ACCT1001 · Financial Accounting 1
The Accounting Cycle and Adjusting Entries
This is the spine of the whole subject and the single largest source of exam marks. It starts from the accounting equation A = L + E and the debit/credit rules (remembered with DEAD/CLIR — Drawings, Expenses, Assets are debit-normal; Capital, Liabilities, Income are credit-normal), then walks the nine-station cycle: source document → journalise → post to the ledger → unadjusted trial balance → adjusting entries → adjusted trial balance → financial statements → closing entries → post-closing trial balance. The heavy lifting is at balance day, where the accrual basis forces adjusting entries in five families — prepayments, unearned revenue, accrued expenses, accrued revenue and depreciation. Each adjustment obeys one iron rule: it pairs exactly one profit-or-loss account with one balance-sheet account and never touches cash. The chapter ends by producing the three statements in the locked order Income Statement → Statement of Changes in Equity → Balance Sheet, which is the exact shape a final-exam question follows.
What this chapter covers
- 012.1 The accounting equation A = L + E — the AHA unit
- 022.2 Debit/credit rules: DEAD & CLIR
- 032.3 The nine-station accounting cycle
- 042.4 Accrual basis vs cash basis & the matching principle
- 052.5 Family (a): prepayments / deferred expenses
- 062.6 Family (b): unearned revenue
- 072.7 Family (c): depreciation
- 082.8 Family (d): accruals (accrued expense & accrued revenue)
- 09Comprehensive worked example → adjusted trial balance → the three statements
Worked example: one prepayment adjustment, posted and re-footed
- +1Find the expired portion: 2 of the 6 months have passed (1 May → 30 June), so $3,600 × 2/6 = $1,200 of insurance has been used up.
- +1Identify the two accounts: the expense (Insurance Expense, a P&L account) and the asset being reduced (Prepaid Insurance, a balance-sheet account) — never cash.
- +1Journalise: Dr Insurance Expense $1,200 / Cr Prepaid Insurance $1,200.
- +1Re-foot: the expense raises total expenses by $1,200 (lowering profit), and the asset Prepaid Insurance falls by $1,200 — equity falls by the same $1,200, so A = L + E still holds.
- +1State the omission effect: leaving it out overstates profit by $1,200 and overstates assets (and therefore equity) by $1,200.
Key terms
- Debit and credit
- The two sides of every entry. Debit means the left side, credit the right; whether a debit increases or decreases an account depends on the element. DEAD accounts (Drawings, Expenses, Assets) are debit-normal and increase with a debit; CLIR accounts (Capital, Liabilities, Income) are credit-normal and increase with a credit.
- Trial balance
- A list of every ledger account balance with debits in one column and credits in the other. It proves the books are arithmetically equal (total debits = total credits) but it does NOT prove they are correct — it cannot catch a missing entry, a misclassification, or two compensating errors.
- Accrual basis
- The basis required for Australian general purpose financial reporting: recognise revenue when it is earned (the performance obligation is satisfied) and expenses when they are incurred (the benefit is consumed), regardless of when cash moves. Contrast with the cash basis, which only records cash in and out.
- Matching principle
- Recognise expenses in the same period as the revenues they helped generate. It is the engine behind depreciation (an asset's cost matched to the periods that use it) and cost of goods sold (inventory cost matched to the sales it produced); cash timing is irrelevant to matching.
- Adjusting entry
- A balance-day journal that brings the accounts to accrual basis before the statements are drawn. Each one pairs one income-statement account with one balance-sheet account and never touches cash; the five families are prepayments, unearned revenue, accrued expenses, accrued revenue and depreciation.
The Accounting Cycle and Adjusting Entries FAQ
Does debit mean add and credit mean subtract?
No — this is the single biggest first-year error. A debit increases a debit-normal account (asset, expense, drawings) but decreases a credit-normal account (liability, capital, revenue). Always anchor on the element type first (is this an asset? a liability? a revenue?), then choose the direction. Debit just means the left column and credit the right; which one increases the account depends entirely on the element.
How do I know which adjusting entry a question needs?
Classify the timing. If cash was paid in advance and is partly used up, it is a prepayment. If cash was received in advance and is partly earned, it is unearned revenue. If an expense has been incurred but not yet paid, it is an accrued expense; if revenue has been earned but not yet received, it is accrued revenue. If a non-current asset's cost is being spread over its life, it is depreciation. Then apply the iron rule: one P&L account, one balance-sheet account, never cash.
Why must the three statements come in the order IS → SOCE → BS?
Because each feeds the next. Profit for the period (from the Income Statement) is an input to the Statement of Changes in Equity; the closing equity figure (from the SOCE) is an input to the Balance Sheet. Students who start with the Balance Sheet get stuck because they have no ending-equity number. The order is locked — produce the Income Statement first, every time.
If the trial balance balances, are the books correct?
No. A trial balance whose debit column equals its credit column only proves arithmetic equality. It will happily hide a whole transaction that was omitted, a classification error (rent recorded as wages), or two equal-and-opposite mistakes that cancel out. The trial balance is necessary but not sufficient — most exam marks live in the adjusting entries at station five, not in the trial balance itself.
Exam move
This chapter is where you bank the most marks, so over-drill it. Lock in DEAD/CLIR until the normal side of any account is instant, and practise the nine-station cycle until you can name what each station produces and which station a question starts and finishes at (most exam prompts hand you a trial balance and ask for a later station). Drill the five adjusting-entry families until the direction is automatic, always checking the iron rule: one P&L account, one balance-sheet account, never cash. Finish by producing the three statements in the locked order IS → SOCE → BS on a comprehensive worked example, because that end-to-end run is the literal shape of the final-exam question.
