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FAR Chapt. 7

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Chapter 7

Completing the Accounting Cycle for a service provider.

Time Period Assumption


- An accountant is allowed to divide the life of the business into uniform periods of time so that regular
financial statements can be prepared.
Calendar
- A twelve-month period ending on December 12
- If it starts on Janu vary 1 and ends on December 31
Fiscal
- Twelve-month period that ends on any month other than December 31.
- It may start on a month other than January 1
The accounting period

“Note: We cannot proceed to prepare the worksheet for the adjustments if the accounting
period is not yet done”
Adjusting the Accounts
Timing Issue
- Time Period Assumption
- The economic life of a business is divided into time periods (monthly, quarterly or
yearly)
- EG.
- A one-year insurance paid in advance on March 1, 2020, should be
expensed only for ten months in 2020 (March to December) and for
two months in 2021 (January to February).
- A consultancy firm received an advance fee of P30,000 good for three
months starting December 1, 2020. Only one month revenue of
P10,000 should be recognized in 2020 and the remaining P20,000 in
2021. ​
The basics of 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
Types of adjusting entries
- Accrued income
- Income already earned but not yet collected
- Accrued expense
- Expense already expired but not yet paid
- Unearned income
- Advance collection recorded as a liability, portion of which has been already
been earned.
- A service that is not yet rendered.
- Prepaid expense
- Advance payment is recorded as an asset, portion of which has been used up
- Bad Debts
- Clients' accounts that may not be collected anymore or are doubtful of
collection
- Depreciation expense
- Declining utility value of asset cost that should be expensed
Adjusting entries for accruals
Accrual Basis Accounting
- Also otherwise known as the Revenue Recognition Principle and the Expense
recognition principle
- Transactions recorded in the period in which the events occur
- Accrued Revenues
- Revenues are recognized when earned, rather than when cash
is received

Increases (debits) an asset account


Increases (credits) a revenue account
- Accrued Expenses
- Expenses are recognized when incurred, rather than when
paid.
Increase (debits) an expense account
Increase (credits) a liability account
EG: Adjusting entries for Accrued Reveneu and Accrued Expense

Cash Basis Accounting


- Revenues are recognized when collected
- Expenses are recognized when paid.
Matching Principle
- The expense representing the effort of the business should be matched
against the income representing the accomplishment of the business during
the period it was earned.
Adjusting entries for deferrals
Prepaid Expenses
- Expenses are paid in cash and recorded as assets before they are used or
consumed
- A prepayment is the opposite of accrual and represents advance payment for
service to be received.
- A payment of cash, that is recorded as an asset because service or benefit
will be received in the future
- EG
- Insurance, Lease, supplies, advertising
- Expenses to be incurred in the future.
Asset method
- The advance payment is recorded as an asset. This represents
a right to receive service for cash already paid.
- If received or expired transfer this amount from the asset called
prepaid expense account to the expense amount
Expense method
- An alternative method to record the advance payment is to
immediately debit it to an expense account.
Preferable method
- The asset method is preferable since it follows the conceptual
framework of cost. Anything with future discernible benefits
should first be recognized as an asset.
- Adjust the prepaid expense to decrease and recognize an expense for the
expired portion, Cost will expire because of the passage of time. The
unexpired balance is shown as a current asset in the statement of financial
position while the expired portion is shown in the income statement.
Unearned revenues
- Advance collection of payments from clients.
- Revenues are received in cash and recorded as liabilities before they are
earned.
- A receipt of cash, that is recorded as a liability, because service or benefit will
be rendered or given in the future.
Liability method
- The advance collection is credited to a liability account. It is a
liability of the company to render service for cash that was
advanced by the client.
- If the service has been rendered, decreased the liability (debit)
and increase (credit) the revenue account
Income method
- An alternative method is to record the advance collection
immediately with a credit to an income account.
Preferable method
- Liability method is preferred because it follows the conceptual
flow of recognizing first the liability until the amount is earned.

- Adjust the unearned revenue to decrease the liability account and recognize
an income for the earned portion. The unexpired balance is shown as a
current liability in the financial statement of financial position while the earned
portion is shown in the income statement.
Bad debts
- Losses from uncollectible accounts are considered part of the risk the entity assumes and
should therefore be considered part of operating expense.
- Sometimes occurs for customers’ accounts that are doubtful of collection. Give rise to a
contra asset account (credit) with a credit to allowance for bad debts and a debit to a bad
debt expense account.
Direct write-off method
- Recognizes bad debt expense only when it is certain that the company will not be
able to collect the account anymore.
- The bad debt expense will be shown in the operating expense
- Credits the account receivable to decrease it directly

Allowance method/Doubtful accounts


- Provides for bad debts or doubtful accounts during the sale of service is recorded.
- Determined by estimation based on the company’s past experience.
- To arrive at an estimate, a certain percentage is derived between the bad debts
expense of the company and its outstanding receivables for the previous years.
- It is a contra asset account which is deducted from the principal account.
Net realizable value
- The difference between accounts receivable and the allowance for
doubtful accounts.
- Only recognizes doubtful accounts every accounting period based on an estimate of
accounts not collected as experienced in the previous years by the entity
- Credits the accounts receivable to decrease it indirectly by using a contra asset
account called allowance for doubtful accounts.

Depreciation
- Often occurs for fixed assets such as furniture and fixtures and equipment when their costs
are often adjusted from new to use.
- Gives rise to a contra asset account credited to accumulated depreciation and a debit to
depreciation expense account.
- Recognizing part of the asset as an expense because of its decreasing utility value

- Depreciation = Amount of current asset/ useful life in years/ 12 months.


Accumulated depreciation
- Increases because of the periodic depreciation while the carrying value
decreases until it is zero unless there is a scrap value.
- A contra asset account, deducted from the cost price to arrive at net vook
value
- Is a decrease in the cost of the asset
Scrap Value
- The amount remaining when the asset has been fully depreciated.
Book value
- The difference between the cost and the accumulated depreciation
- Unexpired cost or the net utility value of the asset.
Utility Value
- Ability to yield service
Obsolescence
- Becomes outdated
Inadequacy
- Cannot cope up with demands for more volume or better quality of service.
Market value
- Realizable value if the asset is to be sold
Rules in depreciation accounting
1. Start depreciating the asset from acquisition date
2. Provision is also the amount presented in the income statement as an
operating expense
3. Depreciation amount is increasing as additional provision are recorded every
year
4. Scarp value is deducted from cost in determining the depreciation cost of the
asset, scrap value is recorded unless it is sold until the end of the useful life of
the asset.
Work Sheet (10-column worksheet)
- Needed to gather and work out the adjustment. A columnar paper where the first two columns are
provided for the trial balance, the next two columns are for the adjustment, The income statement
and the statement of financial position are prepared next.

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