Use the toggle arrows to explore each section at your pace, enabling effective, focused study sessions.
Accrual vs. Deferral Adjusting Entries
#2 — Second, Cash is Received or Paid (via a Subsequent Journal Entry in the following period) Essentially, with Accruals, the recognition of expense or revenue must be “accrued” now, before the end of the period! This can be better understood with an example.
Remember, the pattern for deferral adjusting entries: REVENUE/EXPENSE RECOGNIZED FIRST, CASH RECEIVED/PAID LATER!
When an employee has worked for a company but hasn't been paid by the end of the accounting period, this scenario arises.
- This means the expense (Salaries Expense) is recognized first because the work was done.
- Cash is paid later when the salary is disbursed.
Consider the following example:
By December 31st, 2023, employees of Survive Company have earned $5,000 in salaries, but they will be paid on January 5th, 2024. Accrual Adjusting Entry on Dec 31: Salaries Expense 12,000 Salaries Payable 12,000
The $5,000 Salaries Expense that was debited on December 31st:
- Represents the cost of employee labor that was incurred but not yet paid.
- Salaries Expense is debited to recognize the obligation.
The $5,000 Salaries Payable that was credited on December 31st:
- Indicates the company's obligation to pay this amount to its employees.
- It's a liability that will be settled later when the company disburses the salaries.
On January 5th, when the company pays the salaries:
- Salaries Payable is debited, reducing the liability.
- Cash is credited to indicate the payment.
On January 5th, 2024, the company pays the accrued salaries.
Subsequent Journal Entry on Jan 5: Salaries Payable 12,000 Cash 12,000
See it? Keep in mind the pattern for deferral adjusting entries: REVENUE/EXPENSE RECOGNIZED FIRST, CASH RECEIVED/PAID LATER!
The expense was recognized when the work was done, but the cash was paid LATER. This is why it's an “Accrual” adjusting entry.
đź’ˇ Other examples of accruals exist, but this is a good foundational starting point! It's crucial to consult with your professor to understand the level of depth and specificity required for your exams concerning these journal entries.
- Some professors might require that you simply memorize the accounts used in the journal entries.
- Others may require a deeper understanding, such as the ability to interpret and complete extensive word problems related to these entries.
CASH RECEIVED/PAID FIRST, REVENUE/EXPENSE RECOGNIZED LATER!
In other words…
#1 — First, Cash is Received or Paid
(via Original Journal Entry)
#2 — Second, Expense or Revenue is Recognized (via Adjusting Journal Entry at the end of period)Essentially, with deferrals, the recognition of expense or revenue is deferred to later. This can be better understood with examples.
Remember, the pattern for deferral adjusting entries: CASH RECEIVED/PAID FIRST, REVENUE/EXPENSE RECOGNIZED LATER! When we pay cash upfront for Prepaid Insurance (or anything labeled as "prepaid"), it's quite obvious that this is a “deferral adjusting entry” scenario.
- If something is PREPAID, that means cash is being paid upfront!
The expense is then recognized LATER when we determine through our adjusting entry how much of the prepaid asset has been consumed and needs to be expensed.
Consider the following example:
On July 1st, 2023, Survive Company pays $12,000 in cash for a 12-month insurance policy. Original Entry on July 1:
Prepaid Insurance 12,000 Cash 12,000
On December 31st, 2023, an adjusting entry is required to recognize the insurance expense for the portion used during the year. Deferral Adjusting Entry on Dec 31:
Insurance Expense 6,000 Prepaid Insurance 6,000
The $6,000 Insurance Expense that was debited is calculated as follows:
- The $12,000 paid for the 12-month policy works out to a monthly cost of $1,000.
- From July 1st to December 31st, a total of six months have elapsed.
- Six months at $1,000 per month gives us an Insurance Expense of $6,000.
- We debited the expense to increase it, which is how we recognize an expense — since all expense accounts work like (+/-).
The $6,000 Prepaid Insurance that was credited is calculated as follows:
- On July 1st, we debited Prepaid Insurance for $12,000.
- By December 31st, six months of the policy have been utilized, leaving only half of the initial policy value intact.
- If we don't reduce the Prepaid Insurance account by crediting it, our balance sheet would inaccurately represent an overstated value for our prepaid insurance.
