Difficulty: Intermediate | Prerequisites: Chapters 1–3 study notes
Source: Libby, Libby & Hodge, Financial Accounting 10th ed., Chapters 4, 6, 7 | Course: ACCT2010, Introduction to Financial Accounting
These three chapters move from the mechanics of recording transactions into the messier reality of measurement. Chapter 4 introduces adjusting entries, the tool that makes accrual accounting work at period end, and shows you how to produce a complete set of financial statements. Chapter 6 deals with revenue from sales, the problems that arise when customers do not pay (bad debts), and how companies handle cash. Chapter 7 tackles inventory, one of the largest assets on many balance sheets, and the different methods companies use to value it. Together, these chapters cover the territory tested on Quiz 2 and make up a significant portion of the midterm.
Adjusting entries fix timing mismatches so financial statements reflect reality at period end. Sales revenue must be measured net of returns, allowances, and bad debts. Inventory valuation depends on which cost-flow assumption a company adopts (FIFO, LIFO, weighted average), and the choice affects both the balance sheet and the income statement.
Tags: adjusting entries, deferrals, accruals, prepaid expenses, unearned revenue, depreciation, accrued expenses, accrued revenues, closing entries, post-closing trial balance, earnings quality
Adjusting entries
Journal entries made at the end of an accounting period to ensure that revenues and expenses are recorded in the correct period under accrual accounting. They never involve cash. If cash is part of the entry, it is not an adjusting entry.
Think of them as corrections that align the books with economic reality before the financial statements are prepared.
Deferral
Cash has already changed hands, but the revenue or expense has not yet been recognised. There are two types:
Deferred expense (prepaid expense): cash paid in advance for a future benefit. Example: prepaid rent, prepaid insurance.
Deferred revenue (unearned revenue): cash received in advance before earning it. Example: magazine subscriptions collected in advance.
Accrual
The revenue or expense has been incurred, but cash has not yet changed hands. Two types:
Accrued expense: an expense incurred but not yet paid. Example: wages earned by employees but not yet paid at period end.
Accrued revenue: revenue earned but not yet received. Example: interest earned on a bank deposit but not yet collected.
Depreciation
The systematic allocation of a long-lived asset's cost over its useful life. It is not a measure of declining market value. Depreciation is a non-cash expense: no cash leaves the company when depreciation is recorded.
Closing entries
Entries made at the very end of the period (after adjusting entries and financial statements) that reset all revenue, expense, and dividend accounts to zero, transferring their net effect into Retained Earnings. This prepares the temporary accounts for the next period.
Temporary accounts
Revenue, expense, and dividend accounts. They accumulate amounts for one period only and are closed to Retained Earnings at period end.
Permanent accounts
Asset, liability, and equity accounts. They carry their balances forward from one period to the next and are never closed.
Post-closing trial balance
A trial balance prepared after closing entries have been posted. It contains only permanent accounts (all temporary accounts should show zero balances). It verifies that debits still equal credits before the new period begins.
Why adjusting entries exist
Without adjustments, the financial statements would not accurately reflect the period's revenues and expenses. Adjustments correct two types of timing mismatches: (1) cash moved before the economic event (deferrals), and (2) the economic event happened before cash moved (accruals).
The four types of adjusting entries
Deferred expenses (prepaid expenses): the company paid cash earlier for something it will use up over time. At period end, the used portion is moved from the asset account to an expense account. Example: Prepaid Insurance was $12,000 for 12 months. At the end of month 1, adjust $1,000 from Prepaid Insurance (asset down) to Insurance Expense (expense up).
Deferred revenues (unearned revenues): the company received cash earlier for goods or services it has not yet delivered. At period end, the earned portion is moved from the liability account to a revenue account. Example: Unearned Revenue of $6,000 for 3 months of service. After 1 month, adjust $2,000 from Unearned Revenue (liability down) to Service Revenue (revenue up).
Accrued expenses: an expense has been incurred but not yet paid or recorded. Record the expense and the related liability. Example: employees have earned $5,000 in wages by period end but will not be paid until next period. Debit Wages Expense $5,000, Credit Wages Payable $5,000.
