ADJUSTING THE ACCOUNTS

ACCRUAL BASIS
The financial statements, except for the cash flow statement, are prepared on the accrual basis of
accounting in order to meet their objectives.
Under the accrual basis, the effects of transactions and other events are recognized when they occur and
not as cash is received or paid. This means that the accountant records revenues as they are earned and
expenses as they are incurred. Generally accepted accounting principles require that a business use the
accrual basis.
In cash basis accounting, however, the accountant does not record a transaction until cash is received or
paid. Generally, cash receipts are treated as revenues and cash payments as expenses.
Example:
A client paid the Winter Resort in Boracay Island ₱7,000 on June 8, 2020 for a one-day super deluxe
accommodation on July 13, 2020. Under accrual basis of accounting, the receipt of ₱7,000 will be
considered as revenues when the business has rendered its services on July 13. In contrast, if cash basis
is used, the hotel will recognize revenues on June 8. Expenses related to this revenue transaction will be
incurred on July 13.
Suppose a financial report is prepared at the end of June, under:
a. Accrual basis – no revenue or expense will be reported.
b. Cash basis – revenues of ₱7,000 will be reported but the related expenses will be recognized when
incurred on July 13.
Observe that the accrual basis provided a better measure of the results of transactions.

PERIODICITY CONCEPT
Accounting information is valued when it is communicated early enough to be used for economic decision-
making. To provide timely information, accountants have divided the economic life of a business into
artificial time periods. This assumption is referred to as the periodicity concept. It ensures that accounting
information is reported at regular intervals.
Accounting periods are generally a month, a quarter or a year. The most basic accounting period is one
year. Entities differ in their choice of the accounting year – fiscal, calendar or natural.
 Fiscal year – a period of any twelve consecutive months.
 Calendar year – an annual period ending on December 31.
 Natural business year – a twelve-month period that ends when business activities are at their
lowest level of the annual cycle.
 Interim period – a period of less than a year.

REVENUE AND EXPENSE RECOGNITION PRINCIPLES

The process of measuring the performance of an entity that certain income and expense transactions be
allocated over several accounting periods. Revenue should be recognized when earned. PAS No. 18
Revenue, states that “revenue is recognized when it is probable that economic benefits will flow to the
enterprise and these economic benefits can be measured reliably.” It shall be measured at the fair value of
the consideration received or receivable. In most cases, revenue is earned in the accounting period when
the services are rendered, or the goods sold are delivered.

The expense recognition principle is the basis for recording expenses. Expenses are recognized in the
income statement when it is probable that a decrease in future economic benefits related to a decrease in
an asset or an increase of a liability has arisen, and that the decrease in economic benefits can be
measured reliably.
This principle directs accountants to identify all expenses incurred during the accounting period, to measure
the expenses and to match these expenses against the revenues earned during that same span of time.
To match expenses against revenues means to subtract the expenses from the revenues in order to
compute profit or loss.

There are three broad applications of the expense recognition principle, namely:
a. Direct Association – also called as “associating cause and effect” or matching principle. The
expenses are recognized in the income statement on the basis of a direct association between the
costs incurred and the earning of specific items of income.
b. Systematic and Rational Allocation – this is when the economic benefits are expected to arise
over accounting periods, such as depreciation of property and equipment. These expenses are
incurred regardless of the revenues earned during the period.
c. Expensed Immediately – this is when an expenditure produces no future benefits. Examples
include officers’ salaries, most selling costs and amounts paid to settle lawsuits.

STEP 5. ADJUSTING ENTRIES

Adjusting entries assign revenues to the period in which they are earned, and expenses to the period in
which they are incurred. It involves changing account balance at the end of the period from what is the
current balance of the account to what is the correct balance for proper financial reporting. Without adjusting
entries, financial statements may not fairly show the solvency of the entity in the balance sheet and the
profitability in the income statement.

DEFERRALS AND ACCRUALS

There are two general types of adjustments made at the end of the accounting period – deferrals and
accruals.
Note: Each adjusting entry affects a balance sheet account (an asset or a liability account) and an income
statement account (income or expense account).

