Adjusting Entries Handouts
Adjusting Entries Handouts
Adjusting Entries Handouts
The cash basis of accounting recognizes revenue when cash is received; and recognizes
expenses when cash is paid. For example, under the cash basis, services rendered in 2020 for
which cash is collected in 2021 would be treated as 2021 revenues. Similarly, under the cash
basis, expenses incurred in 2020 for which cash for which cash is disbursed in 2021 are a 2021
expense. Because of these improper assignments of revenues and expenses, the cash basis of
accounting is generally considered unacceptable. There is no need for adjusting entries under
the cash basis of accounting.
The accrual basis of accounting recognizes revenues when sales are made or services
are performed, regardless of when cash is received. It also recognizes expenses as incurred,
whether cash is paid or not. For instance, when services are performed for a customer on
account, the revenue is recorded at that time even though cash has not been received. Later,
when they receive cash, no revenue is recorded because it has already been recorded. Under
the accrual basis, adjusting entries are used to bring the accounts up to date for economic
activity that has taken place but has not yet been recorded.
Accounting Period
Accounting period is the period of time, normally one month, one quarter, or one year
into which an entity’s life is arbitrarily divided for financial statement purposes. The length of a
company’s accounting period depends upon how frequent managers, investors, and other
interested people require information about the company’s performance. Every business
prepares annual financial statements.
The twelve-month accounting period used by an entity is called its fiscal year. The fiscal
year used by most companies coincides with the calendar year and ended on December 31.
Some businesses, however, elect to use a fiscal year which ended on some other date. It may
be convenient for a business to end its fiscal year during a slack season rather than during a
time of peak activity.
Revenue Principle
The revenue principle is the basis of recording revenues; tells the accountants when to
record revenue and the amount of revenue to record. The revenue principle says to record
revenue when it has been earned – but not before. In most cases, revenue is earned when the
businesses have delivered a good or service to the customer. It also says to record revenue
for the cash value of the item transferred to the customer.
The Framework for the preparation and Presentation of Financial Statements states
that “income or revenue is recognized in the income statement when an increase in future
economic benefit related to an increase in an asset or decrease of a liability has arisen that can
be measured. This means, in effect, that the recognition of increases in assets or decreases in
liabilities.” This procedure, however, restricts the recognition of revenue to those items that
can be measure reliably and have been a sufficient degree of certainty.
The matching principle guides accounting for expenses. It identifies all expenses
incurred during the period, measure the expenses, and match them against the revenues
earned during the same time period.
The Framework for the Preparation and Presentation of Financial Statements states
that “expenses are recognized in the income statement when a decrease in future economic
benefit related to decrease in an asset or an increase of a liability has arisen that can be
measured reliably. This means, in effect, that the recognition of expense occurs simultaneously
with the recognition of an increase in liabilities or a decrease in asset.”
Periodicity Concept
Accounting periods are generally a month, a quarter or year. A period of less than a year
is an interim period. Most basic accounting period is one year. Accounting year may be fiscal,
calendar or natural.
a. Fiscal year – period of any twelve consecutive months. Fiscal year may start in any
month of the year as long as it covers 12 months
b. Calendar year – annual period ending on December 31
c. Natural year – twelve-month period that ends when business activities are at their
lowest level of annual cycle
Not all transactions can be precisely divided by the accounting periods. The purchase
of building, furniture and fixtures, machine and equipment provide benefits to the business
over all the years in which such an asset is used. In measuring the net income of a business for
a period of one year or less, the accountant estimate what portion of the cost of the building
and other long-lived assets is applicable to the current year. Since the allocations of these
cost are estimates rather than precise measurements, it follows that income statements
should be regarded as useful approximations of net income rather than an exact
measurement.
The balances of the accounts shown in the trial balance prepared after posting are not
up to date. Some of these accounts do not reflect economic activities that have taken place
but the enterprise has not properly recorded. These activities are not yet recorded because it
is more convenient and economical to wait until the end of the period to record it. Another
reason is that no source documents concerning the activity have yet to come to the attention
of the accountant.
