Lesson 3: Basic Accounting: Completing the Accounting Cycle

Adjusting the Accounts

Lesson Objectives:
§ Explain the reasons for preparing adjusting entries.
§ Learn how to adjust some accounts at the end of the accounting period.
§ Define and prepare a worksheet.
§ Prepare a financial statement from a worksheet.
§ Develop the skills needed in preparing financial statements.
§ Prepare closing and reversing entries and know the purpose of closing and reversing entries.

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 the transactions and other events are
recognized when they occur and not as cash is received or paid. This means that the accounting records
revenues as they are earned and expenses as they incurred. The timing of cash flows is relatively immaterial for
determining when to recognize revenues and expenses.

Financial statements prepared on the accrual basis informs users not only of past transactions involving the
payment and receipt of cash, but also of obligation to pay cash in the future, and of resources that represent
cash to be received in the future. 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 payment as expenses. Cash basis income is the
difference between operating cash receipts and disbursements. These cash flows necessarily exclude
investments by and distributions to the owner in the computation of income.

Illustration: A client paid the Sea Wind Resort in Boracay island Php7,000 on April 8, 2013 for a one-day super
deluxe accommodation on May 13, 2013. Under accrual basis of accounting, the receipt of Php7,000 will be
considered as revenues when the business has rendered its services on May 13.

In contrast, if cash basis is used, the hotel will recognize revenues on April 8. Expenses related to this revenue
transaction will be incurred in May 13. Suppose a financial report is prepared at the end of April, under accrual
basis, no revenue or expense will be reported; under cash basis, revenues of Php7,000 will be reported but the
related expenses will be recognized when incurred on May 13. Observe that the accrual basis provided a better
measure of the results of transactions.

PERIODICITY CONCEPT

The only way to know how successfully a business has operated is to close its doors, sell all its assets, pay the
liabilities and return any excess cash to the owners. This process of going out of business is called liquidation.
This, however, is not a practical way of measuring business performance.
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.

Accounting period 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. A fiscal year is a period of any
twelve consecutive months. A calendar year is an annual period ending on December 31. A natural business
year is a twelve-month period that ends when business activities are at their lowest level of the annual cycle. A
period of less than a year is an interim period. Some even adopts an annual reporting period of 52 weeks.

REVENUE AND EXPENSE RECOGNITION PRINCIPLES

The process of measuring the performance of an entity requires that certain income and expense transactions
be allocated over several accounting periods. The adjustment process relies on the revenue recognition and
expense recognition principles. 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. Per the Framework, 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 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.

The Framework discussed three broad applications of the expense recognition principle. Expenses are
recognized in the income statement on the basis of direct association between the costs incurred and the
earning of specific items of income. Examples of these expenses are sales commissions and costs of goods sold.
If there is no sale, then the entity has no commission expense and cost of goods sold.

When economic benefits are expected to arise over several accounting periods and the association with income
can only be broadly or indirectly determined, expenses are recognized in the income statement on the basis of
systematic and rational allocation procedures. This is often necessary in recognizing the expenses associated
with the using up of assets such as property and equipment, and allocation of prepaid rent and insurance. These
expenses are incurred regardless of the revenues earned during the period.

An expense is recognized immediately in the income statement when an expenditure produces no future
benefits. Examples include officers’ salaries, most selling costs and amounts paid to settle lawsuits.
THE NEED FOR ADJUSTMENTS

Accountants make adjusting entries to reflect in the accounts in the accounts information on economic activities
that have occurred but have not yet been recorded. Adjusting entries assign revenues to the period in which
they are earned, and expenses to the period in which they are incurred. These entries are needed to measure
properly the profit for the period, and to bring related asset and liability accounts to correct balances for the
financial statements.

In short, adjustments are needed to ensure that the revenue recognition and expense recognition principles are
followed thus resulting to financial statements reporting the effects of all transactions at the end of the period.

Adjusting entries involve changing account balances 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.

