Difficulty: Introductory to Intermediate | Prerequisites: Basic understanding of debits and credits, familiarity with the accounting equation from introductory financial accounting.
Chapter 2 of intermediate accounting revisits the full accounting cycle you first met in introductory courses, but with sharper focus on why each step exists and how adjusting entries bridge the gap between cash movements and economic reality. This material sits at the foundation of everything that follows in ACCTG 471: if you cannot trace a transaction from source document through to the financial statements, later topics (revenue recognition, leases, pensions) will feel unmoored.
You should already be comfortable with the basic accounting equation and the idea that every transaction has a dual effect. If terms like "debit" and "credit" still feel slippery, revisit your introductory notes before going further.
The accounting equation (Assets = Liabilities + Shareholders' Equity) is the backbone of every financial statement. The accounting cycle is a 10-step process that starts with identifying transactions during the period, records and posts them, adjusts for accruals, deferrals and estimates, produces financial statements, and closes temporary accounts at year-end so the next period starts clean.
Economic event
Any event that directly affects the financial position of a company, whether external or internal. In simple terms, anything that changes what a company owns, owes, or is worth.
External event (financial accounting transaction)
An exchange between the company and a separate economic entity, such as purchasing merchandise for cash, borrowing from a bank, or paying salaries. Think of it as: any time something crosses the company's boundary, going in or out.
Internal event
An event within the company that affects financial position without an outside party being involved. Examples include depreciation of equipment and use of supplies. Think of it as: the company "using up" its own resources over time.
Permanent accounts (real accounts)
The balance sheet accounts: assets, liabilities, and shareholders' equity. Their balances carry forward from one period to the next. In simple terms, these accounts never get zeroed out at year-end.
Temporary accounts (nominal accounts)
Accounts that track changes in the retained earnings component of shareholders' equity during a single period: revenues, expenses, gains, losses, and dividends. They are closed to zero at the end of each fiscal year. Think of it as: these accounts measure "what happened this year" and then reset.
Journal
A chronological record of all economic events affecting a company, recorded using debits and credits. A special journal handles repetitive transaction types; the general journal records everything else. In simple terms, the journal is the company's diary of transactions.
General ledger
The collection of all of a company's individual accounts. Journal entries are posted (transferred) here so each account has its own running balance. Think of it as: if the journal is a diary, the ledger is an organised filing cabinet, one drawer per account.
Trial balance
A list of all general ledger accounts and their balances at a point in time. Its purpose is to confirm that total debits equal total credits. In simple terms, a quick check that nothing is out of balance before you move on.
Source documents
The original records that provide evidence a transaction occurred: invoices, bills from suppliers, cash register tapes, bank statements. Think of it as: the paper trail.
Posting
The process of transferring debits and credits from journal entries to the individual accounts in the general ledger.
Income summary
A temporary holding account used during closing. Revenues and expenses are closed into it, and then its balance is closed to retained earnings. It is a bookkeeping convenience that confirms all temporary accounts have been properly closed.
Assets = Liabilities + Shareholders' Equity
Read another way: total economic resources of an entity = total claims against the entity. Every transaction must keep this equation in balance.
Shareholders' Equity (SE) = Paid-in Capital + Retained Earnings
Retained Earnings = Revenues (and gains) – Expenses (and losses) – Dividends
Dividends are owners' transactions: distributions from the corporation to its owners. They reduce retained earnings, not expenses.
Change in Assets = Change in Liabilities + Change in Shareholders' Equity
Ending SE = Beginning SE + Change in SE
Change in SE = Net Income – Dividends + Stock Issued
You will typically be given beginning SE and need to compute ending SE.
Increase with a debit:
Assets
Expenses and losses (these decrease retained earnings)
Dividends
Increase with a credit:
Liabilities
Paid-in capital
Retained earnings
Revenues and gains
A useful mnemonic: assets and expenses live on the left (debit) side of the equation; liabilities, equity and revenues live on the right (credit) side.
Permanent accounts are the balance sheet elements: assets, liabilities, shareholders' equity. Their balances carry forward indefinitely.
Temporary accounts track period-specific activity in retained earnings: revenues, expenses, gains, losses, and dividends. At year-end, these are closed (zeroed out) so the next period can measure fresh activity. The net effect of closing flows into the permanent retained earnings account.
Step 1: Identify external transactions
Look at source documents (invoices, bills, cash register tapes) to find events that affect the accounting equation.
Step 2: Analyse the transaction
Determine the dual effect on the accounting equation.
Identify which accounts are affected and in which direction.
Step 3: Record in a journal
Enter the transaction chronologically using debits and credits.
Special journals handle repetitive transactions (e.g. sales journal, purchases journal). The general journal catches everything else.
Step 4: Post to the general ledger
Transfer each debit and credit from the journal to the relevant account in the general ledger.
After posting, every account has a running balance.
Step 5: Prepare the unadjusted trial balance
List every general ledger account with its balance.