Deferral is the postponement of the recognition of “an expense already paid but not yet incurred”, or of
“revenue already collected but not yet earned”. This adjustment deals with an amount already recorded in
a balance sheet account; the entry, in effect, decreased the balance sheet account and increases an
income statement account.
Deferrals would be needed in two cases:
1. Allocating assets to expense to reflect expenses incurred during the accounting period (ex. prepaid
insurance, supplies and depreciation)
2. Allocating revenues received in advance to revenue to reflect revenues earned during the
accounting period (ex. subscriptions)

Accrual is the recognition of “an expense already incurred but unpaid”, or “revenue earned but uncollected”.
This adjustment deals with an amount unrecorded in any account; the entry, in effect, increases both a
balance sheet and an income statement account.
Accruals would be required in two cases:
1. Accruing expenses to reflect expenses incurred during the accounting period that are unpaid and
unrecorded.
2. Accruing revenues to reflect revenues earned during the accounting period that are uncollected
and unrecorded.
 ADJUSTMENTS FOR ACCRUALS

1. Accrued Expenses
An entity often incurs expenses before paying for them. Cash payments are usually made at regular
intervals of time such as weekly, monthly, quarterly or annually. If the accounting period ends on a date
that does not coincide with the scheduled cash payment date, an adjusting entry is needed to reflect the
expense incurred since the last payment. Salaries, interest, utilities (ex. electricity, telecommunications and
water) and taxes are examples of expenses that are incurred before payment is made.

Accrued Salaries (Adj. g). Entities pay their employees at regular intervals. It can be weekly, semi-monthly
or monthly. Weddings and Us pays salaries every two Fridays. Assume that the calendar for August
appears as follows:
August
Su M T W Th F Sa
1
2 3 4 5 6 7 8
9 10 11 12 13 14 15
16 17 18 19 20 21 22
23 24 25 26 27 28 29
30 31
The office assistant and the account executive were paid salaries on August 14 and 28. At month-end, the
employees have worked for two days (August 29, 30 and 31) beyond the last pay period. The salary for
these two days is rightfully an expense for August, and the liabilities should reflect that the entity owes the
employees’ salaries for those days.
Each of the employee’s salary rate is ₱7,800 per month or ₱300 per day (₱7,800/26 working days). The
expense to be accrued is ₱1,800 (₱300 x 3 days x 2 employees).
August 31 Salaries Expense ₱1,800
Salaries Payable ₱1,800
To record accrual of unrecorded salaries

The liability of ₱1,800 is now correctly reflected in the salaries payable account. The actual expense
incurred for salaries during the month is ₱15,600.

Accrued Interest (Adj. h). On August 2, Santos borrowed ₱210,000 from Metrobank. She issued a
promissory note that carried a 20% interest per annum. Both the interest and principal will be payable in
one year. The note issued to the bank accrues interest at 20% annually. At the end of August, Santos owed
the bank ₱3,500 (see computation below) for interest in addition to the ₱210,000 loan. Interest is a charge
for the use of money over time. Interest expense is matched to a particular period during which the benefit-
the use of borrowed money-is received. The interest is a fixed obligation and accrues regardless of the
results of the entity’s operations.
Interest rates are expressed at annual rates, so if interest is being calculated for less than a year, the
calculation must express time as a portion of a 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
= ₱210,000 x 20% per year x 1/12 of a year
= ₱210,000 x .20 x 1/12
= ₱3,500
 August 31 Interest Expense ₱3,500
Interest Payable ₱3,500
To record accrual of unrecorded interest

2. Accrued Revenues
An entity may provide services during the period that are neither paid for by clients nor billed at the end of
the period. The value of these services represents revenue earned by the entity. Any revenue that has been
earned but not recorded during the accounting period calls for an adjusting entry that debits an asset
account and credits an income account.

Accrued Consulting Revenues (Adj. i). Suppose that Weddings and Us agreed to arrange a rush but
simple civil wedding for a madly-in-love couple in the afternoon of August 31. The entity intended to charge
fees of ₱5,300 for the services, which is earned but unbilled.
August 31 Accounts Receivable ₱5,300
Consulting Revenues ₱5,300
To record accrual of unrecorded revenue

A total of ₱67,700 in consulting revenues was earned by the entity during the month.

