Managerial/Cost Accounting, UT Austin | Units 6–7
Difficulty: Intermediate Prerequisites: Units 4–5 study notes (the accounting equation, debits and credits, journal entries, and the trial balance).
Unit 6 introduces accrual accounting in full: the revenue and expense recognition principles, the time period assumption, and the four types of adjusting entries that bring the trial balance up to date. Unit 7 completes the accounting cycle with the worksheet, closing entries, the post-closing trial balance, and the classified balance sheet. If Units 4–5 taught you how to record transactions, Units 6–7 teach you how to tidy everything up at period-end so the financial statements are accurate.
Adjusting entries (Unit 6) fix timing mismatches so revenues and expenses land in the right period. Closing entries (Unit 7) zero out temporary accounts and move net income into retained earnings, resetting the books for the next period.
Fiscal year
An accounting period of one year. It usually begins on the first day of a month and ends 12 months later on the last day of a month. It need not follow the calendar year.
Time period assumption
The economic life of a business can be divided into artificial time periods (months, quarters, years) for reporting purposes.
Revenue recognition principle
Revenue is recognised when the performance obligation is satisfied, regardless of when cash is received.
Expense recognition principle
Expenses are recorded in the same period as the revenues they help generate. "Let the expenses follow the revenues."
Adjusting entries
Journal entries made at the end of a period to ensure revenues and expenses are recorded in the correct period. They never involve cash, always affect one balance sheet account and one income statement account, and occur because of the passage of time.
Deferrals
Transactions where cash moves before the related revenue or expense is recognised. "Defer" means to postpone.
Prepaid expenses
Expenses paid in cash before they are used or consumed (e.g., insurance paid in advance). Before adjustment, assets are overstated and expenses are understated.
Unearned revenues
Cash received before services are performed (e.g., a magazine subscription paid up front). Before adjustment, liabilities are overstated and revenues are understated.
Accruals
Transactions where the revenue or expense is recognised before cash moves. "Accrue" means to accumulate.
Accrued revenues
Revenues earned but not yet received in cash or recorded (e.g., interest earned but not yet collected). Before adjustment, both assets and revenues are understated.
Accrued expenses
Expenses incurred but not yet paid in cash or recorded (e.g., salaries owed but not yet paid). Before adjustment, both liabilities and expenses are understated.
Depreciation
The process of allocating an asset's cost to the periods in which it is used. It does not attempt to measure the asset's change in market value.
Accumulated depreciation
A contra asset account. It is subtracted from the related asset on the balance sheet to arrive at book value.
Book value
The cost of a depreciable asset minus its accumulated depreciation.
In simple terms, this means: how much of the asset's original cost has not yet been expensed.
Contra asset account
An account that is offset against an asset account on the balance sheet. It carries a credit balance (the opposite of a normal asset) and reduces the reported value of the asset.
Worksheet
A multiple-column form used to organise the adjustment process and prepare financial statements. Its use is optional.
Temporary accounts
Accounts that relate only to a single accounting period and are closed (zeroed out) at the end of the period. Includes all revenue accounts, all expense accounts, and dividends.
Permanent accounts
Accounts that carry balances into future periods and are never closed. Includes all asset accounts, all liability accounts, and stockholders' equity accounts.
Closing entries
Journal entries that transfer the balances of temporary accounts to retained earnings and reset those accounts to zero for the next period.
Income summary
A temporary account used during the closing process to collect all revenues and expenses before transferring the net amount to retained earnings.
Post-closing trial balance
A trial balance prepared after all closing entries have been posted. It contains only permanent accounts, all with their correct ending balances.
Classified balance sheet
A balance sheet that groups similar assets and similar liabilities into standard classifications (current and non-current).
Operating cycle
The average time it takes to purchase inventory, sell it on account, and collect cash from customers.
Current accounts
Accounts expected to be used, collected, or paid within 12 months or the operating cycle, whichever is longer.
Non-current accounts
Accounts expected to be used, collected, or paid over a longer period.
Accrual accounting records transactions when the economic event occurs. Revenue is recognised when the performance obligation is satisfied, and expenses are recognised when incurred. Cash accounting, by contrast, records transactions only when cash changes hands. GAAP requires accrual accounting because it matches expenses with the revenues they help generate, producing a more accurate picture of profitability.
The trial balance may not contain up-to-date and complete data at period-end. Adjusting entries correct for timing differences so that the financial statements reflect the right amounts of revenue and expense for the period.
