Now is the perfect time to go through probably the most important concept in
current accountant practice, that is accrual accounting.
To understand accrual accounting, what I'm going to do is that
I'm going to remind you two individual financial transactions we went through for
Illinois Supermarket in year two.
These were payment of insurance premium of 1,000 and
payment of employee salaries of 5,000.
So let me change these questions a little bit.
Suppose that half of the insurance payment, which is 500 is prepayment for
next year's insurance.
Suppose also that employees earn $5,000, but they are not paid yet.
My question is, what happens?
So let's remember the original solution for year 2002.
There was an insurance payment of $1,000, cash goes down and
then it's going to record as insurance expense in income statement.
Similarly, if you pay employees $5,000 there's a cash reduction of $5,000 and
then it's also recorded as an breach expense on income statement, but
we change the questions.
We said, for example, out of insurance payment of $1,000, 500
is related to pre-payment of next year's insurance, how am I going to record this?
First of all, it is no wonder that cash will go down by $1,000 we paid.
Out of this 1,000 payment, half of this is this year's,
this year is 2017, insurance expense.
Therefore, it's going to be recorded as a reduction from income statement.
But what I'm going to do with the prepayment?
This prepayment will be recorded as a prepaid expense account under assets.
So how do we go through our updated questions?
The first one was there is an insurance payment of $1,000, but half of this
insurance payment is a prepayment for next year insurance, how will we record this?
First of all there is a reduction of $1,000 in cash because we pay this.
Out of this $1000, half of this is related to year 2017's insurance expense.
Therefore, it is recorded as reduction from income statement.
And the next remaining $500, which is the pre-payment for
next year insurance will be recorded as prepared expenses.
In accounting, then we prepare for example sum rents, some insurance.
We record this as a prepared expenses.
Note this is a prepared expense account, but it is recorded as an asset.
This is a resource that we are going to use next year.
How about the next one?
Our employees earn, but are not paid, $5,000 yet.
Since they earn it,
I'm going to record this $5,000 as an aging expense on the income statement.
On the other hand, I'm not paying them yet.
But I'm going to pay in the future,
therefore this $5,000 will be recorded as accounts payable.
In general, accounts like prepared expenses, accounts payable,
account receivable are called accruals.
What is accruals or accrual accounting?
Under accrual accounting we are going to use adjusting entries
to ensure that the account it reflects economic reality of the firm.
So what do I mean?
For example, look at the employees.
All the employees worked for us, they earned $5,000 but I'm not paying them yet.
Although I'm not paying them yet,
I'm still recording this in our transaction worksheet.
Whether you pay or not doesn't matter here.
As long as they earn this money, it's going to be recorded as a wage expense.