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Adjusting and closing entries

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Introduction to Adjusting and Closing Entries

In the journey of preparing accurate financial statements, two crucial steps ensure that the records reflect the true financial position and performance of a business: adjusting entries and closing entries. These entries are made at specific points in the accounting cycle to align the books with accounting principles such as the matching principle and revenue recognition principle.

Adjusting entries update account balances before financial statements are prepared, ensuring revenues and expenses are recorded in the correct period. Closing entries, on the other hand, reset temporary accounts to zero, preparing the books for the next accounting period.

Understanding these entries is essential for anyone aiming to master financial accounting, especially for competitive exams where precision and clarity are tested.

Adjusting Entries

Adjusting entries are journal entries made at the end of an accounting period to record revenues and expenses in the period they actually occur, rather than when cash changes hands. This is important because the accounting records must follow the accrual basis of accounting, which recognises economic events regardless of cash flow timing.

Adjusting entries are typically made after preparing an unadjusted trial balance but before preparing final accounts.

graph LR    A[Start of Accounting Period] --> B[Record Transactions in Journal]    B --> C[Post to Ledger Accounts]    C --> D[Prepare Unadjusted Trial Balance]    D --> E[Make Adjusting Entries]    E --> F[Prepare Adjusted Trial Balance]    F --> G[Prepare Final Accounts]    G --> H[Make Closing Entries]    H --> I[Prepare Post-Closing Trial Balance]

Types of Adjusting Entries

  • Accrued Revenues: Revenues earned but not yet recorded or received in cash.
  • Accrued Expenses: Expenses incurred but not yet recorded or paid.
  • Prepaid Expenses: Payments made in advance for expenses to be incurred in future periods.
  • Unearned Revenues: Cash received in advance for services or goods to be delivered later.
  • Depreciation: Allocation of the cost of a fixed asset over its useful life.

Each type of adjusting entry ensures that the financial statements reflect the true financial position and performance for the period.

Closing Entries

Closing entries are journal entries made at the end of the accounting period to transfer the balances of temporary accounts to permanent accounts. This process resets the balances of revenue, expense, and drawing accounts to zero, so they can begin fresh in the next period.

The main purpose of closing entries is to update the capital or retained earnings account with the net profit or loss for the period.

graph TD    A[Revenue Accounts] --> B[Income Summary Account]    C[Expense Accounts] --> B    B --> D[Capital Account]    E[Drawings Account] --> D    D --> F[Permanent Accounts Ready for Next Period]

Temporary vs Permanent Accounts

Temporary accounts include revenue, expense, and drawing accounts. Their balances are closed at the end of each period.

Permanent accounts include assets, liabilities, and capital accounts. Their balances carry forward to the next period.

Post-Closing Trial Balance

After closing entries are posted, a post-closing trial balance is prepared to ensure that total debits equal total credits and that all temporary accounts have zero balances.

Worked Examples

Example 1: Adjusting Prepaid Expenses Easy
A company paid INR 12,000 on 1st January for a 12-month insurance policy. At the end of January, how should the prepaid insurance be adjusted?

Step 1: Determine the monthly insurance expense.

Monthly expense = INR 12,000 / 12 months = INR 1,000

Step 2: Prepare the adjusting entry for one month expired.

Debit: Insurance Expense INR 1,000

Credit: Prepaid Insurance INR 1,000

Answer: The adjusting entry reduces prepaid insurance by INR 1,000 and records insurance expense for January.

Example 2: Accrued Salaries Expense Adjustment Medium
Employees earned salaries of INR 15,000 by 31st March but have not yet been paid. Record the adjusting entry.

Step 1: Identify the accrued expense amount.

Salaries accrued = INR 15,000

Step 2: Prepare the adjusting journal entry.

Debit: Salaries Expense INR 15,000

Credit: Salaries Payable (Liability) INR 15,000

Answer: Salaries expense is recognized, and a liability is recorded for unpaid salaries.

Example 3: Closing Revenue and Expense Accounts Medium
A business has revenue of INR 1,00,000 and expenses of INR 70,000 for the year. Close these accounts to the capital account.

Step 1: Close revenue to capital.

Debit: Revenue INR 1,00,000

Credit: Capital INR 1,00,000

Step 2: Close expenses to capital.

Debit: Capital INR 70,000

Credit: Expenses INR 70,000

Step 3: Calculate net profit added to capital.

Net Profit = Revenue - Expenses = INR 1,00,000 - INR 70,000 = INR 30,000

Answer: Revenue and expenses are closed to capital, increasing capital by net profit of INR 30,000.