Accrued revenues: revenue has been earned but not yet received or recorded. Record the revenue and the related asset. Example: the company has earned $3,000 of interest by period end but will not receive it until next month. Debit Interest Receivable $3,000, Credit Interest Revenue $3,000.
The closing process
Close all revenue accounts to Income Summary (debit each revenue, credit Income Summary).
Close all expense accounts to Income Summary (credit each expense, debit Income Summary).
Close Income Summary to Retained Earnings (if net income, debit Income Summary, credit Retained Earnings).
Close Dividends to Retained Earnings (credit Dividends, debit Retained Earnings).
After closing, only permanent accounts have balances.
Preparing the financial statements after adjustments
The order matters:
Income statement (uses adjusted revenue and expense accounts to calculate net income).
Statement of stockholders' equity (uses net income from step 1 to update retained earnings).
Balance sheet (uses the ending equity from step 2 plus adjusted asset and liability balances).
Depreciation Expense (straight-line) = (Cost - Residual Value) / Useful Life
Book Value = Cost - Accumulated Depreciation
Adjusting entries are why a company's financial results can look very different depending on the choices it makes about timing. A company that defers too many expenses into future periods or accelerates revenue recognition will show stronger earnings now but weaker earnings later. Analysts watch for aggressive or conservative adjustments as a signal of earnings quality.
Students often think adjusting entries involve cash. They never do. If cash is in the entry, it is a regular transaction, not an adjustment.
Students confuse deferrals with accruals. The key distinction: deferrals start with a cash transaction that happened earlier; accruals start with an economic event where cash has not yet moved.
Students sometimes skip the closing process when preparing for exams. Understanding which accounts are temporary and which are permanent is essential for the post-closing trial balance.
Students forget that depreciation is an allocation of cost, not a reflection of market value decline.
⚠️ Be able to identify whether a scenario calls for a deferral or an accrual adjustment and write the journal entry.
⚠️ Know the four types of adjusting entries cold, with an example of each.
⚠️ Understand the closing process and which accounts appear on the post-closing trial balance.
⚠️ Be ready to prepare an income statement, statement of stockholders' equity, and balance sheet from adjusted trial balance data.
True or False: Adjusting entries always involve a debit or credit to Cash.
Fill in the blank: A prepaid expense is an example of a _______ (deferral / accrual).
True or False: After closing entries, revenue accounts should have a zero balance.
Fill in the blank: Book Value = Cost - _______.
True or False: The income statement is prepared before the balance sheet.
Answers: 1. False (adjusting entries never involve cash). 2. Deferral. 3. True. 4. Accumulated Depreciation. 5. True (net income feeds into the statement of stockholders' equity, which feeds into the balance sheet).
Q: On 1 September, a company pays $9,000 for a 9-month insurance policy. What is the adjusting entry on 31 December?
A: Four months of insurance have been used up (September through December). Monthly cost = $9,000 / 9 = $1,000. Adjustment for 4 months: Debit Insurance Expense $4,000; Credit Prepaid Insurance $4,000.
Q: A company receives $18,000 on 1 October for 6 months of services. What is the adjusting entry on 31 December?
A: Three months of service have been earned (October through December). Earned = $18,000 / 6 x 3 = $9,000. Debit Unearned Revenue $9,000; Credit Service Revenue $9,000.
Q: Employees earned $7,000 in wages during the last week of December but will not be paid until January. What is the adjusting entry on 31 December?
A: Debit Wages Expense $7,000; Credit Wages Payable $7,000. This is an accrued expense: the expense is incurred but cash has not yet been paid.
Q: What is the difference between temporary and permanent accounts?
A: Temporary accounts (revenues, expenses, dividends) are closed to Retained Earnings at the end of each period and start the next period at zero. Permanent accounts (assets, liabilities, equity) carry their balances forward indefinitely.
Adjusting entries are the bridge between the transaction recording taught in Chapters 2 and 3 and the completed financial statements. The depreciation concept introduced here is explored in much greater depth in Chapter 8 (Property, Plant, and Equipment). The idea of unearned revenue connects to Chapter 9's treatment of liabilities.
