Hello, I'm Professor Bryan Bouchet. 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 two 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 video and try to come up with the journal entry before I give it to you as the answer. Let's get started. On September 30th, BOC loans $100 thousand to an employee at a 12 percent interest rate. This is a cash transaction that's happening during. During the fiscal period BOC is loaning $100,000 cash. This 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 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 have 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. Of having the money outstanding to the employee over the past three months. We have a contract we're eventually going to get paid, so it meets both the earned and realized criteria. So we're going to recognize 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 that 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 principal and a 12% interest rate. Any time 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 3/12 because it's been three months. And we end up with $3,000 of interest for the three months. Now it's January 6, 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 $3,000. Because we are receiving the interest from receivable before. And if, and if we're receiving the interest receivable, it's no 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 earn $400,000 in salaries. But paychecks do not get issues until January 2. 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 earn 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. Time they worked, the 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, it 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, their cash's going to 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 a debit. So we debit rent expense for $10,000. Our rent is no longer pre paid 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 0. Next set of transactions. So it's June 30th, a customer pays BOC $60,000 for a three-year software license. So in this example, BOC is a company that sells software. We've received $60 thousand cash as BOC, so we need to debit cash for $60 thousand, but BOC hasn't delivered any of the software. Where yet, so they 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 thousand for the other viewers. BOC is going to ear $60,000 in 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 month. So $20,000 times one-half is $10,000. And BOC gets 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 it's 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 of assets. So we debit building for $500,000. Now it's 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 to recognize the depreciation for six months. The format of the depreciation journal entry always look like this. We debit depreciation expense to create the expense, and then we credit a Accumulated Depreciation. Remember a Accumulated Depreciation is a contra asset account, that's where we're going to store up the. 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? 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 two, 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 a useful life, and salvage value are managers best estimate, at the time they buy the building. Of how long the building will last and how much it'll be worth when they're 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 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 is 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 are 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 gotten to the point yet where the company can book revenue from them. So 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 past transactions that happen at different times that we recognize revenues or expenses. The differed revenue and differed 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 pre-paid asset, to bridge the gap. For accrue expenses and accrue 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 is 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 of 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 of the possible types of adjusting journal entries. I can't think of anything better to do, that, do more practice with them. And that's we'll do in the next video when we continue the Relic Spotter case. I'll see you then. >> See you next video.
