Difficulty: Introductory to Intermediate | Prerequisites: Parts 1 and 2 of these notes (Foundations, Income Statement and Accrual Accounting)
This is the final piece of the introductory accounting puzzle. Adjusting entries correct the books at period end so that revenues and expenses land in the right period. The closing process then resets temporary accounts to zero and transfers net income into retained earnings. Together with the recording and posting steps from Part 1, these procedures form the complete accounting cycle. If you are sitting the exam, this is where the most involved procedural questions come from.
Adjusting entries fix timing differences between cash flows and the recognition of revenues and expenses. They never involve cash. Depreciation spreads the cost of long-term assets over their useful lives. After adjustments, the closing process zeros out revenue and expense accounts and moves net income into retained earnings. The full accounting cycle is a nine-step loop that repeats every period.
Adjusting journal entry (AJE)
An entry made at the end of an accounting period to update account balances so they reflect economic reality. AJEs address timing differences between when cash moves and when revenues or expenses should be recognised. Think of it as: tidying up the books before the period closes.
Depreciation
The systematic allocation of a long-term asset's cost over its useful life. In simple terms, it spreads the expense of something like a building or piece of equipment across the years the business uses it, rather than recording the entire cost in the year of purchase.
Depreciation expense
The portion of a long-term asset's cost recognised as an expense in a given period. Debited when recording the adjusting entry.
Accumulated depreciation
A contra-asset account that holds the total depreciation recognised to date on an asset. It is credited when depreciation is recorded and appears on the balance sheet as a deduction from the asset's original cost.
Net book value (carrying value)
The original cost of an asset minus its accumulated depreciation. This represents the asset's remaining value on the books, not necessarily its market value.
Contra-asset account
An account that offsets a related asset account. Accumulated depreciation is the most common example. It carries a credit balance, which is the opposite of a normal asset's debit balance.
Accrued interest
Interest that has been incurred (or earned) but not yet paid (or received). An adjusting entry records the expense or revenue and the corresponding payable or receivable.
Unadjusted trial balance
A trial balance prepared before adjusting entries are recorded. It is the starting point for the adjustment process.
Adjusted trial balance
A trial balance prepared after all adjusting entries have been posted. It is the basis for preparing the income statement and balance sheet.
Post-closing trial balance
A trial balance prepared after closing entries. It confirms that all temporary accounts have been zeroed out and that only permanent accounts (assets, liabilities, equity) remain.
Closing entries
Journal entries that transfer the balances of temporary accounts (revenues, expenses) to retained earnings at the end of the period, resetting them to zero for the next period.
Temporary accounts
Accounts that accumulate data for one accounting period only: revenues, expenses, gains, losses, and dividends. They are closed to zero at period end.
Permanent accounts (real accounts)
Accounts that carry their balances forward from one period to the next: assets, liabilities, and equity (including retained earnings). They are never closed.
To ensure revenues and expenses are recognised in the correct period (accrual basis).
To reflect the consumption of prepaid assets (e.g., insurance used up over time).
To recognise unearned revenues that have now been earned.
To record expenses that have been incurred but not yet paid (accrued expenses such as interest or wages).
To record revenues that have been earned but not yet received (accrued revenues such as interest receivable).
Without AJEs, the income statement and balance sheet would be inaccurate.
When a business action triggers recognition (e.g., delivering goods that were paid for in advance).
When the passage of time affects account balances (e.g., depreciation, accrued interest).
Adjustments are typically made at the end of the accounting period, just before preparing financial statements.
Depreciation allocates the cost of a long-term asset (building, equipment, vehicle) over its estimated useful life.
The adjusting entry each period:
Debit: Depreciation Expense (income statement).
Credit: Accumulated Depreciation (balance sheet, contra-asset).
The original cost of the asset stays on the books. Accumulated Depreciation builds up over time as a running total of all depreciation recorded.
Net book value = Original Cost minus Accumulated Depreciation. This figure represents the asset's remaining undepreciated cost, not what the asset could be sold for.
Interest represents the cost of borrowing (expense) or the income from lending (revenue).
Calculated as: Principal x Annual Interest Rate x (Months / 12).
At period end, an adjusting entry accrues any interest that has been incurred but not yet paid:
Debit: Interest Expense.
Credit: Interest Payable.
For interest earned but not yet received:
Debit: Interest Receivable.
Credit: Interest Revenue.
AJEs never involve the Cash account. If cash is changing hands, it is a regular transaction, not an adjustment.
Every AJE affects at least one income statement account (revenue or expense) and at least one balance sheet account (asset or liability).
AJEs correct timing differences, ensuring the financial statements reflect economic reality.
Unadjusted trial balance: prepared after all transactions have been journalised and posted, but before adjustments. This is the starting point.
Adjusted trial balance: prepared after adjusting entries have been recorded and posted. This is the version used to prepare the income statement and balance sheet.
Post-closing trial balance: prepared after closing entries. Only permanent accounts (assets, liabilities, equity) appear, and all temporary accounts show a zero balance.
At the end of each period, temporary accounts (revenues, expenses) must be closed to zero so they can accumulate fresh data in the next period.