Tags: net sales, sales revenue, sales returns, sales allowances, sales discounts, trade discounts, accounts receivable, bad debts, allowance for doubtful accounts, uncollectible accounts, write-off, aging method, percentage of credit sales, net realizable value, internal controls, cash controls
Net sales revenue
The amount of revenue a company reports after subtracting sales returns, sales allowances, and sales discounts from gross sales. This is the top line of the income statement in most reporting.
Net Sales = Gross Sales - Sales Returns and Allowances - Sales Discounts
Sales returns and allowances
Reductions to revenue because customers returned goods or received a price reduction for defective or unsatisfactory products.
Sales discounts
Reductions offered to customers for paying quickly. Typically expressed in terms like "2/10, n/30," meaning a 2% discount if paid within 10 days, otherwise the full amount is due in 30 days.
Think of it as the seller's incentive to get cash in the door sooner.
Accounts receivable
Amounts owed to the company by customers who bought goods or services on credit. Reported as a current asset on the balance sheet.
Bad debt expense (uncollectible accounts expense)
The estimated cost of credit sales that will never be collected. This expense is recognised in the same period as the related revenue (matching principle), even though the company does not yet know exactly which customers will default.
Allowance for doubtful accounts
A contra-asset account that reduces Accounts Receivable to its net realisable value on the balance sheet. It represents the company's estimate of how much of its receivables it expects never to collect.
Net Realisable Value of Receivables = Accounts Receivable - Allowance for Doubtful Accounts
Write-off
The act of removing a specific customer's account from Accounts Receivable when the company determines the amount is uncollectible. Under the allowance method, a write-off does not affect total assets or net income, because the loss was already estimated.
Aging of accounts receivable method
A method of estimating bad debts by categorising receivables by how long they have been outstanding. Older receivables are assigned higher estimated uncollectible percentages, since the longer an account goes unpaid, the less likely it is to be collected.
Percentage of credit sales method
A method of estimating bad debts based on a percentage of credit sales for the period. It focuses on matching the expense to the period's revenue.
Measuring net sales
Companies start with gross sales and subtract three items to arrive at net sales:
Sales returns and allowances: goods sent back or price concessions granted.
Sales discounts: cash discounts taken by customers for early payment.
Credit card discounts: fees charged by credit card companies (sometimes classified as an operating expense instead).
Recording credit sales and the receivables cycle
When a company sells on credit: Debit Accounts Receivable, Credit Sales Revenue.
When the customer pays: Debit Cash, Credit Accounts Receivable.
If the customer takes a discount (2/10, n/30 and pays within 10 days): Debit Cash (for the discounted amount), Debit Sales Discounts (for the discount portion), Credit Accounts Receivable (for the full amount).
Estimating and recording bad debts
The allowance method (required by GAAP) estimates bad debts before they occur:
At period end, estimate uncollectible amounts using either the aging method or the percentage of credit sales method.
Record: Debit Bad Debt Expense, Credit Allowance for Doubtful Accounts.
When a specific account is determined to be uncollectible:
Write-off: Debit Allowance for Doubtful Accounts, Credit Accounts Receivable.
Notice the write-off does not hit the income statement. The expense was already recorded in step 2.
Aging method vs. percentage of credit sales method
Aging method: focuses on getting the correct balance sheet amount for the allowance. You calculate the required ending balance in the allowance, then adjust to reach it.
Percentage of credit sales: focuses on getting the correct income statement amount for bad debt expense. You calculate the expense directly from credit sales.
Both are acceptable under GAAP. The aging method is generally considered more accurate.
Internal controls over cash
Cash is the most vulnerable asset to theft and misuse. Key controls include:
Separation of duties (the person who handles cash should not be the same person who records it).
Daily deposits of all cash receipts.
All payments made by pre-numbered cheque or electronic transfer.
Regular bank reconciliations.