The General Journal End of the period – adjusting entries recorded in the
General Journal.
____________ xx
___________ xx

Posting to the Ledger

Prepaid Expenses
The Ledger
Unearned
Revenues
Revenues Expenses

Payables

Adjusted Trial
Balance
Assets
Liabilities Adjusted Trial Balance is prepared.
Owner’s Equity
Revenues
Expenses
DEFERRALS AND ACCRUALS

Accountants use adjusting entries to apply accrual accounting to transactions that cover more than one
accounting period. There are two general types of adjustments made at the end of the accounting period –
deferrals and accruals.

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, decreases 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 (e.g. prepaid
insurance, supplies and depreciation).
2. Allocating revenues received in advance to revenue to reflect revenues earned during the accounting
period (e.g. subscription).

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.

The Weddings “R” Us case is continue to illustrate the adjustment process. The letters A, L, OE: I and OE:E are
still used to ensure a better understanding of the nature of the accounts affected.

ADJUSTMENTS FOR DEFERRALS (Step 5)

Allocating Assets to Expenses

Entities often make expenditures that benefit more than one period. These expenditures are generally debited
to an asset account. At the end of each accounting period, the estimated amount that has expired during the
period or that has benefited the period is transferred from the asset account to an expense account. Two of the
more important kinds of adjustments are prepaid expenses, and depreciation of property and equipment.

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:
 Balance Sheet As insurance Income
Cost of
policies expire and
insurance Statement
supplies used.
policies and
Assets Revenues
supplies that
Prepaid Expenses
will benefit Insurance Insurance Expense
future periods. Supplies 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 expense 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 “R” Us has prepaid expenses for supplies
and insurance, both accounts need adjusting entries.

Prepaid Rent (Adjustment a). On May 1, Weddings “R” Us paid Php8,000 for two months’ rent in advance. This
expenditure resulted in 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 May 31, one-half of the asset has expired, and should be
treated as an expense. The analysis of this economic event is shown below:

Transaction Expiration of one month’s rent.

Analysis Assets decreased. Owner’s equity decreased.
Rules Decreases in assets are recorded by credits. Decreases in owner’s equity are recorded by debits.
Entry Decrease in owner’s equity is recorded by a debit to rent expense. Decrease in assets is recorded
by a credit to Prepaid Rent.

Date Account Titles and Explanation P.R. Debit Credit

2020
May 31 Rent Expense (OE:E) 4,000.00
Prepaid Rent (A) 4,000.00
Expiration of one month’s rent.

After adjustments, the prepaid rent account has a balance of Php4,000 (May 1 prepayment of Php8,000 less the
Php4,000 expired portion); the rent expense account reflects the Php4,000 expense for the month.

Prepaid Insurance (Adjustment b). Weddings “R” Us acquired a one-year comprehensive insurance coverage on
the service vehicle and paid Php14,400 premiums. In a manner similar to prepaid rent, prepaid insurance offers
protection that expires daily. The adjustment is analyzed and recorded as shown below:

Transaction Expiration of one month’s insurance.

Analysis Assets decreased. Owner’s equity decreased.
Rules Decreases in assets are recorded by credits. Decreases in owner’s equity are recorded by debits.
Entry Decrease in owner’s equity is recorded by a debit to insurance expense. Decrease in assets is
recorded by a credit to Prepaid Insurance.
 Date Account Titles and Explanation P.R. Debit Credit
2020
May 31 Insurance Expense (OE:E) 1,200.00
Prepaid Insurance (A) 1,200.00
Expiration of one month’s insurance.

The prepaid insurance account has a balance of Php13,200 (May 4 prepayment of Php14,400 less Php1,200) and
insurance expense reflects the expired cost of Php1,200 for the month. As a matter of company policy, the
period May 4 to 31 is considered a month.

Supplies (Adjustment c). On May 8, Weddings “R” Us purchased supplies, Php18,000. 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, Gevera makes a careful physical inventories of the supplies. The inventory count showed
that supplies costing Php15,000 are still on hand. This transaction is analyzed and recorded as follows:

Transaction Consumption of supplies.

