Hello, I'm Professor Brian Bushee, welcome back. In this video we are going to wrap up the final four adjusting entries for relic spotter. Let's get started Transaction 25, the accountant asked what about the prepaid advertising account? Recall that, in transaction (9), Park paid $8,000 upfront on June 30, 2012 for advertising through June 30, 2013 We need an adjusting journal entry to recognize an expense for the six months of advertising that has been used up between June 30th, 2012 and December 31, 2012. So, we debit advertising expense to recognize the expense. And then we If the credit prepaid advertising to reduce the asset so that it's balance now is how much prepaid is going forward. I got 4,000 by taking 8,000 that we prepaid for year and realizing that half a year has gone by. So if you take half a year of 8,000, it's 4,000 for six months. How do you know that half of the prepaid advertising has been used up? What if most of the adverts ran in the first few months? Then, more than half has been used up. >> For deferred expenses, such as a prepaid asset, we allow managers to either allocate it based on time, as we're doing here, or based on usage. For example, if the manager thought that the company would have 50 advertisements run over the next year, and so far this period 30 advertisements have run, then what the manager would do is take three fifths of the prepaid asset as an expense this period and defer further remaining two fifths to next period. So we allow managers to choose whichever method they want, either usage or time based on what they think would best match the business activities of the company. >> Something else. If the manager can choose which method to use, then the manager could choose the one with the lowest expense. How do we know what the correct and true method is? >> Hate to break this to you, but there's often no true or correct way to do something in the accounting system. I often characterize adjusting entries as the creative writing part of the accounting system. We give managers discretion on how to do their adjusting entries, because we want them to best capture the true economics or the true business activities of the company. In other words we give some creative writing to the mangers, hoping their write better nonfiction books. But of course there have been cases where managers have abused this discretion, where they've used the creative writing part to write better novels or fiction books. What you have to do is learn as much accounting as possible so that you know what the options are, then think about manager's incentives to manipulate any given situation, and approach the financial statements with a healthy degree of scepticism. Which you often need to do. We post this to T-account so we post a credit to prepaid advertising. Now the balance will be $4000 which is how much is prepaid as of December 31. And we create an advertising expense T-account with a debit balance. Transaction (26) The accountant asked, what about the notes receivable account? Recall that, in transaction number ten, Park borrowed $5,000 from Relic Spotter at a 10% interest rate on June 30, 2012, with the principle and interest due in a lump sum on June 30, 2013. We need an adjusting journal entry to recognize the interest revenue that we've earned by providing the money outstanding for six months. So, we're going to credit interest revenue for 250. The debit here going to be interest receivable to represent the fact that Rebecca Park owes us $250 in cash. Now where the 250 comes from is the total interest is going to be $5,000 of principal times the 10% annual interest rate is $500 of interest per year. But it's only been six months, so we take half of that to get $250. Why isn't all $500 of interest considered interest receivable? Aren't we going to receive that much in interest between now and June? >> Actually, all $500 of interest is not necessarily receivable between now and June. Let's say Santa Claus brought Rebecca Park $5000 as a Christmas gift. So on January 2nd she decided to come in and repay the loan. On that date she wouldn't owe us $500 of interest because that's for a year, and it's only been six months. She would only owe the $250 of interest that have been accrued so far. So the other $250 is not necessarily receivable, unless the money continues to stay outstanding for the next 6 months. So we can't consider it receivable as of December 31. Then we post this journal entry to the interest receivable and to the interest revenue T accounts. Transaction (27) the accountant asked, what about the unearned revenue account? Recall that in transaction (15), the Penn Antiquities Club paid Relic Spotter $1,200 cash upfront on December 1, 2012 for unlimited rentals over the next year. We need an adjusting entry here to recognize the revenue we've earned by providing one month of unlimited rentals, so we credit rental revenue for 100. Part of our obligation has gone down by delivering one month of unlimited rentals, so we need to reduce our liability. We debit unearned rental revenue to reduce this obligation. Where does the hundred dollars come from? We got 1200 dollars up front for a whole year, one twelfth of the year has gone by so we only recognize $100 of that 1200 during the first month. >> Could this revenue be recognized based on the number of rentals, instead of based on time? >> But, wait, with the contract allowing unlimited rentals, it would seem fishy to do this based on the number of rentals. >> Yes it would seem fishy if the allocation was done based on number of rentals instead of time, when you have a contract which provides unlimited rentals. Yeah, see, you're starting to get it. It's important to understand what the actual business activities of the company are. And then you can see whether the accounting is matching those business activities. If the accounting matches the business activities as it does in the Relic Spotter case, then you could continue to feel comfortable with managers. But if you saw a mismatch, like unlimited rentals being counted for based on number of rentals in the period, then you start to get skeptical about whether managers are manipulating or not. We post this to T accounts, we put a debit in unearned rental revenue. So now the balance in this liability is going to be $1,100, which represents how much of an obligation we have on December 31st. We have to deliver 11 more months of unlimited rentals, and then we add a credit to the rental revenue T account. Transaction (28) Finally the- >> Finally!! Did I ever mention that the word finally is my favorite word in the accounting language? >> Let's try this again, Transaction (28) Finally, the accountant noted that Relic Spotter incurred an estimated income tax expense of $630 for 2012. Park was confused by this because she did not do her taxes until April. We do need an adjusting journal entry here. Even though Park's not going to file her taxes until April, she's incurred taxes by operating the business during 2012 and we have to show an expense because that's a cost of doing business. So, we're going to debit income tax expense for $630. This is money that we owe the government that's an obligation. So we need to credit a liability income tax payable for 630. Then we post this to T accounts. We create an income tax payable so that we can show on our balance sheet that we owe the IRS $630 of taxes as of December 31, and we create an expense account. Income tax expense, which has a debit balance. >> Pardon! Don't we have to do an adjusting entry for par value? I only showed up today because I thought you were going to discuss par value! >> There's no adjusting entry for par value, we only worry about par value when we issue new stock. But glad you came anyway. Okay now that we finished all the adjusting entries for Relic Spotter, all we need to do is learn about financial statements and closing entries. And then we can start doing the balance sheet and income statement for Relic Spotter. I'll see you next time. >> See you next video.
