Difficulty: Introductory to Intermediate | Prerequisites: Chapters 1 and 2 (balance sheet equation, debits and credits, journal entries, T-accounts).
Chapters 3 and 4 move from recording transactions as they happen to handling the timing mismatches that arise between when cash moves and when revenues or expenses should be recognised. This is accrual accounting, the method required under GAAP. Chapter 3 introduces the rules for when to record revenues and expenses, and the timing differences (prepaid assets, unearned revenue) those rules create. Chapter 4 shows how to fix those timing differences at period end through adjusting entries, how to prepare financial statements from the adjusted numbers, and how to close temporary accounts so the books are ready for the next year. If the balance sheet equation and debits/credits from Chapters 1 and 2 are not solid, review those first.
Under accrual accounting, revenues are recorded when earned and expenses when incurred, regardless of when cash changes hands. Adjusting entries at period end correct timing mismatches so the financial statements reflect economic reality. Closing entries then zero out temporary accounts (revenues and expenses) and transfer net income into retained earnings.
Classified income statement
An income statement split into operating and non-operating ("other") sections. Operating items come first. In ACCT 100, only interest and gains/losses are non-operating; everything else is operating.
Revenue
An increase in assets or settlement of liabilities resulting from business operations. Recorded with a credit.
In simple terms, revenue is what the company earns by delivering goods or services.
Expense
A decrease in assets or increase in liabilities resulting from business operations. Recorded with a debit.
In simple terms, expenses are the costs of generating revenue.
Accrual accounting
The method of recording revenues when earned and expenses when incurred, regardless of when cash is received or paid. Required under GAAP.
Think of it as matching the economic event to the correct time period, even if the cash moves earlier or later.
Cash basis accounting
An alternative method (not allowed under GAAP) where revenue is recorded when cash is received and expenses when cash is paid. Simpler, but does not match revenues and expenses to the periods they belong to.
Prepaid asset (prepaid "stuff")
A payment made in advance for something the business will use later (e.g. prepaid rent, prepaid insurance). Recorded as an asset when paid, then expensed as used up.
Think of it as paying now for a future benefit. It sits on the balance sheet until you consume it.
Unearned revenue (deferred revenue)
Cash received before the company has delivered goods or services. Recorded as a liability because the company still owes the customer something. Recognised as revenue when goods or services are delivered.
A common example is selling gift cards: cash comes in, but revenue waits until the card is redeemed.
Cost of goods sold (COGS)
The expense that represents the cost of inventory that has been sold to customers. When inventory is sold, two entries are recorded: one for the revenue and one to move inventory cost into COGS.
Adjusting journal entry (AJE)
A journal entry recorded at the end of an accounting period to correct timing differences between when cash moves and when revenues or expenses should be recognised. Adjustments never change cash.
In simple terms, AJEs update the books so the financial statements reflect what actually happened economically during the period.
Depreciation
The systematic allocation of a long-term asset's cost over its useful life. Recognises that assets like equipment and buildings lose value over time.
Accumulated depreciation
A contra-asset account that holds the total depreciation recorded against an asset to date. Appears on the balance sheet as a reduction of the asset's original cost.
Net book value (carrying value)
The value of a long-term asset on the balance sheet after subtracting accumulated depreciation. Calculated as: Cost - Accumulated Depreciation.
This is not the same as market value. It is simply what remains of the asset's original cost on the books.
Interest
The cost of borrowing money (an expense for the borrower) or the earnings from lending money (revenue for the lender). Interest rates are always stated as annual rates, even if the borrowing period is shorter.
Unadjusted trial balance
A trial balance prepared before adjusting entries are recorded. Reflects account balances at the end of the period but before timing corrections.
Adjusted trial balance
A trial balance prepared after adjusting entries. Used to construct the income statement.
Post-closing trial balance
A trial balance prepared after closing entries. All temporary accounts (revenues, expenses) have zero balances. Retained earnings is updated. Used to construct the balance sheet.
Temporary accounts
Revenue and expense accounts. They accumulate activity for one period only and are zeroed out (closed) at period end.
Permanent accounts
Balance sheet accounts (assets, liabilities, stockholders' equity). Their balances carry forward from period to period. They are never closed.
Closing the books
The process of zeroing out temporary accounts and transferring their net balance (net income or net loss) into retained earnings. One large journal entry at the end of the period.
The income statement is divided into two sections:
Operating: all revenues and expenses from core business activities. This is most of the income statement.
Non-operating ("other"): interest revenue, interest expense, gains, and losses. In ACCT 100, only these items fall here.
Operating items are listed first, non-operating items after.
Revenues are recorded when earned, meaning when goods or services have been delivered to the customer. The timing of cash receipt is irrelevant.
Revenues are recorded with a credit (they increase stockholders' equity through net income).