- Consequently, we must credit Prepaid Insurance, an asset account, to decrease it to the correct remaining amount.
- Refer to the T Account below for reference.
Keep in mind the pattern for deferral adjusting entries: CASH RECEIVED/PAID FIRST, REVENUE/EXPENSE RECOGNIZED LATER!
Cash was paid UPFRONT for an insurance policy. The recognition of the Insurance Expense was DEFERRED until later, at the time of recording adjusting entries. This is why it's a “Deferral” adjusting entry.
Remember, the pattern for deferral adjusting entries: CASH RECEIVED/PAID FIRST, REVENUE/EXPENSE RECOGNIZED LATER! This works exactly like Prepaids do. When we pay cash upfront for supplies (or any asset), this is a “deferral adjusting entry” scenario.
The expense is then recognized LATER when we determine through our adjusting entry how much of the supplies have been consumed and need to be expensed.
Consider the following example:
On June 30th, 2023, Survive Company pays $20,000 in cash for supplies. Original Entry on June 30:
Supplies 20,000 Cash 20,000
On December 31st, 2023, we do an inventory count and determine that 5,000 in supplies remain. Adjusting Entry on Dec 31:
Supplies Expense 15,000 Supplies 15,000
The $15,000 Supplies Expense that was debited is calculated as follows:
- Originally, we purchased $20,000 worth of supplies.
- If, at year end, $5,000 in supplies remain — this indicates that $15,000 in supplies have been used.
- Therefore, we debited Supplies Expense to increase it, which is how we recognize an expense — since all expense accounts work like (+/-).
- This is best illustrated via a T Account for Supplies.
The $15,000 that was credited to Supplies is explained as follows:
- If we don't reduce the Supplies account by crediting it, our balance sheet would inaccurately represent an overstated value for our Supplies.
- Consequently, we must credit Supplies, an asset account, to decrease it to the correct remaining amount.
- Refer to the T Account below for reference.
Keep in mind the pattern for deferral adjusting entries: CASH RECEIVED/PAID FIRST, REVENUE/EXPENSE RECOGNIZED LATER!
Cash was paid UPFRONT for Supplies. The recognition of the Supplies Expense was DEFERRED until later, at the time of recording adjusting entries. This is why it's a “Deferral” adjusting entry.
When we receive cash upfront as Unearned Revenue, this is a “deferral adjusting entry” scenario.
The revenue is recognized LATER when we determine through our adjusting entry how much of the Unearned Revenue has been earned. Consider the following example:
On October 31st, Survive Company receives $240,000 cash in advance for a 12-month consulting contract delivered evenly each month. Original Entry on Oct 31:
Cash 240,000 Unearned Revenue 240,000
On December 31st, 2023, an adjusting entry is required to recognize the unearned revenue that was earned during the year.
Adjusting Entry on Dec 31: Unearned Revenue 40,000 Fees Earned 40,000
Here's how we get the $40,000:
- The total contract value of $240,000 is split evenly over the course of 12 months, leading to an 'earned' revenue of $20,000 per month.
- (240,000 / 12 = 20,000)
- By the end of December, two months of service have been delivered, thereby earning $40,000 in revenue (2 months x $20,000 per month).
- This earned amount of $40,000 is then debited from Unearned Revenue, a liability account (-/+), and credited to Fees Earned, a revenue account (-/+), reflecting a decrease in the liability and an increase in revenue.
This adjustment ensures that the financial statements of the company accurately represent its financial position and earnings performance. It adheres to the revenue recognition principle which mandates that revenues must be recognized in the accounting period in which the services were actually delivered.
- On December 31st, we debited Unearned Revenue, a liability account (-/+), in order to decrease it.
- This accurately shows that we now owe $40,000 less for the consulting contract as we've already provided two out of twelve months of contract.
- To view it differently: If we failed to debit (i.e. decrease) Unearned Revenue, our balance sheet would falsely represent a higher liability. It would seem as though we owe more services than we actually do.
- To illustrate, imagine the company forgot to record this adjusting entry. Consequently, our balance sheet on 12/31 would incorrectly show $240,000 in services owed, whereas the actual figure should be $200,000!
