 Hello and welcome to the session. This is Professor Farhad and the session we would look at introduction to adjustments. This topic is typically covered in a financial accounting course as well as intermediate accounting course, also covered heavily on the CPA exam. What I'm gonna do first, I'm gonna lay the groundwork for adjustments. Why do we need adjustments? Why is that necessary? Then in the next following sessions, I would look at each adjustment separately and explain them. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,600 plus accounting, auditing, finance and tax lectures. Please, if you like my lectures, please like them, it doesn't cost you anything. Click on the like button, share them, put them in playlist. If they benefit you, it means they might benefit other people as well and connect with me on Instagram. If you need additional resources, please visit my website farhadlectures.com. You'll have access to material, multiple choice through false, the notes, the PowerPoint slides. And if you're studying for your CPA exam, 2000 plus CPA questions. So let's take a look at the idea of adjustments. Why do we need adjustments? Why do we need to prepare adjustments? Well, we have an accounting, something called the accounting period concept or the periodicity concept. Simply put, what is this concept and how does it fit into this picture? Well, the life of any company can be broken down artificially. For example, we can take the company and usually even if you are not a medium or a large company or publicly traded, at least annually, you have to sit down and prepare your taxes, at least annually. So basically most businesses, at least they have to prepare their financial statements or they have to report annually on their performance, even though they don't have to report to a bank or investors or anybody else, they have to report for taxes. So some companies might report their financial statements annually. So that's their period. Some companies, they may break down the life of the company into two artificial period and they might report semi-annually. So every six months, they will prepare the financial statements. Okay, here we'll prepare the financial statements once a year. Why would you prepare the financial statements on a semi-annual basis? For example, you have investors, you have creditors, they want to know how well the company is doing or not doing so you prepare financial statements for them. That's why you wanna do it on a semi-annual basis but they're okay, they can wait six months but beyond six months, they don't want to wait. Some businesses, guess what? They want to report, they want their financial statements on a monthly basis. Every month they want the financial statements. Well, a case in point is what I used to practice accounting. What I used to practice accounting, we had a lot of customers that were MDs, medical doctors, dentists or just general doctors. And what they wanted, or at least my partner convinced them that having monthly financial statements will be beneficial for them, which it is because you know what's going on on a monthly basis, what's going on with your practice. So what we did is we'd prepare financial statements every month, that's fine. It's gonna cost more money but it's gonna give them more value. But as we prepare those financial statement constantly, we get efficient at doing so and the timing it will take us to do so it will go down. But that's a monthly reporting period or we can do it quarterly. Now quarterly is very common, not common, it's mandatory. It's common in the sense that everyone has to do it. It's mandatory for publicly traded companies. So publicly traded companies, they have to report on a quarterly basis and there is no really such thing as a fourth quarter. They have to report the annual. So for the whole year. So publicly traded companies, they have to. They have to report their financial statements on a quarterly basis. Now any period other than a full year, it's called interim financial reporting. Interim financial reporting. And let's talk about annually. You could be annually January 1st till December 31st. We call this the calendar year or you could be any 12 month other than January 1st to December 31st. We call this the physical year. Now we need to talk about another term that's important. It's the difference between accrual and cash accounting. So we have accrual basis and cash basis of accounting. So we need to know what is accrual and what is cash basis? Well, we're gonna start with cash basis. It all has to do accrual and cash basis has to do with when do we recognize revenue? When do we recognize when? When do we recognize revenue? And when do we recognize expenses? So simply put, at what point do we recognize revenue? At what point do we recognize expenses? Starting with the cash basis, very easy. We recognize revenue when cash is received. Very simple concept. If I have the revenue, if they paid me its revenue, that's it. Expenses are recorded when the cash is paid. Obviously cash, cash in, cash out. So the cash basis is basically based on the cash. If you paid cash, it's an expense. If you received cash, it's a revenue. And that's very simple and easy to understand. However, that's not the method that we learn, nor that's the method for generally accepted accounting principle. The method that we need to learn is, which is we already kind of learned it without even calling it accrual, is the gap basis, which is accrual basis. So under accrual basis, when do we recognize revenue? We recognize revenue when the product or services are delivered. Simply put, when we earn it. Earn it means we did the work. If we earn something, it means we completed the work. I cannot bill you for something if I did not do the work for you. So once I can bill you, it means I did the work. It means it's revenue for me. You may pay me immediately, okay? So you may pay me now or you may pay me later. Regardless, whether you pay me now or pay me later, I have revenue as long as I can bill you, as long as I did the work for you. Now, when do we recognize expenses under the accrual? We recognize expenses when they are incurred. What does it mean incurred? It means if they happened, if we have the obligation for the expense, then we have an expense. We don't have to pay it in cash yet, but we still have an expense. I always ask my students to kind of think about this. For example, we are in January, February. And let's assume you paid your rent for January. You paid your rent. You had the rent expense, but you paid it. In February, you don't