Expenses are recorded when incurred, meaning when the business has received the benefit of something or used something up. The timing of cash payment is irrelevant.
Expenses are recorded with a debit (they decrease stockholders' equity through net income).
Under cash basis accounting (not allowed under GAAP), revenue would be recorded when cash comes in and expenses when cash goes out. Accrual accounting is more accurate because it matches economic events to the correct period.
Timing differences arise when cash moves in a different period from when the revenue or expense should be recognised.
Prepaid assets
You pay cash now for something you will use later.
At the time of payment, this is not an expense because nothing has been used up yet. Record it as an asset (future benefit).
As the prepaid item is consumed, expense it.
Example: a company prepays 12 months of rent on 1 January. On that date, debit Prepaid Rent (asset), credit Cash. Each month thereafter, debit Rent Expense, credit Prepaid Rent.
Unearned revenue
You receive cash before delivering goods or services.
This is not revenue yet because nothing has been delivered. Record it as a liability (obligation to deliver).
When goods or services are delivered, recognise revenue.
Example: a company sells gift cards. On sale, debit Cash, credit Unearned Revenue (liability). When the customer redeems the card, debit Unearned Revenue, credit Sales Revenue.
Selling inventory always requires two journal entries:
Record the sale: debit Cash or Accounts Receivable, credit Sales Revenue.
Record the cost of inventory used up: debit Cost of Goods Sold (expense), credit Inventory (asset).
The first entry records the revenue; the second recognises that the inventory is gone.
Tags: classified income statement, operating vs non-operating, accrual accounting, cash basis, revenue recognition, expense recognition, prepaid assets, prepaid rent, unearned revenue, deferred revenue, gift cards, cost of goods sold, COGS, inventory, timing differences
Purpose: bring account balances as close to economic reality as possible at the end of a reporting period.
AJEs correct timing differences created during the period (see Chapter 3).
Key rules:
Recorded at the end of the period (typically year-end). Could be done more often, but that would waste time.
Adjustments never change cash. If cash is in your adjusting entry, something is wrong.
Every AJE includes at least one income statement account (revenue or expense) and at least one balance sheet account (asset or liability).
Common examples:
Using up a prepaid asset: debit the relevant expense, credit the prepaid asset.
Earning unearned revenue: debit unearned revenue (liability), credit revenue.
Recording depreciation (see below).
Accruing interest (see below).
Long-term assets (equipment, buildings) are recorded at their original cost, but they lose value over time.
Depreciation spreads that cost over the asset's useful life.
The adjusting entry is always the same pattern:
Debit Depreciation Expense (income statement).
Credit Accumulated Depreciation (contra-asset on the balance sheet).
Net book value = Cost - Accumulated Depreciation. This is what the asset is "worth" on the books, not on the open market.
Interest is the cost of borrowing (expense) or the earnings from lending (revenue).
Interest rates are always stated as annual rates, even when the borrowing period is less than a year.
Calculation: Principal x Interest Rate x (Number of months / 12)
Example: a company borrows $10,000 at 6% annual interest on 1 October. By 31 December (3 months), the interest owed is $10,000 x 0.06 x 3/12 = $150.
The AJE at year end: debit Interest Expense $150, credit Interest Payable $150.
Three versions of the trial balance mark different stages of the accounting cycle:
Unadjusted trial balance: account balances before any adjustments. This is where Chapter 3 ends.
Adjusted trial balance: account balances after all AJEs are recorded. Used to prepare the income statement.
Post-closing trial balance: account balances after closing entries. Temporary accounts are zero. Retained earnings is updated. Used to prepare the balance sheet.
In all three versions, revenues and expenses are listed after the balance sheet accounts, with revenues before expenses.
At the start of a new year, revenues and expenses should be zero (no activity yet). That means we must zero them out at the end of each year. These are temporary accounts.
Closing is one large journal entry:
Revenue accounts have credit balances, so we debit them to bring them to zero.
Expense accounts have debit balances, so we credit them to bring them to zero.
The difference (net income or net loss) goes to Retained Earnings as the balancing amount.
If net income is positive, Retained Earnings is credited (increased).
If net income is negative (a net loss), Retained Earnings is debited (decreased).
This is the same relationship from Chapter 1: net income flows into retained earnings.
Tags: adjusting journal entries, AJE, adjustments never change cash, depreciation, accumulated depreciation, net book value, carrying value, contra-asset, interest calculation, principal times rate times time, unadjusted trial balance, adjusted trial balance, post-closing trial balance, closing the books, closing entries, temporary accounts, permanent accounts, retained earnings
Interest calculation
Interest = Principal x Annual Interest Rate x (Number of months / 12)
Always convert the period to a fraction of a year, because interest rates are annual.