Analysis Assets decreased. Owner’s equity decreased.
Rules Decreases in assets are recorded by credits. Decreases in owner’s equity are recorded by debits.
Entry Decrease in owner’s equity is recorded by a debit to Supplies Expense. Decrease in assets is
recorded by a credit to Supplies.

Date Account Titles and Explanation P.R. Debit Credit

2020
May 31 Supplies Expense (OE:E) 3,000.00
Supplies (A) 3,000.00
Consumption of supplies

The asset account supplies now reflect the adjusted amount of Php15,000 (Php18,000 less Php3,000). In
addition, the amount of supplies expensed during the accounting period is reflected as Php3,000.

Depreciation of Property and Equipment

When an entity acquires long-lived assets such as buildings, service vehicles, computers or office furniture, it is
basically buying or preparing 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. Three factors are
involved in computing depreciation expense:
1. Asset cost is the amount an entity paid to acquire the depreciable asset.
2. Estimated salvage value is the amount that the asset can probably be sold for at the end of its estimated
useful life.
3. Estimated useful life is the estimated number of periods that an entity can make use of the asset. Useful
life is an estimate, not an exact measurement.
 Balance Sheet Income
As the asset’s useful
life expire. Statement
Cost of
depreciable Assets
Revenues
asset. Service Vehicle
Expenses
Office Equipment
Depreciation

Accountants estimate periodic depreciation. They have developed a number of methods for estimating
depreciation. The simplest procedure is called the straight-line method. The formula for determining the
amount of depreciation expense for each period using this method is:

Asset Cost xx
Less: Estimated Salvage Value xx
Depreciable Cost xx
Divided by: Estimated Useful Life xx
Depreciation Expense for each time period xx

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 accounts and its normal balance is opposite that of 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 (Adjustments d and e). Suppose that Weddings “R” Us estimated that
the service vehicle, which was bought on May 4, will last for seven years (eighty-four months) and with a salvage
value of Php84,000. The office equipment that was acquired on May 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 Php4,000 {(Php420,000-
Php84,000)/84 months} and Php1,000 (Php60,000/60 months), respectively. These amounts represents the cost
allocated to the month, thus reducing the asset accounts and increasing the expense accounts. As a matter of
company policy, the period May 4 to 31 is considered a month. The analysis follows:

Transaction Recording depreciation expense.

Analysis Assets decreased. Owner’s equity decreased.
Rules Decreases in assets are recorded by credits. Decreases in owner’s equity are recorded by debits.
Entry Decrease in owner’s equity is recorded by a debit to Depreciation Expense-Service Vehicle and
Depreciation Expense-Office Equipment. Decrease in assets is recorded by a credit to contra-
asset accounts Accumulated Depreciation-Service Vehicle and Accumulated Depreciation-Office
Equipment.
 Date Account Titles and Explanation P.R. Debit Credit
2020
May 31 Depreciation Expense-Service Vehicle (OE:E) 4,000.00
Accumulated Depreciation-Service Vehicle (A) 4,000.00

Depreciation Expense-Office Equipment (OE:E) 1,000.00

Accumulated Depreciation-Office Equipment (A) 1,000.00
To record depreciation expense.

After adjustments, the property and equipment section of the balance sheet for Weddings “R” Us will be:

Weddings “R” Us
Partial Balance Sheet
May 31, 2020

Property Plant and Equipment (Net):

Service Vehicle Php420,000
Less: Accumulated Depreciation 4,000 Php416,000

Office Equipment Php60,000

Less: Accumulated Depreciation 1,000 59,000
Php475,000

Allocating Revenues Received in Advance to Revenues

There are times when an entity receives cash or services or goods even before service is rendered or goods
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.

