We've analyzed events and transactions and recorded them in the books, using journal entries and T-accounts. But before we can prepare the financial statements for the company, we have to make some adjustments to some of the accounts. These are called adjusting entries. To do this, we'll use journal entries and posted T-accounts, just as we did to record transactions before. What are adjusting entries? There are several things to note. First, they almost never involve cash. So, when we're doing an adjusting entry, we won't see a left hand entry or a debit. Or a right hand entry, or credit, to cash. Adjusting entries are recorded to update accounts in accordance with accrual accounting principles. So the matching principle is important to us, as we think about adjusting entries. And then finally, they're recorded generally due to the passage of time. There are two general types of adjusting entries. There are deferred revenues and expenses. Those are situations where a related cash flow had occurred in a prior period but the revenue or expense is recorded in the current period. Before closing the books this period, we need to make an entry to adjust an existing asset or liability account that was created previously when that cash effect occurred. The second general type is accrued revenues and expenses. With accrued revenues and expenses, the related cash flow impact will occur in the following period, but the revenue or expense needs to be recorded in the current period. And before closing the books this period, we need to create a new asset or liability account. Now not to worry, we'll practice this. Let's start with deferred or unearned revenues. Here, we are looking for liabilities on the books that were satisfied this period by delivering products or services during the period, that as a result should now be recorded as revenues. What are some examples? Well, one example is the payment that a publisher receives in advance from a customer for a magazine subscription. Another example is the payment that an airline receives at the time that an airline ticket is purchased, well in advance of the customer taking the flight for which he bought the ticket. Eventually, the publisher or the airline, will be able to record revenue for selling the magazine or airline ticket. But they're not able to record revenue until they've earned it. And they won't earn it until they send the customer the magazine, or complete the flight with the passenger on it. With each of these, the related cash effect occurred in the past when the company received the payment for the magazine subscription or the airline ticket. And at that time, the company recorded an increase in cash and a liability. Because by receiving the customer's cash, it incurred an obligation to provide that customer a product or service in the future. That liability account is often called deferred revenue. Other common terms for this account are unearned revenue, customer deposit or customer advance. But importantly, it's a liability account that captures that the company has incurred an obligation to give a customer something at a later date. And once it has satisfied that obligation, it will be able to record revenue. Now, the company wants to prepare financial statements for the current period. But before it can do so though, it has to make an adjusting entry, to reflect the portion of revenue for which payment was received previously that was earned during this period. So the company reduces the liability, and records revenues. Lets look now at deferred or prepaid expenses. Here we're looking for assets on the books that were used during this period to generate revenues. And that as a result of that matching principle should now be recorded as expenses. What are some examples? One example is the premiums that a company paid in advance for insurance coverage for its employees. Another example would be assets like buildings and equipment that the company purchased in the past and expects to use over a long period of time. Eventually, the company records the cost of the insurance, or the cost of the PP&E as an expense. And they will do so in each period they benefit from or use that insurance, or PP&E. With each of these, the related cash effect occurred in the past, at the point in time the insurance company purchased the insurance coverage, or the PP&E. And at that time, the company recorded a decrease in cash, and created an asset account, either prepaid insurance or PP&E. Now the company wants to prepare the financial statements for the current period. Before it can do so though, it has to make an adjusting entry, to reflect the portion of the asset for which payment was made previously, that is used during this period. So the company reduces the asset and records an expense. Now let's think about accrued revenues. Here we're looking for revenues earned during this period that have not yet been recorded and for which cash has not yet been received. What are some examples? One example is rent that the company has earned from a tenant during this period, but that the tenant will pay the following period. Another example is interest earned on the company's bank account during this period that the bank will deposit in the account in the following period. With each of these, the company has earned the right to record the revenue from the rent or the interest even though it hasn't yet received anything in cash. Now the company wants to prepare the financial statements for the current period. Before it can do so though, it has to make an adjusting entry to record these revenues that it's earned this period. But rather than recording an increase in cash, it records a receivable asset. The related cash effect will occur in the following period when the tenant pays the rent or the bank pays the interest. At that time, the company will record an increase in cash and a decrease in the receivable balance. So overall with accrued revenues, all we're doing is recording revenues the company has earned during the current period that is not yet received in cash. Okay, finally, let's look at accrued expenses. Here, we're looking for expenses that occurred during this period that have not yet been recorded, and for which cash has not yet been paid. What are some examples of these? One example is interest the company owes to the bank that it will pay to the bank the following period. Another example is the wages owed by the company to employees for work done during the current period, but that will not show up in their paychecks until the following period. Now note that in both of these examples, the company has incurred an expense in the current period. The cost of borrowing money or the cost of employees working for the company. That has helped the company generate revenues during this period. So now the company wants to prepare financial statements for the current period but before it can do so though, it has to make an adjusting entry to record these expenses, to match them to the revenues recorded this period. But rather than recorded decrease in cash, it records a payable liability, like an interest payable or a wages payable, to reflect that it has a liability to pay those in a future period. And the related cash effect of these will occur in the following period when the company makes the interest payment, or pays the employees. At which time, it will decrease that payable liability account, and record a corresponding decrease to cash. So overall, with accrued expenses, all we're doing is recording expenses the company has incurred during the current period, but has not yet paid in cash. So, we've talked about two general types of adjusting entries. With deferred revenues and expenses, the related cash flow occurred in the past. But we record the revenue or expenses in this period. While at the same time adjusting the balance in that existing liability or asset account, that was created in the past, at the time that the cash effect occurred. And with our second type, accrued revenues and expenses, the related cash flow will occur in a following period. But we go ahead and record the revenue and expense in this period, and at the same time create a new asset or liability account.
