ADJUSTING ENTRIES

Adjusting entries are entries prepared at the end of the accounting period to update some accounts and ensure
their accuracy before preparing the financial statements.
In this module, calendar year is used thus the end of the accounting period is always on December 31.
SUMMARY OF ADJUSTING ENTRIES

Type of Adjustment Account Balances Before Adjustment Adjusting Entry

Balance Sheet Income Statement Account Debited Account Credited
Account Account

Prepaid Expenses:
Asset method Asset Overstated Expenses Understated Expense Prepaid Expense (A)
Expense method Asset Understated Expenses Overstated Prepaid Expense (A) Expense

Depreciation Assets Overstated Expenses Understated Expense Contra Asset

Unearned Income:
Liability method Liabilities Overstated Income Understated Unearned Income(L) Income
Liabilities
Income method Understated Income Overstated Income Unearned Income(L)

Accrued Expenses Liabilities Expenses Understated Expenses Payable

Understated
Accrued Revenues Asset Understated Income Understated Receivable (A) Income

ACCRUAL PRINCIPLE
Aiding the accountants are some generally accepted accounting principles such as the Accrual Principle
otherwise known as the Revenue Recognition Principle and the Expense Recognition Principle.
Revenue Recognition Principle
Under accrual basis, income is recognized as earned at the time service is rendered and this is recorded regardless
of when cash is collected.
Expense Recognition Principle
Under accrual basis, expense is recognized as incurred at the time service is received or used up regardless of
when cash is paid.
The GAAP favors the accrual basis of fairly measuring income and expenses, thus adjustments should be made along this
rule.
ACCRUED INCOME
- income already earned but were not collected nor recorded
To illustrate; assume that Healthway Clinic referred a patient for laboratory examinations to Makati Diagnostic
Laboratory and for which it is entitled to a commission or referral fee of ₱500. This amount was not yet collected as of
December 31, the end of its accounting period.
ILLUSTRATION I
 From the viewpoint of Healthway Clinic under accrual principle, an adjusting entry should be made at the end of
the accounting period. Thus:

Date Particulars F Debit Credit

2020
Dec 31 Referral Fee Receivable ₱ 50 0
Referral Fee Income ₱ 5 0 0
to adjust for referrals

ACCRUED EXPENSES
- expenses already expired but were not paid nor recorded
From the viewpoint of Makati Diagnostic Laboratory:
Date Particulars F Debit Credit
2020
Dec 31 Referral Fee Expense ₱ 50 0
Referral Fee Payable ₱ 5 0 0
to adjust for referral fee

Take note of two new accounts: Accrued Income called Referral Fee Receivable which is a current asset representing
account to be collected and Accrued Expenses called Referral Fee Payable which is a current liability representing
account to be paid.
ILLUSTRATION II
Healthway clinic issued a 45- day, 18% note for a ₱100,000 cash loan received from RP Finance dated
December 1, 2020.
Since the note is dated December 1, 30 days has lapsed as of December 31, an expense (interest expense) should
be recognized and a liability (interest payable) should be recorded since no payment was made for this.
From the viewpoint of Healthway Clinic, the adjusting entry will appear as follows:

The interest is computed as follows;

Interest= Prinicipal x Interest Rate x Time
= ₱100,000 x 18% x 30/360
= ₱ 1,500
From the viewpoint of RP Finance:
 PREPAID EXPENSE
- advance payment recorded as an asset but a portion of which has already expired
The advance payment may be recorded under the asset method or under the expense method.

 ASSET METHOD
- The advance payment is recorded as an asset Prepaid Expense. This represents a right to receive service for
cash already paid.
ANALYSIS: At the end of the year, if there is already an expired portion or if service has been received, transfer this
amount from the prepaid expense account to the expense account.
ILLUSTRATION:
Assume Marciano Drugstore issued a check on Nov. 1 for ₱ 9,000 as advance payment for six months store
rental.
Original entry on Nov. 1 using ASSET METHOD:
Date Particulars F Debit Credit
2020
Nov 1 Prepaid Rent ₱ 900 0
Cash ₱ 9 0 0 0
to record advance payment

Note that the advance payment for rent was recorded as an asset (PREPAID EXPENSE) under ASSET METHOD.

With the above entry, on December 31, end of the accounting period, the store space has already been used for
two months (November 1 to December 31), the prepaid expense should be decreased and an expense should be
recognized. Thus:
Date Particulars F Debit Credit
2020
Dec 31 Rent Expense ₱ 300 0
Prepaid Rent ₱ 3 0 0 0
to adjust for two months expired rent

SOLUTION:

Advance payment for 6 months rent ₱ 9,000

Divided by number of months 6
Monthly rental ₱ 1,500
Multiplied by expired portion in months 2
(November – December)
Rent Expense (expired portion) ₱ 3,000
  EXPENSE METHOD
- An alternative method to record the advance payment is to immediately debit it to an expense account.
ANALYSIS: At the end of the year, if there is an unexpired portion, transfer this amount from the expense account to the
prepaid expense account.
ILLUSTRATION (using the same transaction from above):
Assume Marciano Drugstore issued a check on Nov. 1 for ₱ 9,000 as advance payment for six months store
rental.
Original entry on Nov. 1 using EXPENSE METHOD:
Date Particulars F Debit Credit
2020
Nov 1 Rent Expense ₱ 900 0
Cash ₱ 9 0 0 0
to record advance payment for six months

Note that the advance payment for rent was recorded as an expense (RENT EXPENSE) under EXPENSE METHOD.
Based on the above entry, on December 31, end of the accounting period, only two months (Nov. 1 to Dec. 31)
have expired, rent expense should be decreased for the unexpired portion and record this to an asset account, Prepaid
Rent. Thus:
Date Particulars F Debit Credit
2020
Dec 31 Prepaid Rent ₱ 600 0
Rent Expense ₱ 6 0 0 0
to adjust for four months unexpired rent

SOLUTION:

Advance payment for 6 months rent ₱ 9,000

Divided by number of months 6
Monthly rental ₱ 1,500
Multiplied by unexpired portion in months 4
(January-April)
Rent Expense (expired portion) ₱ 6,000

Note that the balances of Prepaid Rent and Rent Expense are the same after making adjusting entries regardless of
the method used.
PREFERABLE METHOD: The asset method is preferable since it follows the conceptual flow of cost. Anything with
discernible benefit should first be recognized as asset until a portion is expired then it is recorded as expense.
DEFFERED OR UNEARNED INCOME
- advance collection recorded as a liability, but a portion of which has already been earned
The advance collection may be recorded under the liability method or under the income method.
 LIABILITY METHOD
The advance collection is credited to a liability account called Unearned or Deferred Income. It is a liability of the
company to render service for cash that was advanced by the client.
ANALYSIS: If, before the end of the year, service has been rendered, decrease the liability and an income account
should be recorded.
ILLUSTRATION:
Assume that on October 1, Healthway Clinic sublet a building to Mercurio Drugstore who paid ₱ 60,000 rent in
advance for four months.
Original entry on Oct. 1 using LIABILITY METHOD:
Date Particulars F Debit Credit
2020
Oct 1 Cash ₱ 6 000 0
Unearned Rent Income ₱ 6 0 0 0 0
to record advace collection

Note that the advance collection was recorded as a liability (Unearned Rent Income) under LIABILITY METHOD.
Based on the above entry, on December 31, end of the accounting period, the tenant has already used up the
building space for three months (October 1- December 31), the liability account should be decreased and an income
should be recognized. Thus:

Date Particulars F Debit Credit

2020
Dec 31 Unearned Rent Income ₱ 4 500 0
Rent Income ₱ 4 5 0 0 0
to adjust for three months rent earned

SOLUTION:

Advance collection for 4 months rent ₱ 60,000

Divided by number of months 4
Monthly rental ₱ 15,000
Multiplied by earned portion in months 3
(October 1- December 31)
Rent Income (earned portion) ₱ 45,000

 INCOME METHOD
-An alternative method is to record the advance collection immediately with a credit to an income account.
ANALYSIS: If, before the end of the year, if there is still a service not rendered, decrease the income and a liability
account should be recorded.
ILLUSTRATION (using the same transaction from above):
Assume that on October 1, Healthway Clinic sublet a building to Mercurio Drugstore who paid ₱ 60,000 rent in advance
for four months.
Original entry on Oct. 1 using INCOME METHOD:
 Based on the above entry, on December 31, end of accounting period, the business has rendered service for three
months only (Oct. 1- Dec. 31), income should be decreased and a liability account should be recorded. Thus:
SOLUTION:

Advance collection for 4 months rent ₱ 60,000

Divided by number of months 4
Monthly rental ₱ 15,000
Multiplied by unearned portion in months 1
(January 2021)
Rent Income (earned portion) ₱ 15,000

Note that the balances of Unearned Rent Income and Rent Income are the same after making adjusting entries
regardless of the method used.
PREFERABLE METHOD: The liability method is preferred, again because it follows the conceptual flow of
recognizing first the liability until the amount is earned.

BAD DEBTS
- client accounts that may not be collected anymore or are doubtful of collection
There are two methods of recognizing bad debts: the direct write off method and the allowance method.
 DIRECT WRITE OFF METHOD
- this method recognizes bad debts expense only when it is certain that the company will not be able to collect
the account anymore.
ILLUSTRATION:
Mr. Decena, a 2019 customer who owed the company ₱10,000 became insolvent in 2020 and could not pay his
account anymore.
ANALYSIS: The bookkeeper cancelled his account as authorized by the business owner and prepared the following
entry, in 2020, recording an expense for the bad account of 2019. Thus:
Date Particulars F Debit Credit
2020
Dec 31 Bad Debts Expense ₱ 1 000 0
Accounts Receivable ₱ 1 0 0 0 0
to write off account

Note that under direct write off method, the uncollectible amount is directly deducted to accounts receivable thus a
credit to such.
 ALLOWANCE METHOD
 - provides for bad debts or doubtful accounts during the period the sale of service is recorded. The
doubtful accounts are determined by estimation based on the company’s past experience or the experience of
other companies within the same business industry.
Illustration:
Assuming that the following accounts receivable balances are found in the books of Carla Auto Repair. All
balances are outstanding at the end of the accounting period, December 31.