Key properties of adjusting entries:
Recorded at the end of the period.
Never involve cash.
Each one affects one balance sheet account and one income statement account.
Triggered by the passage of time, not by a new transaction.
1. Prepaid expenses (deferral)
Cash was paid before the expense was incurred (e.g., a 12-month insurance policy paid in advance). Before adjustment, assets are overstated and expenses are understated.
Adjustment: Debit the expense account, credit the asset account.
2. Unearned revenues (deferral)
Cash was received before the service was performed (e.g., a magazine subscription). Before adjustment, liabilities are overstated and revenues are understated.
Adjustment: Debit the liability account (unearned revenue), credit the revenue account.
3. Accrued revenues (accrual)
Revenue has been earned but not yet received in cash or recorded (e.g., interest earned on a loan). Before adjustment, both assets and revenues are understated.
Adjustment: Debit the asset account (accounts receivable or interest receivable), credit the revenue account.
4. Accrued expenses (accrual)
An expense has been incurred but not yet paid in cash or recorded (e.g., salaries owed to employees for work already done). Before adjustment, both liabilities and expenses are understated.
Adjustment: Debit the expense account, credit the liability account (salaries payable or interest payable).
Type | Before adjustment | Adjustment debit | Adjustment credit |
|---|---|---|---|
Prepaid expense | Assets overstated, expenses understated | Expense | Asset |
Unearned revenue | Liabilities overstated, revenues understated | Liability | Revenue |
Accrued revenue | Assets and revenues understated | Asset | Revenue |
Accrued expense | Liabilities and expenses understated | Expense | Liability |
Depreciation allocates the cost of a long-lived asset across the periods in which it is used. It does not measure the asset's decline in market value.
The adjusting entry: Debit Depreciation Expense, Credit Accumulated Depreciation (a contra asset account). Accumulated Depreciation is subtracted from the asset's cost on the balance sheet to arrive at the asset's book value.
Book Value = Cost - Accumulated Depreciation
Accumulated Depreciation has a normal credit balance, which is the opposite of a normal asset. It increases with credits (as more depreciation is recorded) and decreases with debits.
A worksheet is a multi-column form that organises the adjustment process. Its use is optional, but it speeds up the preparation of financial statements.
Five steps:
Prepare the trial balance on the worksheet.
Enter the adjustment data in the adjustment columns.
Compute and enter adjusted balances.
Extend adjusted balances to the appropriate statement columns (income statement or balance sheet).
Total the statement columns, compute net income or net loss, and complete the worksheet.
The adjusted trial balance is obtained by combining the trial balance figures with the adjustments. The income statement and retained earnings statement are prepared from the adjusted trial balance.
If total credits exceed total debits in the income statement columns, the result is net income. The net income figure is entered as a debit in the income statement column (to balance it) and as a credit in the balance sheet column (reflecting the increase in stockholders' equity).
If total debits exceed total credits, the result is net loss. The net loss figure is entered as a credit in the income statement column and as a debit in the balance sheet column.
After entering net income or net loss, the debit and credit totals in the income statement columns must match, and the debit and credit totals in the balance sheet columns must match.
Temporary accounts: relate to a single period and are closed (zeroed out) at period-end. Revenue accounts, expense accounts, and dividends.
Permanent accounts: carry balances into future periods and are never closed. Asset accounts, liability accounts, and stockholders' equity accounts (common stock, retained earnings).
Debit each Revenue account for its balance; credit Income Summary for total revenues.
Debit Income Summary for total expenses; credit each Expense account for its balance.
Debit Income Summary; credit Retained Earnings for the amount of net income. (If there is a net loss, the entry is reversed.)
Debit Retained Earnings for the balance in the Dividends account; credit Dividends for the same amount.
After closing, the Income Summary account has a zero balance, every revenue and expense account has a zero balance, and the Dividends account has a zero balance. Retained Earnings now reflects its updated, period-end figure.
A trial balance prepared after all closing entries have been posted. Because every temporary account is now zero, the post-closing trial balance contains only permanent accounts.
A classified balance sheet groups assets and liabilities into current and non-current categories.
Current: expected to be used, collected, or paid within 12 months or the operating cycle, whichever is longer.
Non-current: everything else.
Analyse business transactions.
Journalise the transactions.
Post to ledger accounts.
Prepare a trial balance.
Journalise and post adjusting entries (deferrals and accruals).
Prepare an adjusted trial balance.
Prepare financial statements (income statement, retained earnings statement, balance sheet).