- Therefore, it's essential to debit Unearned Revenue to adjust it to the accurate remaining value of services we're obligated to deliver.
- Refer to the T Account below for reference.
- On December 31st, we credited Fees Earned, a revenue account (-/+), in order to increase it.
- This accurately captures that we've earned $40,000 from the consulting contract, having delivered two out of twelve months of service.
- To view it differently: If we didn't credit (increase) Fees Earned, our income statement would not fully represent our earnings.
- For instance, if we neglected to record this adjusting entry, our income statement on 12/31 would fall short by $40,000 in revenue.
- Therefore, it's crucial to credit Fees Earned to record the accurate amount of revenue we've generated from services performed.
- This adjusting entry also ensures adherence to the revenue recognition principle. It states that revenues must be captured as they're earned, and in the same period they occur. In other words, failing to record this adjusting entry on 12/31, the final day of the year, would mean missing out on reporting this revenue in the correct year!
Keep in mind the pattern for deferral adjusting entries: CASH RECEIVED/PAID FIRST, REVENUE/EXPENSE RECOGNIZED LATER!
Cash was received UPFRONT as Unearned Revenue. The recognition of the earned revenue (i.e Fees Earned) was DEFERRED until later, at the time of recording adjusting entries. This is why it's a “Deferral” adjusting entry.
When we pay cash upfront for a depreciable long term asset, such as a building, this is a “deferral adjusting entry” scenario.
The expense is recognized LATER when we determine through our adjusting entry how much of the building has depreciated. Consider the following example:
On Jan 1st, Survive Company pays $200,000 cash for a building. The building has a salvage value of $50,000 and an estimated useful life of 15 years. Original Entry on Jan 1: Building 200,000 Cash 200,000
On December 31st, 2023, an adjusting entry is required to recognize the depreciation expense for the building. Use the straight line method.
Adjusting Entry on Dec 31: Depr. Expense 10,000 Accum. Depr. - Building 10,000
Here's how we get the $10,000, using the Straight Line Method:
- NOTE: The Straight Line Method for estimating depreciation, which is discussed deeper in Chapter 8, is sometimes still tested on your first exam. Please consult your professor on whether you need to know this for Exam 1.
- Straight Line Formula: Est. Useful Life (years) 15 = 150,0000 / 15 = 10,000 annual depreciation
- This means $10,000 must be debited to Depreciation Expense (+/-), and credited to Accumulated Depreciation, a contra asset account (-/+), reflecting an increase in the expense and decrease in the asset.
- We will delve into depreciation of assets much deeper in Chapter 8. For now, let this simply serve as an example of Deferral Adjusting Entries!
Original Cost - Salvage Value
200,000 - 50,000
Keep in mind the pattern for deferral adjusting entries: CASH RECEIVED/PAID FIRST, REVENUE/EXPENSE RECOGNIZED LATER!
đź’ˇ Other examples of deferrals exist, but this is a good foundational starting point! It's crucial to consult with your professor to understand the level of depth and specificity required for your exams concerning these journal entries.
- Some professors might require that you simply memorize the accounts used in the journal entries.
- Others may require a deeper understanding, such as the ability to interpret and complete extensive word problems related to these entries.
The Accounting Cycle
Preparing Trial Balances
What is a Trial Balance?
đź“Ś A trial balance is a financial report that lists the balances of all ledger accounts of a business at a specific point in time. It ensures that the total debits equal the total credits, demonstrating the consistency of all recorded transactions.
- All your Trial balance does is list all of your accounts (A = L + E, Revenues, Expenses, any contra accounts) and their current ending debit or credit balance from the T Accounts from the Posting process.
- If debits and credits don’t equal in your trial balance, this indicates that there was an error if your journal entries or during posting.
Unadjusted Trial Balance vs. Adjusted Trial Balance
đź“Ś An unadjusted trial balance is prepared before any adjusting entries are made in the ledger accounts, while an adjusted trial balance is prepared after all adjusting entries have been made. The adjusted trial balance verifies that the total debits equal the total credits after adjustments.
Preparing a Trial Balance
đź“Ś A trial balance is straightforward to prepare. It involves listing all your accounts (Assets = Liabilities + Equity, Revenues, Expenses, Contra Accounts) alongside their current ending debit OR credit balance, which is derived from the posting process.Please refer to the example below for clarity.
