Difficulty: Intermediate | Prerequisites: Accounting Equation and the Accounting Cycle study notes (Part 1 of this set). Familiarity with debits, credits, and the 10-step accounting cycle.
Once the basic transaction cycle is running (steps 1 to 4), the real subtlety of accrual accounting shows up in adjusting entries. These entries ensure that the financial statements reflect economic reality, not just cash movements. This second set of notes covers the three categories of adjustments (deferrals, accruals, estimates), walks through each of the five financial statements, and explains the closing process that resets temporary accounts at year-end.
If you are comfortable with the accounting equation and the difference between permanent and temporary accounts, you are ready for this material. If those terms are shaky, start with Part 1.
Adjusting entries align revenues and expenses with the periods they belong to, handling three situations: deferrals (cash moves before the economic event), accruals (the economic event happens before cash moves), and estimates (depreciation, bad debts). The five financial statements, built from the adjusted trial balance, communicate a company's performance and position to external users. At year-end, temporary accounts are closed to retained earnings so the next period starts with a clean slate.
Deferred revenue (unearned revenue)
Cash received from customers before the company has provided the goods or services. It is recorded as a liability because the company still owes the customer something. Think of it as: the customer paid you in advance, and you owe them the work.
Prepaid expense
An asset created when cash is paid for a benefit that will be consumed in a future period. As the benefit is used up, the asset is reduced and an expense is recognised. In simple terms, you paid now for something you will use later, like 12 months of insurance.
Accrued liability (accrued expense)
An expense that has been incurred but not yet paid in cash. The adjusting entry debits the expense and credits a payable. Think of it as: you used the resource, you owe for it, but the bill has not arrived or been paid yet.
Accrued receivable (accrued revenue)
Revenue that has been earned but not yet received in cash. The adjusting entry debits a receivable and credits revenue. In simple terms, you did the work or lent the money, but you have not been paid yet.
Accumulated depreciation
A contra-asset account that accumulates the total depreciation taken on a long-term asset over its life. It is credited when depreciation is recorded, so its balance grows over time even though it appears on the asset side of the balance sheet. Think of it as: a running total of how much of the asset's value has been "used up."
Contra-asset account
An account that offsets the balance of a related asset account. It has a credit balance (opposite to normal asset accounts). Accumulated depreciation and allowance for doubtful accounts are both contra-assets.
Other comprehensive income (OCI)
Items that affect shareholders' equity but are excluded from net income. Examples include unrealised gains and losses on certain investments and foreign currency translation adjustments. In simple terms, gains and losses the standard-setters decided should bypass the income statement.
Comprehensive income
Net income plus (or minus) other comprehensive income. It captures all changes in shareholders' equity that did not arise from transactions with owners (like dividends or stock issuances).
Bad debt expense (doubtful accounts expense)
An estimate of the portion of accounts receivable that will prove uncollectible. The adjusting entry debits bad debt expense and credits the allowance for doubtful accounts (a contra-asset).
Adjusting entries are recorded at the end of the accounting period (Step 6) to ensure revenues and expenses land in the correct period. They fall into three categories.
Deferred revenue
When the company receives cash before providing the good or service:
At the time cash is received: Debit Cash, Credit Deferred Revenue (a liability).
When the good or service is delivered: Debit Deferred Revenue, Credit Revenue.
Example: A magazine publisher collects a one-year subscription fee up front. Each month, it recognises one-twelfth of that fee as revenue and reduces the liability by the same amount.
Prepaid expenses
When the company pays cash before consuming the benefit:
At the time cash is paid: Debit Prepaid Expense (an asset), Credit Cash.
As the benefit is consumed: Debit Expense, Credit Prepaid Expense.
A prepaid expense arises whenever cash is paid and the payment is not to satisfy a liability or pay a dividend.
Example: Paying 12 months of rent in advance. Each month, one-twelfth of the prepayment is moved from the asset to rent expense.
