Principles of Financial Accounting: The Accounting Cycle Adjusting Entries Accruals Deferrals Depreciation Prepayments Unearned Revenues

What It Is

Adjusting entries are journal entries made at the end of an accounting period to ensure that the financial statements accurately reflect the company's financial position. These entries correct for accruals (expenses or revenues not yet recorded), deferrals (revenues or expenses that have been recorded but not yet earned or incurred), depreciation (the decrease in value of assets over time), prepayments (payments made in advance of services or goods), and unearned revenues (revenues received in advance of services or goods). If a company buys $10,000 of inventory on December 31, but the payment is not made until January 2, an adjusting entry is needed to record the expense on December 31.

Key Concepts & Formulas

• Accrual: An expense or revenue that has been incurred or earned but not yet recorded. Example: A company has $5,000 in accrued salaries at the end of the year.
• Debit: Increases assets, expenses, and losses, and decreases liabilities, equity, and revenues. Formula: Debit = Assets + Expenses + Losses
• Credit: Increases liabilities, equity, and revenues, and decreases assets and expenses. Formula: Credit = Liabilities + Equity + Revenues
• Depreciation: The decrease in value of an asset over time. Formula: Depreciation = Cost – Residual Value
• Prepayment: A payment made in advance of services or goods. Example: A company pays $2,000 in advance for rent in January.
• Unearned Revenues: Revenues received in advance of services or goods. Example: A company receives $3,000 in advance for services to be performed in February.
• Matching Principle: Expenses should be matched with the revenues they help to generate. Formula: Gross Profit = Sales – COGS
• Accrued Expenses: Expenses that have been incurred but not yet paid. Example: A company has $4,000 in accrued rent at the end of the year.
• Accrued Revenues: Revenues that have been earned but not yet received. Example: A company has $6,000 in accrued interest at the end of the year.
• Deferred Revenues: Revenues that have been received but not yet earned. Example: A company has $8,000 in deferred rent at the end of the year.

Journal Entry Examples

1. Accrued Salaries: Dr. Salaries Expense $5,000 Cr. Salaries Payable $5,000 Explanation: The company has incurred salaries expense but not yet paid it. The salaries payable account is credited to increase liabilities.

2. Depreciation: Dr. Depreciation Expense $10,000 Cr. Accumulated Depreciation $10,000 Explanation: The company has incurred depreciation expense on its assets. The accumulated depreciation account is credited to increase equity.

3. Prepayment: Dr. Rent Expense $2,000 Cr. Prepaid Rent $2,000 Explanation: The company has made a prepayment for rent but has not yet incurred the expense. The prepaid rent account is credited to increase assets.

Common Mistakes

1. Mistake: Confusing debits and credits for expense accounts.
   Correction: Remember that debits increase assets, expenses, and losses, and decrease liabilities, equity, and revenues. Credits increase liabilities, equity, and revenues, and decrease assets and expenses.
2. Mistake: Forgetting to match expenses with revenues.
   Correction: Use the matching principle to match expenses with the revenues they help to generate. Formula: Gross Profit = Sales – COGS
3. Mistake: Not reversing normal balances.
   Correction: Remember that assets, expenses, and losses have normal debit balances, while liabilities, equity, and revenues have normal credit balances.

Exam Tips

1. Tip: A debit increases assets AND expenses – remember ‘ADE’ (Assets, Drawings, Expenses).
2. Tip: Be careful with reversing normal balances – assets, expenses, and losses have normal debit balances, while liabilities, equity, and revenues have normal credit balances.
3. Tip: Use the matching principle to match expenses with the revenues they help to generate. Formula: Gross Profit = Sales – COGS

Quick Practice

1. What is the adjusting entry for accrued salaries of $5,000? Answer: Dr. Salaries Expense $5,000, Cr. Salaries Payable $5,000 Explanation: The company has incurred salaries expense but not yet paid it.

2. What is the adjusting entry for depreciation of $10,000? Answer: Dr. Depreciation Expense $10,000, Cr. Accumulated Depreciation $10,000 Explanation: The company has incurred depreciation expense on its assets.

3. What is the adjusting entry for a prepayment of $2,000? Answer: Dr. Rent Expense $2,000, Cr. Prepaid Rent $2,000 Explanation: The company has made a prepayment for rent but has not yet incurred the expense.

Last-Minute Cram Sheet

1. ⚠️ Dividends are NOT an expense – they go directly to retained earnings.
2. Debit = Assets + Expenses + Losses
3. Credit = Liabilities + Equity + Revenues
4. Gross Profit = Sales – COGS
5. Accruals are expenses or revenues not yet recorded.
6. Deferrals are revenues or expenses that have been recorded but not yet earned or incurred.
7. Depreciation is the decrease in value of assets over time.
8. Prepayments are payments made in advance of services or goods.
9. Unearned Revenues are revenues received in advance of services or goods.
10. The matching principle matches expenses with the revenues they help to generate.