Balance Sheet Income

As the goods or
services are Statement
Value of goods
or services to Liabilities provided.
Revenues
be provided in Unearned
Revenues from
Revenues
future periods. ____________
Unearned Referral Revenues (Adjustment f). On May 15 Weddings “R” Us received Php10,000 as advanced
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 Php4,000 pertaining to the referred event has been
realized. This transaction is analyzed as follows:

Transaction Recognition of income when cash is received in advance.

Analysis Liabilities decreased. Owner’s equity increased.
Rules Decreases in liabilities are recorded by debits. Increases in owner’s equity are recorded by
credits.
Entry Decrease in liabilities is recorded by a debit to Unearned Referral Revenues. Increase in owner’s
equity is recorded by a credit to Referral Revenues.

Date Account Titles and Explanation P.R. Debit Credit

2020
May 31 Unearned Referral Revenues (L) 4,000.00
Referral Revenues (OE:I) 4,000.00
To recognized revenues received in advance

The liability account unearned referral revenues reflects the referral revenues still to be earned, Php6,000. The
referral revenue accounts reflects the amount of referrals already completed and considered as revenues during
the month, Php4,000.

ADJUSTMENTS FOR ACCRUALS (Step 5)

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. This adjustment helps the entity to avoid impractical preparation of hourly or daily
journal entries just to accrue expenses. Salaries, interest, utilities (e.g. electricity, telecommunications and
water) and taxes are examples of expenses that are incurred before payment is made.

Accrued Salaries (Adjustment g). Entities pay their employees at regular intervals. It can be weekly, semi-
monthly or monthly. Weekly payrolls are usually made on Fridays (for a five-day workweek) or Saturdays (for a
six-day workweek). Weddings “R” Us pays salaries every two Saturdays. Assume that the calendar for May
appears as follows:

May
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 May 13 and 27. At month-end, the
employees have worked for three days (May 29,30 and 31) beyond the last day period. The employees have
earned the salaries for these day, but it is not due to paid until the regular payday in April. The salary of these
three days is rightfully an expense for May, and the liabilities should reflect that the entity owes the employees
salaries for those days.

Each of the employee’s salary rate is Php7,800 per month or Php300 per day (Php7,800/26 working days). The
expense to be accrued is Php1,800 (Php300 x 3 days s 2 employees). This accrued expense can be analyzed as
shown:

Transaction Accrual of unrecorded expense.

Analysis Liabilities increased. Owner’s equity decreased.
Rules Increases in liabilities are recorded by credits. Decreases in owner’s equity are recorded by
debits.
Entry Decrease in owner’s equity is recorded by a debit to Salaries Expense. Increase in liabilities is
recorded by a credit to Salaries Payable.

Date Account Titles and Explanation P.R. Debit Credit

2020
May 31 Salaries Expense (OE:E) 1,800.00
Salaries Payable (L) 1,800.00
To recognized accrual of salaries expense

The liability of Php1,800 is now correctly reflected in the salaries payable account. The actual expense incurred
for salaries during the month is Php15,600.

Accrued Interest (Adjustment h). On May 2, Gevera borrowed Php210,000 from Metrobank. She issues 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 May, Gevera owed the bank
Php3,500 (see computation below) for interest in addition to the Php210,000 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 times 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

= Php210,000 x 20% per year x 1/12 of a year
= Php210,000 x .20 x 1/12
= Php3,500

The adjusting entry to record the interest expense incurred in May is as follows:

Transaction Accrual of unrecorded expense.

Analysis Liabilities increased. Owner’s equity decreased.
Rules Increases in liabilities are recorded by credits. Decreases in owner’s equity are recorded by
debits.
Entry Decrease in owner’s equity is recorded by a debit to Interest Expense. Increase in liabilities is
recorded by a credit to Interest Payable.

Date Account Titles and Explanation P.R. Debit Credit

2020
May 31 Interest Expense (OE:E) 3,500.00
Interest Payable (L) 3,500.00
To recognized accrual of interest expense

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 (Adjustment i). Suppose that Weddings “R” Us agreed to arrange a rush but
simple civil wedding for a madly-in-love couple in the afternoon of May 31. The entity intended to charge fees
of Php5,300 for the services which are earned but unbilled. This should be recorded as shown below:

Transaction Accrual of unrecorded revenue.