ADJUSTMENTS FOR DEFERRALS

1.Prepaid Expenses
Some expenses are customarily paid in advance. These expenditures (e.g. supplies, rent and insurance)
are called prepaid expenses. Prepaid expenses are assets, not expenses. At the end of an accounting
period, a portion or all of these prepayments may have expired. The portion of an asset that has expired
becomes an expense. Prepaid expenses expire either with the passage of time or through use and
consumption.
The flow of costs from the balance sheet to the income statement is illustrated below:

Cost of As insurance
insurance Balance Sheet policies expire Income Statement
policies and and supplies
supplies used
Assets Revenues
that will
benefit Prepaid Insurance Expenses
future Supplies Insurance Expense
periods Supplies Expense

If adjustments for prepaid expenses are not made at the end of the period, both the balance sheet and the
income statement will be misstated. First, the assets of the entity will be overstated; second, the expenses
of the company will be understated. For this reason, owner’s equity in the balance sheet and profit in the
income statement will both be overstated. Besides prepaid rent, Weddings and Us has prepaid expenses
for supplies and insurance, both accounts need adjusting entries.

Prepaid Rent (Adjustment a). On August 1, Weddings and Us paid ₱8,000 for two months’ rent in
advance. This expenditure resulted to an asset consisting of the right to occupy the office for two months.
A portion of the asset expires and becomes an expense each day. By August 31, one-half of the asset had
expired, and should be treated as an expense.

August 31 Rent Expense ₱4,000

Prepaid Expense ₱4,000
To record for expiration of one month’s rent

After adjustments, the prepaid rent account has a balance of ₱4,000 (August 1 prepayment of ₱8,000 less
the ₱4,000 expired portion); the rent expense account reflects the ₱4,000 expense for the month.

Prepaid Insurance (Adj. b). Weddings and Us acquired a one-year comprehensive insurance coverage
on the service vehicle and paid ₱14,400 premiums. In a manner similar to prepaid rent, prepaid insurance
offers protection that expires daily.
August 31 Insurance Expense ₱1,200
Prepaid Insurance ₱1,200
To record for expiration of one month’s
insurance

The prepaid insurance account has a balance of ₱13,200 (August 4 prepayment of ₱14,400 less ₱1,200)
and insurance expense reflects the expired cost of ₱1,200 for the month. As a matter of company policy,
the period August 4 to 31 is considered a month.

Supplies (Adjustment c). On August 8, Weddings and Us purchased supplies, ₱18,000. During the month,
the entity used supplies in the process of performing services for clients. There is no need to account for
these supplies every day since the financial statements will not be prepared until the end of the month. At
the end of the accounting period, Santos makes a careful physical inventory of the supplies. The inventory
count showed that supplies costing ₱15,000 are still on hand.

The asset account supplies now reflect the adjusted amount of ₱15,000 (₱18,000 less ₱3,000). In addition,
the amount of supplies expensed during the accounting period is reflected as ₱3,000.

2.Deferred Income
There are times when an entity receives cash for services or goods even before service is rendered or
goods are delivered. When such is received in advance, the entity has an obligation to perform services or
deliver goods. The liability referred to is unearned revenues.
For example, publishing companies usually receive payments for magazine subscriptions in advance.
These payments must be recorded in a liability account If the company fails to deliver the magazines for
the subscription period, subscribers are entitled to a refund. As the company delivers each issue of the
magazine, it earns a part of the advance payments.
This earned portion must be transferred from the unearned subscription revenues account to the
subscription revenues account.

As the goods or
Balance Sheet services are Income Statement
Value of provided
goods or
services to
Assets Revenues
be provided Revenues from
in future Unearned
Revenues __________
periods

Unearned Referral Revenues (Adj. f). On August 15, Weddings and Us received ₱10,000 as an advance
payment for referrals made. Assume that by the end of the month, one of the three couples referred has
already taken their marriage vows and as a result the amount of ₱4,000 pertaining to the referred event
has been realized.