Accrued liabilities (accrued expenses)
Expenses incurred but not yet paid:
Adjusting entry: Debit Expense, Credit Payable (liability).
Example: Employees have worked the last week of the month but will not be paid until next month. Debit Salaries Expense, Credit Salaries Payable.
Accrued interest expense
Formula: Principal x Interest Rate x Time = Interest.
Adjusting entry: Debit Interest Expense, Credit Interest Payable.
Accrued receivables (accrued revenues)
Revenue earned but not yet received in cash:
Adjusting entry: Debit Receivable, Credit Revenue.
Example: Interest revenue earned on a note receivable that is not due for two years. Debit Interest Receivable, Credit Interest Revenue (Principal x Interest Rate x Time).
Depreciation expense
Requires two estimates:
Expected useful life of the asset.
Expected residual value at the end of that life.
Adjusting entry: Debit Depreciation Expense, Credit Accumulated Depreciation (a contra-asset).
Accumulated depreciation is credited, so its balance grows over time. The net effect is that the asset's carrying amount (cost minus accumulated depreciation) falls each period.
Bad debt expense
Requires the company to estimate the portion of accounts receivable that will prove uncollectible:
Adjusting entry: Debit Bad Debt Expense, Credit Allowance for Doubtful Accounts.
The allowance is a contra-asset that reduces the net realisable value of accounts receivable on the balance sheet.
Financial statements are the primary means of communicating financial information to external parties. They are prepared from the adjusted trial balance (Step 8).
Summarises the profit-generating activities of the company over a period. It reports changes in retained earnings caused by revenues, expenses, gains, and losses.
Sales Revenue
Less: Cost of Goods Sold
= Gross Profit
Less: Operating Expenses (salaries, supplies, rent, depreciation)
= Operating Income
Plus or minus: Other Income/Expense (rent revenue, interest revenue/expense)
= Net Income
Reports all changes in shareholders' equity during the period that were not the result of transactions with owners.
Includes net income plus other comprehensive income (OCI) items.
Can be presented in two ways:
A single continuous statement of comprehensive income.
Two separate consecutive statements: first the income statement, then a comprehensive income statement that begins with net income and adds OCI items.
Presents the financial position of the company on a particular date. It is an organised list of assets, liabilities, and shareholders' equity at a specific point in time.
Key distinction: the income statement covers a period; the balance sheet is a snapshot ("as of December 31").
Reports the events that caused cash (cash plus cash equivalents) to change during the period, organised into three categories:
Operating activities: cash inflows and outflows related to generating net income.
Investing activities: acquisition and sale of long-term assets and nonoperating investment assets.
Financing activities: cash inflows and outflows from transactions with creditors and owners (borrowing, repaying debt, issuing stock, paying dividends).
Discloses the sources of changes in the permanent shareholders' equity accounts:
Investment by owners.
Distributions to owners (dividends).
Net income.
Other comprehensive income.
Closing happens at the end of the fiscal year (Steps 9 and 10). Its purpose is to zero out all temporary accounts so the next period can measure fresh activity.
Close revenues to income summary:
Debit each revenue account (zeroing it out).
Credit Income Summary.
Close expenses to income summary:
Credit each expense account (zeroing it out).
Debit Income Summary.
Close income summary to retained earnings:
If net income: Debit Income Summary, Credit Retained Earnings.
If net loss: Debit Retained Earnings, Credit Income Summary.
Close dividends to retained earnings:
Debit Retained Earnings, Credit Dividends.
The income summary account is a bookkeeping convenience. It gathers all revenues and expenses in one place, and its final balance (which equals net income or net loss) is transferred to retained earnings. Once this is done, you can verify: Beginning Retained Earnings + Net Income – Dividends = Ending Retained Earnings.
Investors put cash into the company for common stock:
Debit Cash; Credit Common Stock.