Confirm that total debits = total credits. This is a completeness check, not a guarantee of accuracy (errors that cancel out will not show here).
Step 6: Record adjusting entries and post them
Adjusting entries ensure that revenues and expenses are recognised in the correct period regardless of when cash changes hands.
Three categories of adjustments:
Prepayments/deferrals: cash flow comes before the expense or revenue is recognised. Includes deferred (unearned) revenue and prepaid expenses.
Accruals: expense or revenue is recognised before cash flow. Includes accrued liabilities (expenses incurred but not yet paid) and accrued receivables (revenue earned but not yet received).
Estimates: depreciation expense (requires estimates of useful life and residual value) and bad debt expense (requires an estimate of uncollectible accounts receivable).
Step 7: Prepare the adjusted trial balance
A new trial balance after adjusting entries have been posted. Again, total debits must equal total credits.
Step 8: Prepare the financial statements
Income statement, statement of comprehensive income, balance sheet, statement of cash flows, and statement of shareholders' equity are produced from the adjusted trial balance. (Covered in detail in the second set of notes.)
Step 9: Close temporary accounts
Revenue accounts are debited and retained earnings is credited.
Expense accounts are credited and retained earnings is debited.
Income summary collects these, then is itself closed to retained earnings.
Dividends are closed directly to retained earnings.
After closing, every temporary account has a zero balance, ready for the new period.
Step 10: Prepare the post-closing trial balance
Verify that closing entries were posted correctly by confirming total debits still equal total credits.
Only permanent accounts (assets, liabilities, equity) should remain with balances.
Students often think "debit" means "increase" and "credit" means "decrease." That is only true for assets and expenses. For liabilities, equity, and revenues, credits increase the balance.
Dividends are frequently misclassified as an expense. Dividends are a distribution to owners and reduce retained earnings directly; they never appear on the income statement.
A trial balance that balances does not guarantee that the books are error-free. If you debit and credit the wrong accounts by equal amounts, the trial balance still balances.
Students sometimes confuse the unadjusted trial balance (Step 5) with the adjusted trial balance (Step 7). Adjusting entries have not yet been recorded at Step 5, so revenue and expense figures are incomplete at that stage.
⚠️ The equation Change in Assets = Change in Liabilities + Change in SE is a near-certain exam question. Be ready to compute ending SE from beginning SE, net income, dividends, and stock issued.
⚠️ Know which accounts are debited and which are credited for each type of adjusting entry (deferrals, accruals, estimates).
⚠️ Understand why temporary accounts must be closed and what happens to their balances during the closing process.
⚠️ Be able to distinguish between the three trial balances (unadjusted, adjusted, post-closing) and explain the purpose of each.
True or False: Assets are increased with a credit.
False. Assets have a normal debit balance.
Fill in the blank: Ending Retained Earnings = Beginning Retained Earnings + ______ – ______ – ______.
Net Income – Expenses (already netted) – Dividends. More precisely: + Net Income – Dividends.
True or False: A balanced trial balance guarantees that all transactions have been recorded in the correct accounts.
False. Errors that affect both sides equally will not be caught.
True or False: Temporary accounts include assets and liabilities.
False. Temporary accounts are revenues, expenses, gains, losses, and dividends.
Fill in the blank: The post-closing trial balance should contain only ______ accounts.
Permanent (assets, liabilities, shareholders' equity).
Q: A company has beginning shareholders' equity of $200,000, net income of $45,000, dividends of $10,000, and issued $30,000 in new stock. What is ending shareholders' equity?
A: Ending SE = $200,000 + $45,000 – $10,000 + $30,000 = $265,000.
Q: An attorney invests $50,000 cash to open a law office. What is the journal entry?
A: Debit Cash $50,000; Credit Common Stock (or Owner's Equity) $50,000.
Q: A company borrows $40,000 from a bank by signing a note payable. What accounts are affected and how?
A: Debit Cash $40,000 (asset increases); Credit Notes Payable $40,000 (liability increases).
Q: What is the purpose of adjusting entries?
A: To ensure that revenues and expenses are recognised in the period in which they are earned or incurred, regardless of when cash is received or paid. They bridge the gap between cash-basis and accrual-basis accounting.
Q: During closing, how are revenue accounts closed?
A: Debit each revenue account for its balance (reducing it to zero) and credit Retained Earnings (or Income Summary) for the same amount.
Q: Why does the post-closing trial balance contain only permanent accounts?
A: Because all temporary accounts (revenues, expenses, gains, losses, dividends) have been closed to retained earnings. Only balance sheet accounts carry a balance into the next period.
The accounting cycle is the scaffold for every later chapter. Revenue recognition (Ch. 5) builds directly on the accrual and deferral adjusting entries covered here. The balance sheet and income statement formats introduced in this chapter reappear in discussions of financial statement analysis, earnings quality, and disclosure requirements. Understanding permanent vs. temporary accounts is essential when you reach the statement of cash flows, where you reconcile accrual-basis net income back to cash.
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