Adjusting entries are entries prepared at the end of the accounting period to update
or to adjust the balance of the accounts. It assigns revenues to the period in which they are
earned and expenses to the period in which they are incurred. Adjusting entries are needed to
(a) measure properly the period’s income and (b) to bring related asset and liability accounts
to correct balances for financial statements. This end-of-period process of updating the
accounts is called adjusting the accounts, making the adjusting entries, or adjusting the
books. The two basic categories of adjustments are prepayments or deferrals and accruals.
The two methods of accounting for prepaid expenses are the asset method and the
expense method. The asset method is used when prepaid expense is recorded initially as an
asset, and the asset account is debited at the date of purchase.
The expense method is used when the prepaid expense is recorded initially as an
expense, and an expense account is debited at the date of purchase.
Prepaid expenses are analyzed at the end of the period to determine the expired
portion and the unexpired portion, and adjusting entries are made. In summary form, the
methods of recording prepaid expenses are as follows:
Asset Method Expense Method
Initial entry: Record the payment by Record the payment by
debiting the asset account. debiting the expense
account.
Adjusting entry: Transfer the amount used to Transfer the amount unused
the appropriate expense to the appropriate asset
account. account.
It is easier to determine the inventory of supplies (supplies at hand) at the end of the
period than to keep a record of the supplies used during the period. To determine the amount
of supplies used, subtract the inventory of supplies at the end of the period from the balance
of the supplies account. The effects of these entries are illustrated in the following T-accoun
ASSET METHOD
Prepaid Office Supplies Office Supplies Expense
100,000.00 60,000.00 60,000.00
40,000.00
EXPENSE METHOD
Office Supplies Expense Prepaid Office Supplies
100,000.00 40,000.00 40,000.00
60,000.00
Illustration 2. BB Company purchase an insurance policy amounting to P12,000 on July 30,
2020, coverage of which is until July 30, 2022, what is the balance of the prepaid insurance
and insurance expense?
ASSET METHOD
Prepaid Insurance Insurance Expense
12,000.00 2,500.00 2,500.00
9,500.00
EXPENSE METHOD
Insurance Expense Prepaid Insurance
12,000.00 9,500.00 9,500.00
2,500.00
Some accountants prefer to use the first methods; others prefer the second method,
and still others use the first method for prepayments of certain types of expenses and the
second method for other types. For example, they may use the first method for prepayment
of insurance and supplies, while they may use the second method for other expenses like
rent, taxes, or interest.
Regardless of which method the accountant employed in any particular case, the
amount reported as expense in the income statement, and the amount reported as an asset
in the balance sheet will be the same. To avoid confusion and waste of time, the accountant
must consistently follow the method adopted for each particular type of prepaid expense
from year to year.
Unearned Revenue or Deferred Revenue
As in the case of prepaid expenses, there are two methods of recording unearned
revenue: liability method, and the revenue method. Under the liability method, a liability
account is credited when the revenue is received in advance. In the revenue method, a
revenue account is credited when the revenue is received in advance. At the end of the
accounting period, the amount earned and unearned is determined for proper adjusting
entry.
The two methods of recording unearned revenue and the related entries at the end of
the period may be summarized as follows:
Initial entry: Record the receipt of cash to Record the receipt of cash to
the appropriate liability the appropriate revenue
account account
Adjusting entry: Transfer the amount earned to Transfer the amount unearned to
the appropriate revenue the appropriate liability account
account
Illustration 1. CC Tax Consultancy received P150,000 representing advanced payment for six
(6) months tax compliance and consultancy service from their clients on November 1, 2020. The
accounting period of the entity ends on December 31, 2020.
LIABILITY METHOD REVENUE METHOD
11/1/2020 Cash 150,000.00 Cash 150,000.00
Unearned Service Revenue 150,000.00 Service Revenue 150,000.00
(To record payment received in advance) (To record payment received in advance)
LIABILITY METHOD
Unearned Service Revenue Service Revenue
50,000.00 150,000.00 50,000.00
100,000.00
REVENUE METHOD
Service Revenue Unearned Service Revenue
100,000.00 150,000.00 100,000.00
50,000.00
As was explained in connection with prepaid expenses, the results obtained are the
same under both methods. The accountant must consistently follow the method adopted for
each particular kind of unearned revenue from year to year.