Sold merchandise costing $20,000 for $35,000 cash:
Debit Cash $35,000; Credit Sales Revenue $35,000.
Debit Cost of Goods Sold $20,000; Credit Merchandise Inventory $20,000.
Received $1,000 cash for rent in advance:
Debit Cash $1,000; Credit Deferred Rent Revenue (liability) $1,000.
Corporation paid a $1,000 cash dividend:
Debit Retained Earnings $1,000; Credit Cash $1,000.
(Dividends reduce retained earnings, not expenses.)
Students often confuse deferrals with accruals. The distinction is simple: deferrals mean cash moved first and recognition follows; accruals mean recognition happened first and cash follows. If you remember the order of cash vs. recognition, the journal entries follow logically.
Accumulated depreciation is frequently misunderstood. Students expect crediting an account to reduce it, but accumulated depreciation is a contra-asset, so a credit increases its balance. The asset's carrying amount (cost minus accumulated depreciation) is what falls.
Many students treat comprehensive income and net income as interchangeable. Comprehensive income is the broader measure; it includes net income plus OCI items. Exam questions that ask for comprehensive income expect you to add OCI to net income.
The balance sheet is a snapshot at a single date, while the income statement and statement of cash flows cover a period. Students sometimes forget this distinction and refer to "balance sheet for the year ended," which is incorrect. The correct phrasing is "as of" a date.
⚠️ Be able to write the adjusting journal entry for each type: deferred revenue, prepaid expense, accrued liability, accrued receivable, depreciation, and bad debts. The exam will likely give you a scenario and ask for the entry.
⚠️ Know the interest formula (Principal x Rate x Time) and be ready to compute accrued interest for partial periods.
⚠️ Understand the structure of the income statement from sales revenue down to net income, including the distinction between operating and non-operating items.
⚠️ Know the two formats for presenting comprehensive income (single continuous statement vs. two-statement approach).
⚠️ Be able to classify cash flows into operating, investing, and financing activities.
⚠️ The closing process question is a favourite: which accounts get closed, in what order, and what is the role of income summary?
Q: A company receives $12,000 cash on 1 July for a one-year magazine subscription. What adjusting entry is needed on 31 December?
A: Six months of service have been provided, so $6,000 of revenue has been earned. Debit Deferred Revenue $6,000; Credit Subscription Revenue $6,000.
Q: On 1 October, a company borrows $100,000 at 6% annual interest. What adjusting entry is needed on 31 December?
A: Interest for three months: $100,000 x 6% x 3/12 = $1,500. Debit Interest Expense $1,500; Credit Interest Payable $1,500.
Q: Equipment costing $60,000 has an expected useful life of 10 years and an expected residual value of $5,000. What is the annual straight-line depreciation entry?
A: ($60,000 - $5,000) / 10 = $5,500 per year. Debit Depreciation Expense $5,500; Credit Accumulated Depreciation $5,500.
Q: Name the three categories of activities reported on the statement of cash flows.
A: Operating activities, investing activities, and financing activities.
Q: What is the difference between net income and comprehensive income?
A: Comprehensive income = Net Income + Other Comprehensive Income (OCI). OCI includes items such as unrealised gains/losses on certain investments and foreign currency translation adjustments that bypass the income statement.
Q: A company has revenues of $500,000 and expenses of $350,000. Write the closing entries using income summary.
A: (1) Debit Revenue $500,000; Credit Income Summary $500,000. (2) Debit Income Summary $350,000; Credit Expenses $350,000. (3) Debit Income Summary $150,000; Credit Retained Earnings $150,000.
Adjusting entries for deferrals and accruals are the mechanical foundation for revenue recognition (ASC 606) and expense matching, both of which receive much deeper treatment in later chapters. The distinction between operating, investing, and financing activities on the cash flow statement will reappear throughout the course, particularly when analysing complex transactions. OCI items become important when you study investments (debt and equity securities) and foreign currency accounting.
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