Step 1: Close revenue accounts. Debit each revenue account for its balance, credit a summary account or Retained Earnings directly.
Step 2: Close expense accounts. Credit each expense account for its balance, debit the summary account or Retained Earnings.
Step 3: The net effect (revenue minus expenses = net income or net loss) is transferred to Retained Earnings.
After closing, Retained Earnings reflects the cumulative profit kept in the business, and all temporary accounts start the next period at zero.
Analyse and record transactions in journal entries.
Post journal entries to T-accounts (the ledger).
Prepare an unadjusted trial balance.
Record adjusting entries.
Prepare an adjusted trial balance.
Prepare financial statements (income statement, statement of retained earnings, balance sheet).
Record closing entries.
Prepare a post-closing trial balance.
The cycle repeats for the next period.
\text{Net Book Value} = \text{Original Cost} - \text{Accumulated Depreciation}This is the carrying value of a long-term asset on the balance sheet at any point in time.
\text{Interest} = \text{Principal} \times \text{Annual Rate} \times \frac{\text{Months}}{12}Used to calculate the amount of interest accrued over a portion of the year. For example, a $10,000 note at 6% for three months: $10,000 x 0.06 x 3/12 = $150.
\text{Straight-Line Depreciation per Period} = \frac{\text{Original Cost} - \text{Residual Value}}{\text{Useful Life in Periods}}The most common depreciation method at this level. Allocates an equal amount of expense to each period of the asset's useful life.
Depreciation is why airlines, manufacturers, and any asset-heavy business report large non-cash expenses each year. A fleet of aircraft costing billions is depreciated over 20 to 30 years, and that depreciation expense reduces reported profit even though no cash leaves the business.
Accrued interest is how banks and lenders recognise income on loans that span accounting periods. A bank that issues a loan on 1 November will accrue two months of interest revenue by 31 December, even if the borrower's first payment is not due until February.
Students often think adjusting entries can involve the Cash account. They cannot. If cash is moving, it is a regular transaction.
Students sometimes believe depreciation reduces the asset's value to what it could be sold for. Net book value is not the same as market value; it is simply the undepreciated cost remaining on the books.
Students frequently confuse the unadjusted and adjusted trial balances. The unadjusted version is the starting point; the adjusted version is what you use to prepare the financial statements.
Students sometimes think closing entries are optional. They are not. Without closing, temporary accounts would carry balances from prior periods and the income statement would be meaningless.
Expect questions asking you to prepare an adjusting entry for depreciation, prepaid expenses, unearned revenue, or accrued interest. You need to identify which accounts are affected and whether each is debited or credited.
The rule that AJEs never touch Cash is tested directly and indirectly. If your adjusting entry includes Cash, something has gone wrong.
Know the order of the nine steps in the accounting cycle. Questions may ask what comes before or after a given step.
Be prepared to explain the difference between temporary and permanent accounts, and to identify which accounts appear on the post-closing trial balance (only permanent ones).
Interest calculations using Principal x Rate x Time are a staple. Be comfortable converting months to a fraction of a year.
True or False: Adjusting entries can involve the Cash account.
Fill in the blank: Net Book Value = Original Cost minus __________.
True or False: Revenue accounts appear on the post-closing trial balance.
Fill in the blank: When recording depreciation, you debit __________ and credit __________.
True or False: The adjusted trial balance is prepared before adjusting entries are recorded.
Answers: 1. False. 2. Accumulated Depreciation. 3. False (revenue is a temporary account and is closed to zero). 4. Depreciation Expense; Accumulated Depreciation. 5. False (it is prepared after adjusting entries).
Q: A company purchased equipment for $60,000 with a useful life of 10 years and no residual value. What is the annual depreciation expense using straight-line depreciation?
A: $60,000 / 10 = $6,000 per year. The adjusting entry each year debits Depreciation Expense $6,000 and credits Accumulated Depreciation $6,000.
Q: After three years, what is the net book value of the equipment in the question above?
A: Original cost $60,000 minus accumulated depreciation of $18,000 (3 x $6,000) = $42,000.
Q: A company borrows $20,000 at 9% annual interest on 1 October. What adjusting entry is needed on 31 December?
A: Three months of interest have accrued: $20,000 x 0.09 x 3/12 = $450. Debit Interest Expense $450, credit Interest Payable $450.
Q: What is the purpose of closing entries?
A: To reset temporary accounts (revenues, expenses) to zero and transfer the net income (or net loss) to Retained Earnings, so that the next period starts with a clean slate for measuring performance.
Q: Which of the following appear on the post-closing trial balance: (a) Sales Revenue, (b) Cash, (c) Depreciation Expense, (d) Retained Earnings, (e) Accounts Payable?
A: (b) Cash, (d) Retained Earnings, and (e) Accounts Payable. These are permanent accounts. Sales Revenue and Depreciation Expense are temporary and have been closed to zero.
Adjusting entries rely on the revenue recognition and matching principles from Part 2. The closing process connects the income statement to the balance sheet by moving net income into retained earnings (covered in Part 1). Depreciation reappears in more advanced courses when you study different methods (declining balance, units of production) and impairment. The accounting cycle as a whole is the procedural backbone for everything that follows in intermediate accounting.
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