Example 4: Depreciation Adjustment Using Straight Line Method Medium
A machine costing INR 1,20,000 has a useful life of 10 years and a residual value of INR 20,000. Calculate annual depreciation and prepare the adjusting entry.

Step 1: Calculate annual depreciation using the formula:

\[ \text{Depreciation Expense} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life}} \]

Substitute values:

\[ \frac{1,20,000 - 20,000}{10} = \frac{1,00,000}{10} = INR 10,000 \]

Step 2: Prepare the adjusting entry.

Debit: Depreciation Expense INR 10,000

Credit: Accumulated Depreciation INR 10,000

Answer: Depreciation expense of INR 10,000 is recorded for the year.

Example 5: Preparing Post-Closing Trial Balance Hard
After closing entries, prepare a post-closing trial balance from the following adjusted balances:
AccountDebit (INR)Credit (INR)
Cash50,000
Accounts Receivable30,000
Equipment1,00,000
Accumulated Depreciation20,000
Accounts Payable15,000
Capital1,45,000

Step 1: List all permanent accounts and their balances.

Step 2: Prepare the trial balance.

AccountDebit (INR)Credit (INR)
Cash50,000
Accounts Receivable30,000
Equipment1,00,000
Accumulated Depreciation20,000
Accounts Payable15,000
Capital1,45,000
Totals1,80,0001,80,000

Answer: The post-closing trial balance balances with total debits and credits of INR 1,80,000, confirming all temporary accounts are closed.

Tips & Tricks

Tip: Remember the acronym "A-P-U-E" for common adjusting entries: Accrued, Prepaid, Unearned, Expenses.

When to use: When identifying which adjusting entries to prepare at period-end.

Tip: Close revenue and expense accounts by transferring balances to Income Summary or directly to Capital to avoid confusion.

When to use: During the closing entries process.

Tip: Always cross-check the trial balance before and after adjusting entries to ensure debits equal credits.

When to use: While preparing adjusting and closing entries.

Tip: Use a flowchart to visualize the accounting cycle stages to better understand where adjusting and closing entries fit.

When to use: When revising the accounting cycle.

Tip: For depreciation, memorize the straight-line formula as it is the most common and exam-relevant method.

When to use: While solving depreciation adjustment problems.

Common Mistakes to Avoid

❌ Failing to record accrued expenses leading to understated liabilities and expenses.
✓ Always check for expenses incurred but not yet paid and record adjusting entries accordingly.
Why: Students often overlook expenses without cash transactions.
❌ Confusing prepaid expenses with expenses incurred leading to incorrect debit/credit entries.
✓ Understand that prepaid expenses are assets initially and need adjustment to expense portion only.
Why: Misunderstanding of asset vs expense timing.
❌ Not closing temporary accounts causing balances to carry over to next period.
✓ Ensure all revenue and expense accounts are closed to capital or income summary accounts.
Why: Lack of clarity on temporary vs permanent accounts.
❌ Incorrect calculation of depreciation due to ignoring residual value or useful life.
✓ Always subtract residual value and use correct useful life in formula.
Why: Rushing through calculations without careful reading.
❌ Posting adjusting entries before trial balance preparation causing confusion.
✓ Prepare unadjusted trial balance first, then post adjusting entries.
Why: Misunderstanding of accounting cycle sequence.

Formula Bank

Depreciation Expense (Straight Line)
\[ \text{Depreciation Expense} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life}} \]
where: Cost = Initial cost of asset; Residual Value = Estimated salvage value; Useful Life = Expected life in years
Accrued Expense Adjustment
\[ \text{Expense}_{\text{Accrued}} = \text{Expense}_{\text{Incurred but not Paid}} \]
where: ExpenseAccrued = Amount of expense to be recognized
Unearned Revenue Adjustment
\[ \text{Revenue}_{\text{Earned}} = \text{Revenue}_{\text{Received in Advance}} - \text{Revenue}_{\text{Unearned}} \]
where: RevenueEarned = Revenue to be recognized; RevenueUnearned = Portion still unearned

Key Takeaways

  • Adjusting entries align revenues and expenses to the correct accounting period following accrual accounting.
  • Closing entries reset temporary accounts to prepare for the next period.
  • Common adjustments include accrued items, prepaid expenses, unearned revenues, and depreciation.
  • Accurate adjusting and closing entries ensure reliable financial statements.
  • Always verify trial balances before and after adjustments to maintain accuracy.
Key Takeaway:

Mastering adjusting and closing entries is essential for accurate financial reporting and exam success.

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