Net book value
Net Book Value = Cost - Accumulated Depreciation
Closing entry relationship
Revenues (credited to zero) - Expenses (debited to zero) = Net Income, which is credited (or debited, if a loss) to Retained Earnings.
This mirrors the retained earnings equation from Chapter 1: Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earnings.
Accrual accounting is the reason a company like Netflix recognises subscription revenue month by month as the service is delivered, even though the customer may have paid for the full year upfront. That upfront payment sits as unearned revenue on Netflix's balance sheet until each month's service is provided. Similarly, airlines record unearned revenue when you buy a ticket and recognise the revenue only when you fly.
Depreciation is how companies account for the wear and tear on factories, trucks, and office buildings. When you see "depreciation expense" on a company's income statement, that is the portion of a long-term asset's cost allocated to the current year.
"If cash has not changed hands, nothing has happened." Under accrual accounting, plenty of economic events are recorded without any cash movement. Revenue can be earned before cash arrives; expenses can be incurred before cash is paid.
"Adjusting entries can include cash." They cannot. If cash appears in an AJE, the entry is wrong. Adjustments correct timing differences in non-cash accounts.
"Depreciation means the asset is losing market value." Depreciation is a cost allocation method, not a valuation method. Net book value on the balance sheet may bear no resemblance to what the asset would sell for.
"Closing entries are optional or cosmetic." They are essential. Without closing entries, revenue and expense balances would carry over into the next year, making the next year's income statement incorrect.
⚠️ Adjustments never involve cash. This is the most common trap in exam questions.
⚠️ Every AJE must include at least one income statement account and at least one balance sheet account.
⚠️ Interest rates are annual. Always convert to the relevant fraction of a year. Students frequently forget to divide by 12.
⚠️ Know the three trial balances (unadjusted, adjusted, post-closing) and which stage of the cycle each belongs to.
⚠️ Closing entries: revenues are debited to zero, expenses are credited to zero, and retained earnings absorbs the difference. Know which direction retained earnings moves for a profit vs. a loss.
True or false: Under accrual accounting, revenue is recorded when cash is received.
Answer: False. Revenue is recorded when earned (goods or services delivered), regardless of cash timing.
Fill in the blank: Adjustments never change ________.
Answer: Cash.
True or false: Depreciation Expense is debited and Accumulated Depreciation is credited in the depreciation AJE.
Answer: True.
Fill in the blank: Interest = Principal x Rate x (________ / 12).
Answer: Number of months.
True or false: After closing entries, revenue and expense accounts have zero balances.
Answer: True. They are temporary accounts and start fresh each period.
Q: A company receives $6,000 cash on 1 September for 6 months of service to be provided monthly. What is the adjusting entry on 31 December?
A: Four months of service have been delivered (September through December). Revenue earned = $6,000 x 4/6 = $4,000. AJE: Debit Unearned Revenue $4,000, Credit Service Revenue $4,000. (The initial entry on 1 September was Debit Cash $6,000, Credit Unearned Revenue $6,000.)
Q: Equipment was purchased for $120,000. After 3 years, accumulated depreciation is $36,000. What is the net book value?
A: $120,000 - $36,000 = $84,000.
Q: A company borrows $50,000 at 8% on 1 November. What interest expense has accrued by 31 December?
A: $50,000 x 0.08 x 2/12 = $666.67. The AJE: Debit Interest Expense $666.67, Credit Interest Payable $666.67.
Q: Why does a closing entry debit revenue accounts?
A: Revenue accounts carry credit balances from the period's activity. To zero them out, we debit them. The offsetting credit goes to Retained Earnings (assuming net income is positive).
Q: A company prepays $12,000 for a one-year insurance policy on 1 March. What is the adjusting entry on 31 December?
A: Ten months of insurance have been used up (March through December). Expense = $12,000 x 10/12 = $10,000. AJE: Debit Insurance Expense $10,000, Credit Prepaid Insurance $10,000.
Q: What is the difference between the adjusted trial balance and the post-closing trial balance?
A: The adjusted trial balance still includes revenue and expense account balances and is used to prepare the income statement. The post-closing trial balance is prepared after closing entries; all temporary accounts are zero, retained earnings is updated, and it is used to prepare the balance sheet.
Chapters 3 and 4 build directly on the balance sheet equation and debit/credit mechanics from Chapters 1 and 2. The adjusting and closing entries here complete the full accounting cycle: record transactions during the period, adjust at period end, prepare financial statements, close temporary accounts. Understanding this cycle is essential for later topics in the course, including more complex adjustments, ratio analysis, and multi-period reporting.
The accrual concept also connects to broader financial literacy. Any time you read a company's income statement, the numbers reflect accrual accounting, not cash flow. The statement of cash flows exists precisely because accrual income and cash flow can differ significantly.
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