Net Sales = Gross Sales - Sales Returns and Allowances - Sales Discounts
Net Realisable Value of Receivables = Accounts Receivable - Allowance for Doubtful Accounts
Accounts Receivable Turnover = Net Sales / Average Net Accounts Receivable
Average Collection Period = 365 / Accounts Receivable Turnover
Retailers with generous return policies (such as online fashion retailers) often have large sales returns. Their reported net sales can be significantly lower than gross sales. Investors compare net sales growth, not gross, when evaluating performance. Companies that sell heavily on credit, like B2B wholesalers, spend considerable effort estimating bad debts because a misjudgement can materially misstate both assets and expenses.
Students often think a write-off of a specific account reduces net income. Under the allowance method, it does not: both Accounts Receivable and the Allowance are reduced by equal amounts, leaving net realisable value and net income unchanged.
Students confuse the two estimation methods. Remember: aging focuses on the balance sheet (what should the allowance balance be?), and percentage of credit sales focuses on the income statement (what should the expense be?).
Students forget that the allowance account often has a pre-existing balance. When using the aging method, you must calculate the adjustment needed, not simply record the full estimated amount as expense.
Students sometimes think sales discounts are bad for the company. In practice, they accelerate cash collection and reduce bad debts.
⚠️ Know how to calculate net sales from a set of sales data.
⚠️ Be able to record journal entries for credit sales, collections, discounts, and write-offs.
⚠️ Understand the allowance method and be able to calculate bad debt expense using both the aging and percentage of credit sales methods.
⚠️ Know why a write-off under the allowance method does not change total assets or net income.
True or False: Under the allowance method, writing off a specific uncollectible account reduces net income.
Fill in the blank: Net Sales = Gross Sales - Sales Returns and Allowances - _______.
True or False: The aging method focuses on determining the correct balance sheet valuation of receivables.
Fill in the blank: A contra-asset account that reduces Accounts Receivable is called _______.
True or False: The direct write-off method is required by GAAP.
Answers: 1. False (the expense was already estimated; the write-off is a balance sheet reclassification). 2. Sales Discounts. 3. True. 4. Allowance for Doubtful Accounts. 5. False (GAAP requires the allowance method).
Q: A company has $200,000 in Accounts Receivable. The aging analysis estimates that $8,000 will be uncollectible. The Allowance for Doubtful Accounts currently has a $2,000 credit balance. What is the adjusting entry?
A: The required ending balance is $8,000. The existing balance is $2,000. Therefore, the adjustment is $6,000. Debit Bad Debt Expense $6,000; Credit Allowance for Doubtful Accounts $6,000.
Q: A customer who owes $3,500 is determined to be uncollectible. Record the write-off under the allowance method.
A: Debit Allowance for Doubtful Accounts $3,500; Credit Accounts Receivable $3,500. No effect on net income, total assets, or net realisable value of receivables.
Q: What does "2/10, n/30" mean?
A: The customer may take a 2% discount if payment is made within 10 days. Otherwise, the full amount is due within 30 days.
Q: Why is the allowance method preferred over the direct write-off method?
A: The allowance method matches the estimated bad debt expense to the period when the related sales occurred (matching principle). The direct write-off method records the expense only when the specific account is known to be uncollectible, which may be a different period entirely.
Accounts receivable links to Chapter 2's balance sheet classifications (current asset). Bad debt expense connects to Chapter 3's matching principle and Chapter 4's adjusting entries. Cash controls connect to the broader theme of financial statement reliability introduced in Chapter 1.
Tags: inventory, cost of goods sold, COGS, FIFO, LIFO, weighted average cost, specific identification, perpetual inventory, periodic inventory, lower of cost or net realisable value, LCNRV, inventory turnover, cost flow assumptions, goods available for sale
Inventory
Goods held for sale to customers in the ordinary course of business. For a retailer, inventory is the merchandise on the shelves. For a manufacturer, it includes raw materials, work-in-process, and finished goods.
Cost of goods sold (COGS)
The total cost of the inventory that was sold during the period. It is the largest expense on the income statement for most merchandising and manufacturing companies.