- Knowing how to start a trial balance makes them much less overwhelming.
- Begin by creating a column listing all your accounts in order by type (Assets = Liabilities + Equity, Revenues, Expenses). Refer to all your T Accounts (ledgers) from the posting process that have a balance and list them.
- Notice in the example provided, assets are listed first, followed by liabilities, etc.
- Contra accounts should be nested next to the type of account they're contra to. For instance, 'Dividends' is listed after the equity accounts as it is a Contra Equity account.
- Although not essential for scoring full points on an exam, ordering accounts this way demonstrates your understanding of report formatting, which can impress your professor!
- After listing all your accounts, create two more columns for Debit and Credit.
- The next step is to enter the ending balance of each account in either the Debit or Credit column, based on its normal balance.
- For instance, in the trial balance above, every account has its ending balance entered in its normal balance column:
- Cash, an asset (+/-), has a normal debit balance, so its amount is in the debit column.
- Accounts Payable, a liability (-/+), has a normal balance of credit. It’s amount is in the credit column!
- Dividends, a contra equity account (+/-), has a normal debit balance, so its amount is in the debit column.
- Service Revenue, a revenue account (-/+), has a normal credit balance, so its amount is in the credit column.
- And so on…
- Get it? Understanding the normal balance of an account ensures you'll never put the amount in the wrong column in a trial balance!
Accounts Payable (-/+), a liability, has a normal credit balance, so its amount is in the credit column.
- Once you've entered all account balances, check if total debits equal total credits.
- If they match: Excellent! Your accounting cycle is error-free, and you can proceed.
- If they don't: Don't worry! This implies an error either in your accounting cycle or in your trial balance. Take a deep breath and try to identify the mistake.
- Here are some possibilities:
- Is any account missing from your list?
- Did you enter an amount in the wrong column?
- Did you make a calculation error in total debits and credits?
- If none of the above, revisit your journal entries and posting processes. An incorrect journal entry or an error in posting or totaling the ending balance of a T account can cause an error in your trial balance.
- This is precisely why we prepare a trial balance - to identify any errors before preparing financial statements!
Preparing Financial Statements
Income Statement Formula
The income statement shows a company's revenues, expenses, gains, and losses over a specific period. Its formula is: Company Name Income Statement For Period Ended [date]
Revenue - Expenses = Net Income (or Net Loss)
The income statement summarizes the company's financial performance during the reporting period. Meanwhile, the Balance Sheet includes only Assets, Liabilities, and Equity accounts (A = L + E). Avoid the common mistake of mixing Balance Sheet accounts with the Income Statement or vice versa. They are separate!
Statement of Retained Earnings Formula
The statement of retained earnings outlines changes in a company's retained earnings balance over a specific period. If a company has Net Income, its formula is:
Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earnings If a company has Net Loss, its formula is: Beginning Retained Earnings - Net Loss - Dividends = Ending Retained Earnings
This statement helps track the accumulated profits or losses that have been retained in the business.
Balance Sheet Formula
The balance sheet presents a company's financial position at a specific point in time. Its formula is:
Assets = Liabilities + Equity
The balance sheet provides an overview of what a company owns (assets), what it owes (liabilities), and the residual value for owners (equity).
“Flow” of Financial Statements
#1 Income Statement
Revenues - Expenses = Net Income
Always start with the Income Statement!
#2 Statement of R/E
Beginning R/E + Net Income - Dividends = Ending R/E
Net Income flows into the Statement of Retained Earnings!
#3 Balance Sheet
Assets = Liabilites + Equity
Ending R/E flows into the Equity section of the Balance Sheet!
Cash Flows Statement Formula
The cash flow statement reports the cash inflows and outflows from a company's operating, investing, and financing activities over a specific period. Its formula generally consists of three sections:
Cash Flows from Operating Activities + or - Cash Flows from Investing Activities + or - Cash Flows from Financing Activities = Net Increase/Decrease in Cash
Temporary vs. Permanent Accounts
Temporary accounts are closed at the end of each period. Use the R.E.I.D acronym to remember which accounts get closed at the end of each period:
- Revenues
- Expenses
- Income Summary
- Dividends
Keep in mind, Balance Sheet accounts (A = L + E) never get closed. Their balances persist from one period to the next.