Journalise and post closing entries.
Prepare a post-closing trial balance.
Students often think adjusting entries involve cash. They never do. If cash is part of the entry, it is a regular transaction, not an adjustment.
A frequent error is confusing prepaid expenses with accrued expenses. Prepaid expenses involve cash paid before the expense is recognised (cash first, expense later). Accrued expenses involve the expense being recognised before cash is paid (expense first, cash later).
Students sometimes close permanent accounts. Assets, liabilities, and equity accounts are never closed. Only revenue, expense, and dividend accounts are closed.
Depreciation is often misunderstood as measuring the asset's decline in market value. It does not. It is a cost allocation method that spreads the asset's cost over its useful life.
Students forget that each adjusting entry must touch one balance sheet account and one income statement account. An adjusting entry that affects two income statement accounts or two balance sheet accounts is incorrect.
⚠️ You will almost certainly be given a scenario and asked to write the adjusting entry. Know the four types cold: prepaid expenses, unearned revenues, accrued revenues, accrued expenses.
⚠️ Be able to identify what is overstated or understated before each adjustment and what the adjustment corrects.
⚠️ Depreciation questions are common. Know that the debit goes to Depreciation Expense and the credit to Accumulated Depreciation (not to the asset account directly).
⚠️ The closing process is a favourite multi-step question. Memorise the four closing entries and the order they follow.
⚠️ Expect a question asking which accounts appear on the post-closing trial balance. The answer: only permanent accounts (assets, liabilities, and equity). All temporary accounts have been zeroed out.
⚠️ Know the full nine-step accounting cycle and be able to put the steps in order.
True or False: Adjusting entries may involve debits or credits to cash.
Answer: False. Adjusting entries never involve cash.
Fill in the blank: Before adjusting for prepaid expenses, assets are ______ and expenses are ______.
Answer: Overstated; understated.
True or False: Revenue accounts are permanent accounts.
Answer: False. Revenue accounts are temporary and are closed at the end of the period.
Fill in the blank: Book Value = Cost - ______.
Answer: Accumulated Depreciation.
True or False: The post-closing trial balance includes expense accounts.
Answer: False. All expense accounts have been closed to zero. Only permanent accounts remain.
Q: A company paid $12,000 on 1 January for a 12-month insurance policy. On 31 March, what adjusting entry is needed?
A: Three months of insurance have been used ($12,000 / 12 = $1,000 per month, so $3,000 total). Debit Insurance Expense $3,000, Credit Prepaid Insurance $3,000.
Q: A company received $6,000 in advance for services on 1 February. By 28 February, it has performed one-third of the work. What is the adjusting entry?
A: Debit Unearned Revenue $2,000, Credit Service Revenue $2,000. The liability decreases by the amount earned.
Q: Employees have earned $4,500 in wages by 31 December, but will not be paid until 5 January. What adjusting entry is recorded on 31 December?
A: Debit Salaries and Wages Expense $4,500, Credit Salaries and Wages Payable $4,500. This is an accrued expense.
Q: List the four closing entries in order.
A: (1) Debit each Revenue account, credit Income Summary. (2) Debit Income Summary, credit each Expense account. (3) Debit Income Summary, credit Retained Earnings for net income. (4) Debit Retained Earnings, credit Dividends.
Q: Equipment was purchased for $50,000. After three years of straight-line depreciation at $5,000 per year, what is the book value?
A: Accumulated Depreciation = $5,000 x 3 = $15,000. Book Value = $50,000 - $15,000 = $35,000.
Adjusting entries build directly on the debit/credit rules from Unit 5. Every adjusting entry is simply a journal entry that follows the same mechanics. The financial statements produced after adjustment connect back to the formulas from Units 1–3 (contribution margin and CVP analysis use the same revenue and cost figures that the income statement reports). Closing entries and the accounting cycle complete the full loop: from identifying transactions to presenting finished, period-end financial statements.
Adjusting entries, accrual accounting, cash accounting, revenue recognition principle, expense recognition principle, time period assumption, fiscal year, deferrals, accruals, prepaid expenses, unearned revenues, accrued revenues, accrued expenses, depreciation, accumulated depreciation, contra asset account, book value, worksheet, adjusted trial balance, closing entries, income summary, temporary accounts, permanent accounts, post-closing trial balance, classified balance sheet, current assets, non-current assets, current liabilities, long-term liabilities, operating cycle, accounting cycle, nine steps of the accounting cycle, keying