COGS = Beginning Inventory + Purchases - Ending Inventory
Goods available for sale
The total pool of inventory that could have been sold during the period. It equals beginning inventory plus all purchases (or production costs) during the period. This pool is then split between what was sold (COGS) and what remains (ending inventory).
FIFO (first-in, first-out)
Assumes the oldest inventory items are sold first. Ending inventory on the balance sheet reflects the most recent purchase costs. In a period of rising prices, FIFO produces lower COGS, higher net income, and higher ending inventory compared to LIFO.
LIFO (last-in, first-out)
Assumes the most recently purchased items are sold first. Ending inventory reflects the oldest costs. In a period of rising prices, LIFO produces higher COGS, lower net income, and lower ending inventory. LIFO is allowed under GAAP but prohibited under IFRS.
Weighted average cost
Calculates a single average cost per unit by dividing the total cost of goods available for sale by the total number of units available. This average is used for both COGS and ending inventory.
Weighted Average Cost Per Unit = Total Cost of Goods Available for Sale / Total Units Available
Specific identification
Tracks the actual cost of each individual item. Used for unique, high-value goods (cars, jewellery, custom machinery). Impractical for large volumes of similar items.
Lower of cost or net realisable value (LCNRV)
The conservatism principle applied to inventory. If the market value (net realisable value) of inventory drops below its recorded cost, the company must write the inventory down to the lower amount and recognise a loss.
Net Realisable Value = Estimated Selling Price - Estimated Costs to Complete and Sell
Inventory turnover ratio
Measures how quickly a company sells its inventory. A higher ratio suggests faster-moving inventory.
Inventory Turnover = Cost of Goods Sold / Average Inventory
Average Days to Sell Inventory = 365 / Inventory Turnover
The cost principle and inventory
Inventory is initially recorded at cost: the purchase price plus all costs necessary to get the inventory ready for sale (freight-in, insurance during transit, import duties). Discounts received from suppliers reduce the recorded cost.
Why cost flow assumptions matter
When a company buys identical items at different prices over time, it needs a rule to determine which cost goes to COGS (income statement) and which stays in ending inventory (balance sheet). The choice of method does not describe the physical flow of goods. A company using FIFO is not required to sell its oldest items first; it simply assigns the oldest costs to COGS for accounting purposes.
Comparing FIFO, LIFO, and weighted average in a rising-price environment
FIFO: oldest (lowest) costs go to COGS, newest (highest) costs stay in ending inventory. Result: lower COGS, higher gross profit, higher net income, higher taxes, higher ending inventory on the balance sheet.
LIFO: newest (highest) costs go to COGS, oldest (lowest) costs stay in ending inventory. Result: higher COGS, lower gross profit, lower net income, lower taxes, lower ending inventory on the balance sheet.
Weighted average: falls between FIFO and LIFO for all measures.
In a period of falling prices, the effects reverse.
Why would a company choose LIFO?
Tax savings. In the United States, if a company uses LIFO for tax purposes, it must also use LIFO for financial reporting (the LIFO conformity rule). Lower taxable income means lower tax payments, which preserves cash. The trade-off is that reported net income is also lower, which can make the company look less profitable to investors.
Lower of cost or net realisable value
At each reporting date, the company compares the cost of each inventory item (or category) to its net realisable value. If NRV is lower, the inventory is written down:
Debit Cost of Goods Sold (or Loss on Inventory Write-down), Credit Inventory.
This is a one-way adjustment under GAAP: once written down, the inventory cannot be written back up, even if NRV recovers. (Under IFRS, reversals are permitted up to the original cost.)
Perpetual vs. periodic inventory systems
Perpetual: the inventory account is updated with every purchase and every sale in real time. Most modern companies use this system because technology makes it practical.
Periodic: the inventory account is updated only at the end of the period through a physical count. COGS is calculated as a plug: Beginning Inventory + Purchases - Ending Inventory = COGS.
