Adjusting and Closing Process

Accrual Accounting

Revenues are recorded when earned, and expenses are recorded in the period they help earn revenues (when incurred), as required by GAAP.

Realization Principle

Revenues are recorded in the period they are earned, regardless of when cash is received.

Matching Concept

Expenses are recognized in the period they are incurred to help generate revenues, regardless of when cash is paid

Adjusting Entries

Journal entries made at the end of an accounting period to update account balances, required because of accrual accounting.

Two Main Categories of Adjustments

1. Deferrals (cash exchanged before action) 2. Accruals (action occurs before cash exchange)

Deferrals Definition

Transactions where cash has been received or paid while the related revenue or expense has not yet been recorded.

Deferred (Prepaid) Expenses

Expenses paid for in advance and initially recorded as an asset; they become expenses only when "used up".

Adjusting Entry for Prepaid Expenses

Debit an Expense account and credit an Asset account.

Supplies Classification

Classified as an asset when purchased, and becomes an expense (Supplies Expense) once used up

Formula to Find Supplies Used

Beginning Supplies + Supplies Purchased - Ending Supplies (on hand) = Supplies Used.

Deferred Revenues (Unearned Revenue)

When a company receives cash in advance for services to be performed or goods delivered later; recorded as a liability.

When Unearned Revenue Becomes Revenue

Only when it is earned by performing the service or delivering the good.

Adjusting Entry for Unearned Revenues

Debit a Liability account (Unearned Revenue) and credit a Revenue account.

Important Learning Tip for Unearned Revenue

It is classified as a liability on the balance sheet, not a revenue, and does not affect net income when initially received.

Accruals Definition

Transactions where cash has not yet been received or paid, but the related revenue or expense has been earned or incurred.

Accrued Revenues Adjusting Entry

Debit an Asset account (Accounts Receivable) and credit a Revenue account.

Accrued Expenses Adjusting Entry

Debit an Expense account and credit a Liability account (e.g., Salaries Payable).

Depreciation Definition

The systematic allocation of the cost of a plant asset (buildings and equipment) to expense over its useful life ("using up" the asset).

Key Misconception About Depreciation

Depreciation has absolutely nothing to do with market value; it is a cost-allocation process based on the matching concept, not asset valuation

Adjusting Entry for Depreciation

Debit Depreciation Expense and credit Accumulated Depreciation.

Accumulated Depreciation Classification

A contra asset account with a normal credit balance that appears on the balance sheet directly underneath the related asset.

Annual Depreciation Formula

(Cost−Residual Value)÷Useful Life=Depreciation Expense.

Interest Formula

Interest=Principal×Rate×Time.

Three Rules for Interest Calculation

1. The rate is always an annual rate. 2. Time is always a fraction over 12 (number of elapsed months divided by 12). 3. Assumes interest is repaid at the end of the loan term unless stated otherwise.

Adjusting Entry for Interest Expense

Debit Interest Expense and credit Interest Payable (classified as an accrual).

Adjusting Entry for Interest Revenue

Debit Interest Receivable and credit Interest Revenue

Nominal (Temporary) Accounts

Accounts closed to a zero balance at the end of every year; include revenues, expenses, and dividends

Permanent (Real) Accounts

Accounts that are never closed to zero; include assets, liabilities, and equity.

Purpose of Closing Entries

To transfer net income/loss and dividends balances into Retained Earnings.

Three Closing Steps

1. Close revenues into Retained Earnings (Debit revenue, credit Retained Earnings). 2. Close expenses into Retained Earnings (Debit Retained Earnings, credit expenses) 3. Close dividends into Retained Earnings (Debit Retained Earnings, credit dividends).

State of Accounts After Closing

All temporary accounts have a zero balance, and Retained Earnings reflects accumulated undistributed earnings.