Analysis Assets increased. Owner’s equity increased.
Rules Increases in assets are recorded by debits. Increases in owner’s equity are recorded by credits.
Entry Increase in assets is recorded by a debit to Accounts Receivable. Increase in owner’s equity is
recorded by a credit to Consulting Revenues.

Date Account Titles and Explanation P.R. Debit Credit

2020
May 31 Accounts Receivable (A) 5,300.00
Consulting Revenues (OE:I) 5,300.00
To recognized accrual of unrecorded expense

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

The Weddings “R” Us illustration did not tackle entries related to uncollectible accounts. Hence, the ensuing
discussion on the accrual of uncollectible accounts is not in any way related to the Weddings “R” Us illustration.
This is to complete the illustrations on the adjustments for accruals.

ACCRUAL FOR UNCOLLECTIBLE 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.

Assume that an entity made credit sales of P1,100,000 in 2013 and prior experience indicates an expected 1%
average uncollectible accounts rates based credit sales. The contra account – Allowance for Uncollectible
Accounts has a normal credit balance and is shown in the balance sheet as a deduction from Accounts
Receivable. The allowance account need to be increased by Php11,000 (Php1,100,000 x 1%) because accounts
receivable in that amount is doubtful of collection. The adjustment will be:

Account Titles Debit Credit

Uncollectible Accounts Expense (OE:E) 11,000.00

Allowance for Uncollectible Accounts (A) 11,000.00

Throughout the accounting period, when there is positive evidence that a specific account is definitely
uncollectible, the appropriate amount is written off against the contra account. For example, if Php1,500
receivable were considered uncollectible, that amount would be written off as follows:

Account Titles Debit Credit

Allowance for Uncollectible Accounts (A) 1,500.00

Accounts Receivable (A) 1,500.00

No entry is made for Uncollectible Accounts Expense, since the adjusting entry has already provided for an
estimated expense based on previous experience for all receivables.

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 an entity. Inaccuracies in one accounting period
can cause further inaccuracies in the statements of subsequent periods.

Illustration: On July 1, 2013, Santa Rita Manpower Services owned by Bienvenida Alvaro borrowed Php100,000
by signing an 18-month note at 16% interest per annum. The principal and interest are to be repaid when the
note matures on December 31, 2014.

As at December 31, 2013, the entity has incurred an interest expense of Php8,000 (Php100,000 x 16% x 6/12).
The accountant did not record the adjustment for the accrued interest. The entry should have been debit to
Interest Expense and a credit to Interest Payable for Php8,000.

The effects of the omission in the 2013 financial statements are as follows:

• In the 2013 income statement, interest expense is understated by Php8,000 and, therefore, profit is
overstated by Php8,000.
 • In the December 31, 2013 balance sheet, owner’s equity is overstated by Php8,000 because of the
overstatement in profit. Total liabilities is understated because of the omission of the Php8,000 interest
payable.

On December 31, 2014, the maturity date, the note is paid together with interest. Since there was no adjusting
entry made to accrue interest, the interest of Php24,000 (Php100,000 x 16% x 18/12) was erroneously charged
against 2014 profit. The correct interest expense for 2014 should have been Php16,000 (Php100,000 x 16% x
12/12). The effects of the omissions in the 2014 financial statements are as follows:

• In the 2014 income statement, interest expense is overstated by Php8,000 and, therefore, profit is
understated by Php8,000.
• The December 31, 2014 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 of Php500,000 in the 2013 and 2014 income statements. As a result
of the omission, the proprietorship’s profit in 2013 is Php508,000 and in 2014, Php492,000.