have money to pay your rent. No money. Do you still have an expense? Yes, you do. Although you did not pay it, you still have an expense because now you are responsible for paying it. Although you did not pay it, you still have an expense. We're gonna see what do we call this later. We call this accrued expense, but we'll hold on that on the terminology. But the point is you have an expense as long as the expense did was incurred. And the best way to illustrate the accrual versus cash is just to look at a quick example. Then we're gonna work with this a little bit further when we work the adjustments. But the adjustments are based on the accrual basis and based on the periodicity principle where revenues and expenses have to be reported in the correct period. So let's take a look at this transaction. First, it treated as on a cash basis. Then we treat it as an accrual basis just to see the difference. Let's assume a company paid 2,400 for 24 month insurance policy beginning December 1st. Here's what's gonna happen. Under the cash basis, what do I do? Under the cash basis, I paid, therefore I have an insurance expense 2,400, credit cash 2,400. I have an expense. This is EXP or expense damages. Under the cash basis, I have an expense. So on December 31st, I paid 2,400 cash. Using the cash basis, the entire 2,400 would be recognized as an insurance expense in 2019. And notice this month is highlighted in yellow to tell you the insurance expense took place on in December of 2019 when I made the payment. So no insurance expense from the policy would be recognized in 2020, 2021, which is that's what we learned. We learned that when we prepay for something, it's an asset initially, then we expense it later. So let's look, this is the cash basis. Let's look how we treat this transaction under the accrual basis. Under the accrual basis, what's gonna happen is this. We have, we paid 2,400. We're gonna divide this by 24 month and we're gonna expense it $100 a month. Therefore for December, we're only gonna expense 100 for 2019. For 2020, we're gonna expense 100 each month. And for 2021, we're gonna expense the remaining 11 month. So on the accrual basis, 100 of insurance expenses recognized in 2019, 1,200 in 2020 and 1,100 in 2021. So what we did is we took the expense and we spread out the expense over the period it covers because this insurance policy doesn't only cover 2019 because under the cash basis, it's as if it only covered 2019. That's all with the expense took place. Well, the expense should take place over 2019, 2020 and 2021, 11 month in 2021 because it's serving those periods. So the expense must be matched. The expense is matched with the period benefited by the insurance coverage. Therefore, what do we do when we buy the policy initially? When we buy the policy initially on December 1st, we're gonna debit a prepaid insurance 2,400 and we're gonna credit cash versus an expense when we debit it earlier. So this is prepaid insurance. Remember, this is an asset. Then we're gonna learn later on. We need to adjust this account. We'll work on that shortly. Two more topics. I just wanna make sure we cover them one more time although we kind of cover them directly or indirectly recognizing revenue. Okay, the revenue recognition required that revenue must be recorded when the goods or services are provided to customer and at any amount expected to be received from the customer. Simply put, you did the work. How much do you expect to receive? This is the revenue recognition which is the revenue recognition under accrual. Expenses or the expense recognition or the matching require that expenses be recorded in the same accounting period as the revenue that are recognized as a result of those expenses. This is matching of expenses with the revenue benefit as a major part of the adjusting process. Remember for the insurance policy, we did not expense the whole thing in December of 2019. The reason is because we're gonna give all the expense for one period and that's not true. We have to match the expense to the period at generating revenue which is one month in 2019, 12 month in 2020 and 11 month in 2021. So we are here complying with the recognizing expenses or the matching principle. So having setting all this information, we're gonna learn about four types of adjusting entries that help us comply with the time period assumption with revenue recognition and expense recognition. Okay, that's why we have those is we wanna make sure the revenue is reported in the prior period, expenses are reported in the prior period. To do so, we're gonna deal with four types of adjustments and the four types are the furl of expenses or prepaid expenses. This is also called prepaid expenses, the furl or revenue or this is called unearned revenue. So those two are called the furls, the furls. Then we have two more. One is called accrued expenses and one is called accrued revenue. Those are called accruals. Okay, so we have four types of adjustments, two deferrals and two accruals. What are we gonna do? We're gonna go over each one of them separately, each one of them separately and those adjustments, they will help us make sure our financial statements are properly reported. So how do we prepare the adjustments? Well, it's a three step process which I will go over when we'll do on this but if you're gonna copy this down, first determine what the account, what is the current account balance? So what is the balance now that's showing on the trial balance and we have to determine what is the balance should be? What is the balance should be? What is it now and what it should be? If it's now a hundred and it should be a hundred, I have no adjustment to make. If it is now 100 and it should be 80 then I have to reduce it by 20. If it's 100 and it's supposed to be 120 I need to increase it by 20. So this is how we prepare adjustments. We need to know what's the balance now and what's the balance should be, what's the correct balance and we make the adjustments. So we take the difference between step one and step two and prepare the proper adjustments. Now, this will not make any sense unless we look at actual adjustments and the first adjustments we're gonna be looking at is the fertile of expenses or prepaid expenses which we'll see in the next session. As always, I would like to remind you if you're looking for additional practice, exercises, additional help studying for your CPA exam, visit my website, invest in your career. It's a long-term investment. Study hard, accounting is worth it. 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