumed
since the last time the company
published their statements.
Adjustments can be made
either monthly, quarterly,
or annually depending
on the company.
That's it for prepaid
expenses right now.
In our next video, we'll be
focusing on unearned revenue
adjusting entries.