ANAYSIS USING T-ACCOUNTS

To recapitulate, each adjusting entry affects a balance sheet account (an asset or a liability account) and an
income statement account (an income and an expense account). Almost every revenue or expense account on
the income statement has one or more related accounts on the statement of financial position. For instance,
rent expense is related to prepaid rent, supplies expense to supplies, service revenues to unearned service
revenues and salaries expense to salaries payable.

Having been apprised of these relationships, transactions affecting particular accounts can now be analyzed
using T-accounts. These learning will be use in reconstructing accounts to derive details like cash inflows, cash
outflows, revenues recognized for the period or expenses charged for the period.

To illustrate, Eco-Tours, established by Galicano Del Mundo at the start of the month, reported at month-end
the following related accounts and account balances : Supplies, Php36,600 and Supplies Expense, Php15,400.

Looking at the foregoing, Del Mundo wants to know how much cash was paid out to purchase supplies. Start by
placing the relevant information in a T-account. Input the beginning balance on the normal balance of the
account. In this case, Supplies is debit.

There is no beginning balance since the company just started operations this month. As a technique, the ending
balance of an account, here, Supplies for Php36,600, is placed opposite its normal balance. In adjusting for
supplies expense, the entry made was debit Supplies Expense, Php15,400 and credit Supplies, Php15,400. Total
both debit and credit sides. The cash paid out for the supplies can now be derived; it’s Php52,000 (Php52,000 –
zero), the plug figure. If there was a beginning balance of Php2,000, then cash paid out would have been
Php50,000 (Php52,000 – Php2,000).
 Supplies
Debit Credit
(+) (-)
Beginning Balance -0- 15,400 Expense for the month
Cash Paid for Supplies Plug figure 36,600 Ending Balance
Total 52,000 52,000 Total

Assume instead that the Php36,000 ending balance for Supplies and the Php52,000 cash paid for supplies were
given, using the T-account, supplies expense is Php15,400 (Php52,000 – Php36,600).

Supplies
Debit Credit
(+) (-)
Beginning Balance -0- Plug figure Expense for the month
Cash Paid for Supplies 52,000 36,600 Ending Balance
Total 52,000 52,000 Total

To illustrate further, a company reported at month-end the following related accounts and account balances:
Prepaid Insurance, End, Php67,000; Insurance Expense, Php12,000 and Prepaid Insurance, beginning,
Php48,000. How much was used to pay for insurance this period? Answer: Php31,000.

Prepaid Insurance
Debit Credit
(+) (-)
Beginning Balance 48,000 12,000 Expense for the month
Cash Paid for Plug figure 67,000 Ending Balance
Insurance
Total 79,000 79,000 Total

To have an ending balance of Php67,000, there must have been a Php31,000 debit to the Prepaid Insurance
account. Since a debit to this account is normally offset by a credit to Cash, the analysis confirms that cash
outflows for insurance was Php31,000.
SUMMARY OF ADJUSTING ENTRIES

Account Balances Before Adjustment Adjusting Entry

Type of
Balance Sheet Income Statement
Adjustment Account Debited Account Credited
Account Account

Prepaid Expenses:
Asset Method Assets Overstated Expenses Understated Expense Prepaid Expense (A)
Expense Method Assets Understated Expenses Overstated Prepaid Expense (A) Expense

Depreciation Assets Overstated Expenses Understated Expense Contra Asset

Unearned Revenues:
Liability Method Liabilities Overstated Income Understated Unearned Revenues (L) Revenues
Income Method Liabilities Understated Revenues Overstated Revenue Unearned Revenues (L)

Accrued Expenses Liabilities Understated Expenses Understated Expense Payable (L)

Accrued Revenues Assets Understated Income Understated Receivable (A) Revenues

ALTERNATIVE METHODS OF RECORDING DEFERRALS

In the discussions, all transactions that required adjustments are initially recorded in balance sheet accounts. A
prepaid expense is initially recorded in a prepaid asset account. Likewise, revenue received in advance is initially
recorded in a liability account – unearned revenues. In the case of a prepaid expense, an adjusting entry is made
at the end of the period to transfer the portion of the expires asset to an expense account. Similarly an adjusting
entry is made to transfer earned revenues from the liability account to an income statement account.