December 31, 2019 December 31, 2020

Accounts Receivable ₱ 30,000 ₱ 90,000

Assume that based on the past experience on bad debts, it is estimated that 5% of its outstanding accounts
receivable will be doubtful of collection. The entry for the year 2019 is as follows:
Date Particulars F Debit Credit
2019
Dec 31 Bad Debts Expense ₱ 150 0
Allowance for Bad Debts ₱ 1 5 0 0
to adjust doubtful accounts

SOLUTION:

Accounts Receivable- 12/31/19 ₱30,000

Multiplied by estimated doubtful of collection 5%
in percentage
Required 2019 allowance for bad debts ₱ 1,500

The entry for the year 2020 is as follows:

Date Particulars F Debit Credit
2020
Dec 31 Bad Debts Expense ₱ 300 0
Allowance for Doubtful Accounts ₱ 3 0 0 0
to adjust doubtful accounts

SOLUTION:

Accounts Receivable- 12/31/20 ₱90,000

Multiplied by estimated doubtful of collection 5%
in percentage
Required 2020 allowance for bad debts ₱ 4,500
Less 2016 allowance 1.500
Adjust to increase allowance by ₱ 3,000

The Allowance for Doubtful Accounts is a contra asset account which is deducted from the principal account to get the
net realizable value of accounts receivable.
DEPRECIATION
- transfer of asset cost to expense based on its declining value.
 Depreciation is recognizing part of the asset as an expense because of its decreasing utility value. To illustrate:
cost of machine is ₱ 300,000 acquired January 2015, and can be used for five years. Table analyzing decline in utility
value will appear as follows:

Year Cost Depreciation Expense Accumulated Net Book Value

Depreciation
Jan. 2015 ₱ 300,000
Dec. 31, 2015 ₱ 60,000 ₱ 60,000 ₱ 240,000
Dec. 31, 2016 ₱ 60,000 ₱ 120,000 ₱ 180,000
Dec. 31, 2017 ₱ 60,000 ₱ 180,000 ₱ 120,000
Dec. 31, 2018 ₱ 60,000 ₱ 240,000 ₱ 60,000
Dec. 31, 2019 ₱ 60,000 ₱ 300,000 --

Note that the accumulated depreciation increases as a result of the periodic depreciation while the carrying value
decreases until it is zero, if there is no scrap value. Accumulated depreciation which is a contra- asset account is
deducted from the cost price to arrive at net book value.
FORMULA FOR DEPRECIATION:
Cost – Scrap Value, if any = Depreciation
Useful life stated in no. of years

ILLUSTRATION:
Assume that Carla Motor Repair Service has the following accounts, among others, in its trial balance as of
December 31, 2020, the end of its accounting period:

Debit Credit
Machinery & Equipment ₱750,000
Accumulated Depreciation- Machinery & Equipment ₱125,000
Building 1,000,000
Furniture & Fixtures 300,000

Additional Information:
1. The machinery and equipment were acquired Jan. 1, 2019 with an estimated life of 6 years, no scrap value.
2. The building was newly constructed on March 1, 2020 with an estimated life of 10 years, scrap value of ₱100,000.
3. The furniture and fixtures were acquired January 1, 2020 with a useful life of 10 years, scrap value of ₱ 30,000.

Thus, the adjusting entries are as follows:

Date Particulars F Debit Credit

2020
Dec 31 Depreciation Expense- Machinery & Equipment ₱ 12 500 0
Accumulated Depreciation- Machinery & Equipment ₱ 12 5 0 0 0
to provide depreciation

/ Depreciation Expense- Building 7 500 0

Accumulated Depreciation- Building 7 5 0 0 0
to provide depreciation

/ Depreciation Expense- Furniture & Fixtures 2 700 0

Accumulated Depreciation- Furniture & Fixtures 2 7 0 0 0
to provide depreciation
SOLUTIONS:
Using the formula:

Cost – Scrap Value, if any = Depreciation

Useful life stated in no. of years

1. Machinery depreciation: ₱ 750,000/ 6 years = ₱125,000

2. Building depreciation: ₱ 1,000,000 -₱ 100,000 = ₱ 90,000 per year

10 years

₱ 90,000 x 10/12 = ₱75,000 for 10 months

Note that the depreciation for a year is 90,000 but since the building was constructed only March 1, it can only be
depreciated for 10 months in 2020. A full year depreciation will be provided the following year.

3. Furniture & Fixtures depreciation:

₱300,000- ₱30,000 = ₱27,000

10 years