August 31 Unearned Referral Revenues ₱4,000

Referral Revenues ₱4,000
To record for recognition of income where
cash is received in advance

The liability account unearned referral revenues reflect the referral revenues still to be earned, ₱6,000. The
referral revenues reflect the amount of referrals already completed and considered as revenues during the
month, ₱4,000.

ALTERNATIVE METHODS OF RECORDING DEFERRALS

(Pre-collected Income and Prepaid Expense Adjustments)

PRECOLLECTION OF INCOME
2 methods in recording pre-collection

1. Income Method (Nominal Approach) - an income account is credited upon collection or

receipt of cash.
2. Liability Method (Real Approach) - a liability account is credited upon collection or receipt of
cash.

To illustrate:
On October 1, 20A, Cordillera Realty Co. collected P 12, 000 from a tenant representing an advance
collection from building rental for one year. The accounting period ends on December 31, 20A.
 COMPARATIVE JOURNAL ENTRIES
Income Method Liability Method
Upon
Cash P 12,000.00 Cash P 12,000.00
Receipt
Rent Income P 12,000.00 Unearned Rent Income P 12,000.00
of Cash
To record collection of advance To record collection of advance
on Oct. 1,
20A rental for the period from Oct. rental for the period from Oct.
1, 20A to Oct. 1 20B 1, 20A to Oct. 1 20B

Income or earned portion is computed as follows

P 12,000
= 1,000 x 3 months = P 3,000
12 mos.
(Oct. 1, 20A to Dec. 31, 20A)

Liability or unearned portion is computed as follows

P 12,000
= 1,000 x 9 months = P 9,000
12 mos.
(Jan. 1, 20B to Oct. 31, 20B)
Total pre-collection P 12,000

COMPARATIVE JOURNAL ENTRIES

Income Method Liability Method
Adjusting Rent Income P 9,000.00 Unearned Rent Income P 3,000.00
entry on Unearned Rent Income P 9,000.00 Rent Income P 3,000.00
Dec. 31, To record unearned portion To record earned portion
20A (liability) of rental collected (income) of rental collected
in advance in advance

The respective general ledger accounts under both methods are shown below before and after the
adjusting entries are being posted with their respective balances:
 UNDER INCOME METHOD UNDER LIABILITY METHOD

Before Adjustment Before Adjustment

Rent Income Unearned Rent Income

P 12,000 Oct.1 P 12,000 Oct.1
(Original (Original
entry) entry)

After Adjustment After Adjustment

Rent Income Unearned Rent Income

Dec.31 P 9,000 P 12,000 Oct.1 Dec.31 P 3,000 P 12,000 Oct.1
AJE (Original AJE (Original
entry) entry)

P 3,000 P 9,000

Unearned Rent Income Rent Income

Dec.31 Dec.31
P 9,000 AJE P 3,000 AJE

PREPAYMENT OF EXPENSES
2 methods in recording prepayment of expenses
1. Expense Method (Nominal Approach) - an expense account is debited upon payment of
prepaid expense.
2. Asset Method (Real Approach) - an asset account is debited upon payment of prepaid
expense.

To illustrate:
On September 1, 20A, Rajah Buayan Commercial paid an insurance premium covering the period from
September 1, 20A to September 1, 20B in the amount of P 3, 600. The accounting period ends of
December 31, 20A.
COMPARATIVE JOURNAL ENTRIES
Expense Method Asset Method
Upon Insurance expense P 3,600.00 Prepaid Insurance P 3,600.00
payment Cash P 3,600.00 Cash P 3,600.00
on Sept. To record insurance premium To record insurance premium
1, 20A paid paid
Expense or expired portion computed as follows:

P 3,600
= 300 x 4 months = P 1,200
12 mos.
(Sept. 1, 20A to Dec. 31, 20A)

Liability or unearned portion is computed as follows

P 3,600
= 300 x 8 months = P 2,400
12 mos.
(Jan. 1, 20B to August. 31, 20B)
Total prepayment P 3,600

The respective general ledger accounts under both methods are shown below before and after the
adjusting entries are being posted with their respective balances:
 UNDER EXPENSE METHOD UNDER ASSET METHOD

