AFM 101 - Chapter #4 Notes
The accounting cycle is the process used by firm to analyse and record transactions, adjust entries, prepare
financial statements for investors, and prepare records for the next period
In this chapter, we focus on end-of-period adjusting of entries in order to record revenues and expenses in
the proper period.
Although accounting systems are designed to record most transactions daily dealing with cash, this is most
effective when the service and the payment for the service occurs within the same fiscal period.
HOWEVER , cash in NOT ALWAYS received in the same period in which the company earns revenue,
LIKEWISE the cash is NOT ALWAYS paid in the same period in which the company incurs an expense.
HOW does the accounting system record expenses and revenue when ONE transaction in needed to
account for cash receipts and payments and ANOTHER to account for expenses incurred or revenues
earned? THE SOLUTION TO THIS problem is the recording of adjusting entries at the end of the period so
1. Revenues are recorded in the period they are earned
2. Expenses are recorded in the same principle as the revenue they helped earn
3. Assets are reported at the amounts they truly represent, meaning what is left of them (ex - prepaid
4. Liabilities are reported at the amount that they truly represent.
Companies wait until the end of the period to adjust their entries because adjusting them on a
daily basis would be very time consuming and costly.
There are 4 types of adjustments divided in 2 categories: Deferred (money paid/received in
advance) and Accrued (money paid/received after service is received or performed)
1. Deferred Revenues (or unearned revenue): are LIABILITIES that result from cash being
paid in advance before services are performed. An example of this is if a customer pays in
advance for one years insurance $1200. Therefore, we debit cash and credit unearned
revenue or deferred revenue. This is because ALTHOUGH we receive the cash THIS year,
we earn the Revenue NEXT year! Why? Because technically speaking, this deferred revenue
is a liability because it is an OBLIGATION to perform a service, and when and only when
this service is performed, then the cash can become revenue. It is only when the entry is
adjusted that you debit this unearned revenue and finally credit revenue ( the form of the
adjusting entry is liability↓ and revenue ↑)
2. Deferred Expenses( or prepaid expense) – are ASSETS that result from cash being paid
in advance before services are received (before expense is incurred). Example – my
company buys a years worth of rent for $1400. Therefore we debit prepaid insurance and
credit cash. This is because we PAID in advance and so becomes an assets HOWEVER
with time it will LATER become an expense. The adjusting entry for this is debit
insurance expense and credit prepaid insurance. (The form of the adjusting entry is
expense ↑ asset ↓)
Note: Deferred transactions ↑, are during period and adjusting entry is at the end of the period
3. Accrued Revenues – are ASSETS that result from performing a service in advance
(EARNING REVENUE IN ADVANCE) and receiving cash after. An example of this is lets say,
you’re a plumber and you’ve performed a service, therefore you’ve EARNED your revenue IN
ADVANCE but haven’t sent the bill. This is because although the service has been
performed, the revenue earned, it has NOT been RECORDED yet and therefore cannot be
recorded as a revenue, only when you receive this cash can you record the revenue. This is an ASSET because you are OWED money. Therefore, you debit accounts receivable
and credit respective revenue account. THIS IS DONE AT THE END OF THE PERIOD AS
AN ADJUSTING ENTRY(asset ↑ revenue↑). In the next period, when cash is received and
revenue recorded, cash is debited and receivables are credited.
4. Accrued Expenses – are LIABILITIES that result from incurring