5. Adjusting Entries, Closing Accounts, & the Income Statement
Page 1: Title and Author
Topic: Adjusting Entries, Closing Accounts, & the Income Statement
Author: S. Levkoff, PhD, CAP®
Institution: UC San Diego Department of Economics & Rady School of Management
Page 2: The Accounting Cycle Overview
The accounting cycle includes key steps to manage financial transactions:
Analyze Start new period Transactions
During Period: Journalize and Post
End of Period: Adjusted Trial Balance, Financial Statements
Closing Entries to finalize accounts
Page 3: Steps in the Accounting Cycle
Analyze Transactions
Journalize: Record each transaction as a journal entry in the general journal.
Post: Transfer each journal entry to the appropriate T-account or general ledger.
Page 4: Unadjusted Trial Balance
After posting, prepare an unadjusted trial balance:
Sum account balances to verify debits = credits.
Adjusting Entries: Necessary to update account balances for:
Deferred revenues and expenses
Unrecorded assets and liabilities
Accrued revenues and expenses
Page 5: Purpose of Adjusting Entries
Ensure complete accounting of expenses/revenues incurred.
Adjusting entries update account balances before concluding the cycle:
Must comply with accrual principles (recognizing revenues & matching expenses).
Page 6: Categories of Adjusting Entries
Four main categories of adjusting entries:
Deferred Revenues
Deferred Expenses
Accrued Revenues
Accrued Expenses
Page 7: Deferred Revenues
Reflect cash inflows for services/goods provided but not yet recognized as revenue.
Page 8: Examples of Deferred Revenues
Are liabilities recognized by delivery of goods/services?
Examples include:
Unearned rental revenue
Unearned revenue on long-term contracts
Deferred subscription revenue
Journal Entry:
Dr. Unearned Revenue Liability
Cr. Revenue
Page 9: Deferred Expenses
Expenses incurred but not yet recognized.
Recognizing cash outflows from using up assets this period.
Page 10: Examples of Deferred Expenses
Common deferred expenses may include:
Prepaid rent
Prepaid insurance
Software licenses
Legal counsel fees
Depreciation
Journal Entry:
Dr. Expense
Cr. Prepaid Asset
Page 11: Accrued Revenues
Revenues that are earned but not yet recorded.
Create new account balances for expected future cash inflow.
Page 12: Examples of Accrued Revenues
Examples include:
Interest Receivable
Rent Receivable
Journal Entry:
Dr. Receivable Asset
Cr. Revenue
Page 13: Accrued Expenses
Expenses incurred but not yet accounted for.
Create new accounts for expected future cash outflow.
Page 14: Examples of Accrued Expenses
Examples include:
Income Taxes Payable
Interest Payable
Salaries/Wages Payable
Journal Entry:
Dr. Expense
Cr. Payable Liability
Page 15: Overview of Adjusting Entries
Examples of debits and credits for different types of adjusting entries.
Consistent use of accounts ensures accurate recognition of revenues and expenses.
Page 16: Depreciation
Depreciation relates to the reduction in value of an asset due to use/wear and tear.
Recognized as an expense without cash outflows being recorded simultaneously.
Page 17: Amortization
Amortization refers to allocating the cost of a tangible asset over its useful life.
It applies the same concept as depreciation but typically for intangible assets.
Page 18: Tangible Assets
Tangible: Physical assets that incur depreciation. Examples include:
Office equipment
Buildings
Page 19: Intangible Assets
Intangible: Non-physical assets that do not depreciate.
Amortization is used for these assets, aligning with the matching principle.
Page 20: Accounting for Depreciation
Depreciation recorded in a Contra Asset Account named Accumulated Depreciation.
It has a credit balance, which reduces the book value of PP&E on the balance sheet.
Page 21: Salvage Value
Definition: Estimated resale value of an asset at the end of its useful life.
Important for determining depreciation expense.
Page 22: Straight-Line Depreciation
Method to uniformly allocate depreciation over the asset's useful life.
Steps include:
Subtracting salvage value from the asset's cost.
Spreading the remaining value over the usage horizon.
Page 23: Mathematical Calculation of Straight-Line Depreciation
Depreciation Expense Formula:
[ \text{Depreciation Expense} = \frac{\text{Cost} - \text{Salvage Value}}{\text{Useful Life}} ]
Page 24: Visual of Straight-Line Depreciation
Graph showing depreciation expense over number of periods (years).
Page 25: Other Methods of Depreciation
Other reporting methods exist beyond straight-line depreciation (e.g., MACRS).
Different methods may provide tax advantages by recognizing higher expenses earlier.
Page 26: Example 1 - Interest Revenue
Sept. 30: Loan transaction recorded for $100,000 at 12% interest.
December 31, adjusting for interest receivable.
January 10, recording cash received for interest.
Page 27: Example 2 - Salaries Payable
Salaries earned but unpaid at year-end adjustment.
Adjusted entries made for expenditures incurred in the period.
Page 28: Example 3 - Prepaid Rent
Prepaid rent recorded in advance; adjusting entry made at year-end.
Page 29: Example 4 - Depreciation Expense
Building purchased with adjusting entry for depreciation recognized at year-end.
Page 30: Example 5 - Unearned Revenue
Payment received for software in advance, adjusting entries recognized at year-end.
Page 31: Example 6 – Adjusting Entry Rule
Outstanding order means no adjustment; revenue has not been earned yet.
Page 32: Accounting Cycle Reminder
Routine steps of the accounting process highlighted.
Page 33: Trial Balances Explanation
Unadjusted Trial Balance: Account balances before adjustments.
Adjusted Trial Balance: Balances after adjustments, used for financial statements.
Page 34: Preparing Financial Statements
Prepare the Statement of Income
Update Retained Earnings based on Net Income to prepare the Balance Sheet.
Complete the Statement of Cash Flows.
Complete the Statement of Stockholders’ Equity.
Page 35: Income Statement Format
Structure of an Income Statement includes Revenues, COGS, Gross Profit, Operating Income, Pre-tax Income, and Net Income.
Page 36: Balance Sheet Format
Assets listed first, ordered by liquidity:
Current assets, followed by noncurrent assets.
Tangible and intangible distinctions noted.
Page 37: Liabilities and Stockholders’ Equity Format
Structure for liabilities and equity:
Current liabilities followed by noncurrent liabilities.
Summarizes capital structures like Retained Earnings.
Page 38: Closing Accounts Overview
Differentiates between temporary and permanent accounts:
Temporary accounts closed to Retained Earnings.
Permanent accounts reflect transactions throughout business life.
Page 39: Closing Entries Process
Closing entries defined for final accounting transactions
Transfer balances from revenue and expenses to Retained Earnings at period-end.
Page 40: Recap of the Accounting Cycle
Reinforces the previously outlined accounting process steps.