Accrued revenues are revenues earned but not yet received at the end of the period. An
example of this type of adjustment would be services that have been performed but have not
been billed or collected. To present an accurate picture of the affairs of the business, the
revenue earned must be recognized on the income statement and the asset on the balance
sheet.
Illustration 1. CC Tax Consultancy rendered year-end tax compliance and consultancy to
XYZ Company on December 15-19, 2020, amounting to P50,000. It was ascertained that XYZ
Company will be paying CC Tax Consultancy on the first quarter of 2021. The journal entry
will be:
The service revenue appears in the income statement, and the asset, accounts
receivable, appears on the balance sheet.
Some expenses accrue from day to day, but the company ordinarily records them only
when they are paid. Accrued expenses are expenses incurred but are not yet paid at the end
of the fiscal period. They are both an expense and a liability. Hence, they are referred to as
accrued liability, accrued payable, or accrued expense.
Illustration 1. The most common example of accrued expense is the accrued salaries.
Companies paying their employees every end of the week instead of the end of the month
usually have accrued salaries, since the end of the week normally does not coincide with the
end of the month. For example, CC Tax Consultancy pays their liaison officers on a weekly basis.
The company has ten (10) liaison officers receiving P3,000 weekly, every Friday. The last day of
the year, December 31, 2020, fell on a Thursday.
If the company prepares financial statements on December 31, they will understate the
balance of salaries expense account because salaries recorded are only up to December 31
but payment is made every Friday. The entry required updating the salaries expense account
would be:
Dec. 31 Salaries Expense 24,000
Salaries Payable 24,000
(10x3,000x4/5)
Interest is a charge for the use of money over time. Interest expense is match to the
period during which the benefit- the use of the money- is received. The interest is a fixed
obligation and accrues regardless of the result of the company’s operation.
Interest rates are expressed at annual rates, so if the interest is being calculated for
less than a year, the calculation must express time as portion of the year. Thus, the interest
expense (simple) incurred on this note during the month is determined by the following
formula:
Interest = Principal x Interest Rate x Length of time
= P200,000 x 12% x 8/12
= P16,000
The adjusting entry to record the interest expense incurred in December is as follows:
Depreciation of Property, Plant and Equipment are tangible assets, which are
relatively fixed or permanent nature, use in the business and not held for sale. These assets,
such as buildings, equipment, furniture and fixtures, provide service to the business. The value
of these assets gradually decreases over time. Depreciation is the decrease in the value of
assets through wear and deterioration and the passage of time.
a. Asset cost. The cost of an asset is the amount paid by the company to purchase the
depreciable asset.
b. Estimated residual value/salvage value/scrap value. The estimated residual value
is the amount that the company can probably sell the asset at the end of its estimated
useful life. The other terms used for residual value are salvage value, scrap value, and
trade-in value.
c. Estimated useful life. The estimated useful life of an asset is the estimated number of
time periods that a company can make use of the asset.
The equation for determining the amount of depreciation expense for each time period is:
EQUIPMENT
P500,000 – P50,000 = P90,000 annual
5 years depreciation
The asset’s depreciable amount is the difference between as asset’s cost and its salvage
value. The accountant must allocate the depreciable amount as an expense to the various
periods in the asset’s useful life to satisfy the matching principle.
The Depreciation Expense account is reported in the income statement while the
accumulated depreciation is reported in the balance sheet as a deduction from the related
asset.
The accumulated depreciation account is a contra asset account that shows the total
of all charges recorded on the asset up through the balance sheet date.
A contra asset account is a deduction from the asset to which it relates in the balance
sheet. The purpose of a contra asset account is to reduce the original cost of asset down on
its undepreciated cost or book value.
Book value is the cost not yet allocated to an expense. The depreciation is credited
to an Accumulated Depreciation account instead of directly to the asset account because they
have recorded the assets correctly using historical cost. To provide more complete balance
sheet information to the users of financial statements, the original acquisition cost is shown
with the accumulated depreciation. For example, on January 31 balance sheet, the
Accumulated Depreciation is shown as a deduction from the asset Equipment.
The accumulated depreciation account balance increases each period by the amount
of depreciation expense recorded until it finally reaches the amount equal to the original cost
of the asset less estimated residual value.