- Also, remember: All income statement accounts are considered temporary.
- By closing these accounts at the end of each period, we ensure that the revenues and expenses reflected in an income statement pertain only to that specific period.
Permanent accounts do not get closed at the end of each period. Utilize the R.E.I.D acronym to remember which accounts get closed at the end of each period:
- Revenues
- Expenses
- Income Summary
- Dividends
Any account not in the R.E.I.D. acronym (like an asset such as cash or accounts receivable) is known as “permanent” — meaning it’s never closed. In particular, no Balance Sheet accounts (represented by A = L + E) are ever closed. They retain their balances from one period to the next.
Closing Entries
Use the R.E.I.D acronym to easily recall the accounts closed at the end of each period!
- Revenues
- Expenses
- Income Summary
- Dividends
Closing Revenue Accounts
With a solid understanding of debits & credits for each account type, closing entries become very straightforward. Let's reference the following framework from Chapter 2 for debits & credits: Assets = Liabilities + Equity Revenues / Expenses (+/-) (-/+) (-/+) (-/+) (+/-)
- Revenues operate on a (-/+) basis, meaning to close (i.e., reduce to zero), we must DEBIT THEM.
- Then, we total the closed revenue accounts, and “dump” them into the Income Summary on the other side of the entry — ensuring debits are equal to credits.
- This is simply a hypothetical scenario.
- Depending on your exam, you may have only one revenue account to close (e.g. Fees Earned), or multiple revenue accounts needing closing (Fees Earned, Consulting Revenue, Rent Revenue, Sales, etc.).
- In essence, the point I’m trying to illustrate is that, whatever revenues you see on the income statement — they will ALL need to be closed!
Use the R.E.I.D acronym to easily recall the accounts closed at the end of each period!
- Revenues
- Expenses
- Income Summary
- Dividends
Closing Expense Accounts
With a solid understanding of debits & credits for each account type, closing entries become very straightforward. Let's reference the following framework from Chapter 2 for debits & credits: Assets = Liabilities + Equity Revenues / Expenses (+/-) (-/+) (-/+) (-/+) (+/-)
- Expenses work the opposite of revenues, like (+/-), which means to close, i.e. reduce them to zero, — we must CREDIT THEM.
- Then, we total the closed expense accounts, and “dump” them into the Income Summary on the other side of the entry — ensuring debits are equal to credits.
- This is simply a hypothetical scenario.
- Depending on your exam, you may have only one expense account to close (e.g. Cost of Goods Sold), or multiple expense accounts needing closing (Depreciation Expense, Wages Expense, Rent Expense, Advertising Expense, etc.).
- In essence, the point I’m trying to illustrate is that, whatever expenses you see on the income statement — they will ALL need to be closed!
Use the R.E.I.D acronym to easily recall the accounts closed at the end of each period!
- Revenues
- Expenses
- Income Summary
- Dividends
- Closing the Income Summary Account (Net Income Scenario)
- Closing this account depends on whether we had a net income (Revenues > Expenses) or a net loss (Revenues < Expenses) for a given period.
- This is best illustrated by using a T Account for Income Summary, which includes entries from the previous steps of closing revenues and expenses (R.E.I.D).
- Refer to the example below, drawing on prior examples of closing entries — which lead to Net Income:
- Simply put, the "Income Summary" account is a summarization of the Net Income or loss.
- Therefore, in this example, context, the $25,000 debit balance in Income Summary represents Net Income!
- This ending balance is derived from the debit to Income Summary of $100,000 (closing revenues) minus the credit to Income Summary of $75,000 (closing expenses),
- Since Revenues were greater than Expenses, this results in our Net Income of $25,000.
- This aligns with the Net Income calculation in an income statement:
- Revenues Equals Net Income or Loss
- Making sense?
- In my opinion, this understanding of how the Income Summary account functions is crucial — as it provides a much deeper comprehension than simply memorizing the closing entry.
- Remembering the closing entry for Income Summary, in a Net Income scenario, becomes way easier when we focus on why Retained Earnings, an equity account (-/+), is credited.
- Recall that crediting an equity account (-/+), like Retained Earnings, will INCREASE that account.