Entities may initially account for deferrals using income and expense accounts. The alternative approach is
illustrated in this section.

Prepaid Expenses

On October 1, 2013, Calaguas Company acquired a 3-year insurance policy for Php36,000 paid in advance.
Calaguas may record this transaction depending on which of the two accounting policies it follows. The
Php36,000 payment may initially be recorded either as an asset or as an expense.

Initial entry is recorded as:

1. An asset
Date Account Titles Debit Credit
2013
Oct. 10 Prepaid Insurance (A) 36,000.00
Cash (A) 36,000.00
 2. An expense

Date Account Titles Debit Credit

2013
Oct. 10 Insurance Expense (OE:E) 36,000.00
Cash (A) 36,000.00

At the end of the year, an adjusting entry is needed to establish the proper balances in the prepaid insurance
and insurance expense accounts. On December 31, 2013, three months’ insurance has been consumed, or
insurance expense is equal to Php3,000 (Php36,000/36 months x 3 months). Prepaid insurance equivalent to
Php33,000 (Php36,000- Php3,000) remain. The appropriate adjustment depends on how the initial transaction
was recorded.

Adjusting entry required if initial entry is recorded as:

1. An asset
Date Account Titles Debit Credit
2013
Dec. 31 Insurance Expense (OE:E) 3,000.00
Prepaid Insurance (A) 3,000.00

2. An expense

Date Account Titles Debit Credit

2013
Dec. 31 Prepaid Insurance (A) 33,000.00
Insurance Expense (OE:E) 33,000.00

The effect of the adjusting entry on the ledger accounts after posting is the same regardless of the initial debits
as shown below:

As an Asset As an Expense
Dec. 31 balances: Dec. 31 balances:
Prepaid Insurance 33,000 debit Prepaid Insurance 33,000 debit
Insurance Expense 3,000 debit Insurance Expense 3,000 debit

Unearned Revenues

On July 1, 2013, Marasigan Company received Php48,000 check for 2 years’ rent paid in advance. On this date,
Marasigan may record a credit in that account as either unearned rental revenue or rental revenue, depending
on its accounting policy.
Initial entry is recorded as:

1. A liability
Date Account Titles Debit Credit
2013
July 1 Cash 48,000.00
Unearned Rent Revenues (L) 48,000.00

2. A revenue

Date Account Titles Debit Credit

2013
July 1 Cash 48,000.00
Rent Revenues (OE:I) 48,000.00

At the end of the year, an adjusting entry is needed to establish the proper balances in the rent revenue and
unearned rent revenue accounts. On December 31, 2013, six months’ rent has been earned, or rent revenue is
equal to Php12,000 (Php48,000/24 months x 6 months). Unearned rent revenues equivalent to Php36,000
(Php48,000 – Php12,000) remain. The appropriate adjustment depends on how the initial transaction was
recorded.

Adjusting entry required if initial entry is recorded as:

1. A liability
Date Account Titles Debit Credit
2013
Dec. 31 Unearned Rent Revenue (L) 12,000.00
Rent Revenue (OE:I) 12,000.00

2. A revenue

Date Account Titles Debit Credit

2013
Dec. 31 Rent Revenues (OE:I) 36,000.00
Unearned Rent Revenue (L) 36,000.00

The effect of the adjusting entries on the ledger accounts after posting is the same regardless of the initial credits
as shown below:

As a Liability As an Income
Dec. 31 balances: Dec. 31 balances:
Unearned Rent Revenues 36,000 credit Unearned Rent Revenues 36,000 credit
Rent Revenues 12,000 credit Rent Revenues 12,000 credit
Reference: Ballada, Win, Accounting and its Environment, page 213-232, Basic Accounting Made Easy,18th
Edition, Dom Dane Publishing, 2013.