COGS = Beginning Inventory + Purchases - Ending Inventory
Goods Available for Sale = Beginning Inventory + Purchases
Weighted Average Cost Per Unit = Cost of Goods Available for Sale / Units Available for Sale
Inventory Turnover = COGS / Average Inventory
Average Days to Sell Inventory = 365 / Inventory Turnover
Net Realisable Value = Estimated Selling Price - Estimated Costs to Complete and Sell
Grocery stores and fuel retailers face volatile input costs. Their choice of inventory method can materially shift reported profits. Walmart uses LIFO for a significant portion of its inventory, which lowers its U.S. tax bill. Meanwhile, companies reporting under IFRS (such as many European firms) cannot use LIFO, so direct comparisons of inventory values between a U.S. LIFO company and an IFRS company require adjustment.
Students often think FIFO and LIFO describe the physical movement of goods. They do not. They are cost flow assumptions, assigning costs to units sold regardless of which physical units left the warehouse.
Students confuse the effects of FIFO and LIFO in rising-price vs. falling-price environments. The standard exam question uses rising prices, where FIFO gives higher income and LIFO gives lower income, but you should understand that the relationship flips when prices fall.
Students forget to apply the LCNRV rule. If ending inventory's NRV drops below cost, you must write it down.
Students sometimes think LIFO is universally available. It is prohibited under IFRS, which matters in this course given the discussion of IFRS adoption in Vietnam.
⚠️ Be able to calculate COGS and ending inventory under FIFO, LIFO, and weighted average given a set of purchase and sales data.
⚠️ Know the effects of each method on COGS, net income, taxes, and the balance sheet.
⚠️ Understand the LCNRV rule and be able to apply it.
⚠️ Be able to compute and interpret the inventory turnover ratio.
⚠️ Know that LIFO is allowed under GAAP but not under IFRS.
True or False: FIFO assumes the newest inventory is sold first.
Fill in the blank: COGS = Beginning Inventory + Purchases - _______.
True or False: LIFO is permitted under IFRS.
Fill in the blank: Inventory Turnover = COGS / _______.
True or False: In a period of rising prices, LIFO produces higher net income than FIFO.
Answers: 1. False (FIFO assumes the oldest inventory is sold first). 2. Ending Inventory. 3. False (LIFO is prohibited under IFRS). 4. Average Inventory. 5. False (LIFO produces lower net income because it assigns higher recent costs to COGS).
Q: A company has the following inventory data. Beginning inventory: 100 units at $10. Purchase 1: 150 units at $12. Purchase 2: 50 units at $14. It sold 200 units. Calculate COGS under FIFO.
A: Under FIFO, the oldest costs are assigned to COGS first. 100 units at $10 = $1,000, then 100 units at $12 = $1,200. COGS = $1,000 + $1,200 = $2,200. Ending inventory: 50 units at $12 + 50 units at $14 = $600 + $700 = $1,300.
Q: Using the same data, calculate COGS under LIFO.
A: Under LIFO, the newest costs are assigned first. 50 units at $14 = $700, then 150 units at $12 = $1,800. COGS = $700 + $1,800 = $2,500. Ending inventory: 100 units at $10 = $1,000.
Q: Why would a company voluntarily choose LIFO when it lowers reported net income?
A: In a rising-price environment, LIFO assigns higher costs to COGS, which lowers taxable income and therefore reduces cash paid in taxes. The tax savings, which are real cash, can outweigh the disadvantage of reporting lower earnings.
Q: A company's inventory cost is $50,000 and its net realisable value is $45,000. What action is required?
A: The company must write the inventory down to $45,000. The entry is: Debit Cost of Goods Sold (or Loss on Inventory Write-down) $5,000; Credit Inventory $5,000. This applies the lower of cost or net realisable value rule.
Inventory is one of the largest current assets on the balance sheet (Chapter 2). COGS is the largest expense on the income statement for merchandising firms (Chapter 3). The write-down under LCNRV is conceptually similar to the allowance for doubtful accounts in Chapter 6: both apply conservatism to asset valuation. Inventory methods also interact with the IFRS vs. GAAP discussion from Chapter 1 and the guest speaker session on IFRS adoption in Vietnam (Week 13).
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