- If we have Net Income, why should we increase Retained Earnings when closing Income Summary?
- Because Net Income for the period does exactly that—it gets added to the Retained Earnings account!
- To illustrate this, reflect on the Statement of Retained Earnings formula from previous chapters:
- PLUS NET INCOME*
- Seeing it?
- Notice that when closing the Income Summary account under a Net Income scenario — we need to increase Retained Earnings by crediting it, since we know that Net Income is added to Retained Earnings!
- If you remember this, you'll automatically know that the opposite side, the debit, goes to Income Summary.
Less Expenses
Beginning R/E
Minus Dividends
Equals Ending R/E
Use the R.E.I.D acronym to easily recall the accounts closed at the end of each period!
- Revenues
- Expenses
- Income Summary
- Dividends
- Closing the Income Summary Account (Net Loss Scenario)
- Revenues
- Expenses
- Income Summary
- Dividends
- Closing the Income Summary Account (Net Loss Scenario)
- Closing this account depends on whether we had a net income (Revenues > Expenses) or a net loss (Revenues < Expenses) for a given period.
- This is best illustrated by using a T Account for Income Summary, which includes entries from the previous steps of closing revenues and expenses (R.E.I.D).
- Refer to the example below, drawing on hypothetical examples of closing entries — which lead to a Net Loss:
- Simply put, the "Income Summary" account is a summarization of the Net Income or loss.
- Therefore, in this example, context, the $25,000 credit balance in Income Summary represents a Net Loss!
- This ending balance is derived from the debit to Income Summary of $75,000 (closing revenues) minus the credit to Income Summary of $100,000 (closing expenses),
- Since Expenses were greater than Revenues, this results in our Net Loss of $25,000.
- This aligns with the Net Income calculation in an income statement:
- Revenues Equals Net Income or Loss
- Making sense?
- In my opinion, this understanding of how the Income Summary account functions is crucial — as it provides a much deeper comprehension than simply memorizing the closing entry.
- Remembering the closing entry for Income Summary, in a Net Loss scenario, becomes way easier when we focus on why Retained Earnings, an equity account (-/+), is debited.
- Recall that debiting an equity account (-/+), like Retained Earnings, will DECREASE that account.
- If we have a Net Loss, why should we decrease Retained Earnings when closing Income Summary?
- Because Net Loss for the period does exactly that—it gets subtracted from the Retained Earnings account!
- To illustrate this, reflect on the Statement of Retained Earnings formula from previous chapters:
- MINUS NET LOSS*
- Seeing it?
- Notice that when closing the Income Summary account under a Net Income scenario — we need to decrease Retained Earnings by debiting it, since we know that Net Income is added to Retained Earnings!
- If you remember this, you'll automatically know that the opposite side, the credit, goes to Income Summary!
Use the R.E.I.D acronym to easily recall the accounts closed at the end of each period!
Less Expenses
Beginning R/E
Minus Dividends
Equals Ending R/E
Use the R.E.I.D acronym to easily recall the accounts closed at the end of each period!
- Revenues
- Expenses
- Income Summary
- Dividends
Closing Dividends (Contra Equity)
With a solid understanding of debits & credits for each account type, closing entries become very straightforward. Let's reference the following framework from Chapter 2 for debits & credits: Assets = Liabilities + Equity Revenues / Expenses (+/-) (-/+) (-/+) (-/+) (+/-)
Contra — i.e. opposite of — Equity? (+/-)
- Dividends operates on a (+/-) basis, meaning to close (i.e., reduce to zero), we must CREDIT the account.
- Recall that debiting an equity account (-/+), like Retained Earnings, will DECREASE that account.
- If we’ve paid Dividends, why does this decrease Retained Earnings?
- Because Dividends for the period do exactly that—they gets subtracted from the Retained Earnings account!
- To illustrate this, reflect on the Statement of Retained Earnings formula from previous chapters:
Beginning R/E
Plus Net Income
- Minus Dividends*
Equals Ending R/E
- Seeing it?
- Connecting the closing of Dividends to the idea that Dividends are subtracted in the Statement of Retained Earnings can be a super useful memorization tool.
- If you remember that Dividends decrease Retained Earnings — it will help you recall that Retained Earnings must be debited when closing out Dividends!