Before Adjustment Before Adjustment

Insurance Expense Prepaid Insurance

Sept. 1 P 3,600 Sept. 1 P 3,600
(Original (Original
entry) entry)

After Adjustment After Adjustment

Insurance Expense Prepaid Insurance

Sept. 1 P 3,600 Dec. 31 P 2,400 Sept. 1 P 3,600 Dec. 31 P 1, 200
(Original AJE (Original AJE
entry) entry)

P 1,200 P 2,400

Prepaid Insurance Insurance Expense

Dec.31 Dec.31
AJE P 2,400 AJE P 1,200

Accounts Receivable and its related provision for doubtful accounts

Entities often allow clients to purchase goods or avail of services on credit. Some of these accounts will
never be collected; hence, there is a need to reflect these as charges against income. In practice, an
expense is recognized for the estimated uncollectible accounts in the current period, rather than when
specific accounts actually become uncollectible. This practice produces a better matching of income and
expenses. Estimates of uncollectible accounts may be based on credit sales for the period or on the
accounts receivable balance.

2 methods of recognizing uncollectible account expense

1. Allowance Method- under this method, uncollectible account is being recognized in anticipation
that “what if the whole amount of Accounts Receivable cannot be collected”? An estimate should
be made to provide a certain percent as “estimated uncollectible accounts” based on the
company’s past experiences. The Estimated Uncollectible accounts is then deducted from
Accounts Receivable to arrive at the Estimated Realizable Value or Doubtful Accounts.
 2. Direct Write-Off Method- Under this method, the business adopts a policy of directly charging
to Uncollectible Account Expense the account of a customer whom it believed could not pay its
balance anymore without providing an Estimated for Uncollectible Accounts. This results in
identifying the particular customer’s account that needs to be written-off.

COMPARATIVE JOURNAL ENTRIES

Transaction
Allowance Method Direct Write-Off Method
Accounts Receivable P 20,000 Accounts Receivable P 20,000
1. Rendered services on Service Income P 20,000 Service Income P 20,000
account for P 20,000 To record services rendered To record services rendered
(Original Entry) on account on account
2. Estimated to be doubtful Uncollectible account P 1,000
of collection is 5% Est. Uncollectible account P 1,000
NO ENTRY
(Adjusting entry) To set-up provision for uncollectible
accounts.
3. Amount ascertained to Est. Uncollectible account P 800 Uncollectible account P 800
be worthless is P 800 Accounts Receivable P 800 Accounts Receivable P 800
(Write-off Entry) To record uncollectible account written-off To record uncollectible account written-off

PROPERTY AND EQUIPMENT AND THE RELATED DEPRECIATION

Depreciation of Property and Equipment

When an entity acquires long-lived assets such as buildings, service vehicles, computers or office
furnitures, it is basically buying or prepaying for the usefulness of that asset. These assets help generate
income for the entity., Therefore, a portion of the cost of the assets should be reported as expense in each
accounting period. Proper accounting requires the allocation of the cost of the asset over its estimated
useful life. The estimated amount allocated to any one accounting period is called depreciation or
depreciation expense.

1. Useful life is an estimate, not an exact measurement.

As the asset’s
Balance Sheet useful life Income Statement
expires
Cost of a
depreciable Assets Revenues
asset Service Vehicle Expenses
Office Equipment Depreciation

2 Kinds of Depreciation
1. Physical Depreciation- results to the ultimate retirement of the property or termination of the
service of the asset because of wear and tear due to frequent use, passage of time due to non-
use, action of the elements, such as wind, sunshine, rain or dust and others.
2. Functional Depreciation- arises from the obsolescence or inadequacy of the assets to
perform efficiently.

3 factors that must be considered in determining depreciation

 1. Acquisition cost- It is the amount paid or liability incurred when the asset is acquired. It
includes the purchase price and other incidental cost of its acquisition.
2. Scrap value or salvage value or residual value- The estimated value of the asset at the end
of its economic or useful life.
3. Estimated Economic or Useful Life- the estimated length of time usually stated in years that
the asset can be of use.

The straight-line method computes depreciation using this formula:

Acquisition Cost- Salvage value

Annual Depreciation =
Estimated life of the asset in years

The asset account is not directly reduced when recording depreciation expense. Instead, the reduction is
recorded in a contra account called accumulated depreciation. A contra account is used to record
reductions in a related account and its normal balance is opposite that of the related account. Use of the
contra account – accumulated depreciation – allows the disclosure of the original cost of the related asset
in the balance sheet. The balance of the contra account is deducted from the cost to obtain the book value
of the property and equipment.

Service Vehicle and Office Equipment (Adjs. d and e). Suppose that Weddings and Us estimated that
the service vehicle, which was bought on August 4, will last for seven years (eighty-four months) and with
a salvage value of P84,000. The office equipment that was acquired on August 5 will have a useful life of
five years (sixty months) and will be worthless at that time. Substitution of the pertinent amounts into the
basic formula will yield depreciation for service vehicle and office equipment for the month as ₱4,000
[(₱420,000 – ₱84,000)/84 months] and ₱1,000 (₱60,000/60 months), respectively. These amounts
represent the cost allocated to the month, thus reducing the asset accounts and increasing the expense
accounts. As a matter of company policy, the period August 4 to 31 is considered a month.

August 31 Depreciation Expense – Service Vehicle ₱4,000

Accumulated Depreciation – Serv. Vehicle ₱4,000
To record for depreciation of service vehicle

August 31 Depreciation Expense – Office Equipment ₱1,000

Accumulated Depreciation – Off. Equipt. ₱1,000
To record for depreciation of office equipment

After adjustments, the property and equipment section of the balance sheet for Weddings and Us will be:
 Weddings and Us
Partial Balance Sheet
August 31, 2020

Property and Equipment (Net):

Service Vehicle ₱420,000

Less: Accumulated Depreciation 4,000 ₱416,000

Office Equipment ₱60,000

Less: Accumulated Depreciation 1,000 ₱59,000
₱475,000

EFFECTS OF OMITTING ADJUSTMENTS

When an accountant failed to include the proper adjusting entries, the resulting financial statements will not
accurately reflect the financial position and the performance of the entity. Inaccuracies in one accounting
period can cause further inaccuracies in the statements of subsequent periods.

Illustration. On July 1, 2020, Santa Rita Manpower Services owned by Bienvenida Alvaro borrowed
₱100,000 by signing an 18-month note at 16% interest per annum. The principal and interest are to be
repaid when the note matures on Dec. 31, 2020.

As at Dec. 31, 2020, the entity has incurred interest expense of ₱8,000 (₱100,000 x 16% x 6/12). The
accountant did not record the adjustment for the accrued interest. The entry should have been a debit to
Interest Expense and a credit to Interest Payable for ₱8,000.

The effects of the omission in the 2020 financial statements are as follows:
 In the 2020 income statement, interest expense is understated by ₱8,000 and, therefore, profit is
overstated by ₱8,000.
 In the De. 31, 2020 balance sheet, owner’s equity is overstated by ₱8,000 because of the
overstatement in profit. Total liabilities is understated because of the omission of the ₱8,000 interest
payable.

On Dec. 31, 2021, the maturity date, the note is paid together with interest. Since there was no adjusting
entry made to accrue interest in 2020, the entire interest of ₱24,000 (₱100,000x 16% x 18/12) was
erroneously charged against 2021 profit. The correct interest expense for 2021 should have been ₱16,000
(₱100,000 x 16% x 12/12).

The effects of the omissions in the 2021 financial statements are as follows:
 In the 2021 income statement, interest expense is overstated by ₱8,000 and, therefore, profit is
understated by ₱8,000.
 The Dec. 31, 2021 balance sheet is correctly stated since the note along with its interest has been
settled by year-end. The effect of the omission has counterbalanced by the end of the second
accounting period.

In summary, the omission has produced two erroneous income statements and one erroneous balance
sheet. If the entity should have reported a correct profit of ₱500,000 in the 2020 and 2021 income
statements. As a result of the omission, the proprietorship’s profit in 2020 is ₱508,000 and in 2021,
₱492,000.