Review Class for ACT111-0 and ACT112-0

E.T. Yuchengco School of Business and Management

Module 3
ADJUSTING THE ACCOUNTS

Time-Period Assumption
The time period (or periodicity) assumption assumes that the economic life of a business can be
divided into artificial time periods.

Accounting time periods are generally a month, a quarter, or a year. The accounting time period of one
year in length is usually known as a fiscal year.

Accrual Basis of Accounting

The revenue recognition and matching principles are used under the accrual basis of accounting.
Under cash basis accounting, revenue is recorded only when cash is received and expenses are
recorded only when paid.

Generally accepted accounting principles require accrual basis accounting rather than cash basis
accounting because the cash basis of accounting often leads to misleading financial statements.

Revenue Recognition Principle

The revenue recognition principle states that revenue should be recognized in the accounting period
in which it is earned.

The Matching Principle

The matching principle dictates that efforts (expenses) be matched with accomplishments (revenues).

Adjusting Entries
Adjusting entries are made in order for:
a. Revenues to be recorded in the period in which they are earned, and for expenses to be recognized
in the period in which they are incurred.
b. The revenue recognition and matching principles to be followed.

Adjusting entries are required every time financial statements are prepared. Adjusting entries can be
classified as (a) prepayments (prepaid expenses, depreciation or unearned revenue) or (b) accruals
(accrued revenues or accrued expenses).

Prepayments
Prepaid expenses are expenses paid in cash and recorded as assets before they are used or
consumed. Prepaid expenses expire with the passage of time or through use and consumption. An
asset-expense account relationship exists with prepaid expenses. Prior to adjustment, assets are
overstated and expenses are understated. The adjusting entry results in a debit to an expense
account and a credit to an asset account. Examples of prepaid expenses include supplies, insurance,
and depreciation.

To illustrate a prepaid adjusting entry, assume on October 1, Kubitz Company pays P2,400 cash to
Sandy Insurance Co. for a one-year insurance policy effective October 1. The adjusting entry at October
31 is:

Insurance Expense (P2,400 x 1/12) 200

Prepaid Insurance 200

Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational
and systematic manner. The purchase of equipment or a building is viewed as a long-term prepayment of
services and, therefore, is allocated in the same manner as other prepaid expenses. Depreciation is an
estimate rather than a factual measurement of the cost that has expired. In recording depreciation,
Depreciation Expense is debited and a contra asset account, Accumulated Depreciation, is credited. In
the balance sheet, Accumulated Depreciation is offset against the asset account. The difference
between the cost of the asset and its related accumulated depreciation is referred to as the book value
of the asset.
Review Class for ACT111-0 and ACT112-0
E.T. Yuchengco School of Business and Management

To illustrate an adjusting entry for depreciation, assume Resch Co. purchases a machine for P6,000
cash on January 1, 2014. Assuming that annual depreciation is P1,200, the adjusting entry at December
31, 2014 is:

Depreciation Expense 1,200

Accumulated Depreciation--Machinery 1,200

Unearned revenues are revenues received and recorded as liabilities before they are earned. Unearned
revenues are subsequently earned by rendering service to a customer. A liability-revenue account
relationship exists with unearned revenues. Prior to adjustment, liabilities are overstated and
revenues are understated. The adjusting entry results in a debit to a liability account and a credit to a
revenue account. Examples of unearned revenues include rent, magazine subscriptions, and customer
deposits for future service.

To illustrate an unearned revenue adjusting entry, assume on October 1, Schoen Co. receives P3,000
cash from a renter in payment of monthly rent for the period October through December. At October 31,
the adjusting entry to record the rent earned in October is

Unearned Rent Revenue 1,000

Rent Revenue (P3,000 x 1/3) 1,000

Accruals
Accrued revenues are revenues earned but not yet received in cash. Accrued revenues may
accumulate with the passing of time as in the case of interest and rent, or through services performed
but not billed or collected. An asset-revenue account relationship exists with accrued revenues. Prior
to adjustment, both assets and revenues are understated. The adjusting entry results in a debit to an
asset account and a credit to a revenue account.

To illustrate an accrued revenue adjusting entry, assume in October, Mayer, a dentist, performs P800 of
services for patients who are not billed until November. The adjusting entry at October 31 is:

Accounts Receivable 800

Dental Fees Earned 800

Accrued expenses are expenses incurred but not yet paid or recorded. Accrued expenses result from
the same causes as accrued revenues and include interest, rent, taxes, and salaries. A liability-expense
account relationship exists with accrued expenses. Prior to adjustment, both liabilities and expenses are
understated. The adjusting entry results in a debit to an expense account and a credit to a liability
account.

To illustrate an accrued expense adjusting entry, assume Schwenk Company incurs salaries of P4,000
during the last week of October that will be paid in November. The adjusting entry on October 31 is:

Salaries Expense 4,000

Salaries Payable 4,000

Each adjusting entry affects one balance sheet account and one income statement account.

Adjusted Trial Balance

After all adjusting entries have been journalized and posted an adjusted trial balance is prepared. This
trial balance shows the balances of all accounts, including those that have been adjusted, at the end of
the accounting period.

The purpose of an adjusted trial balance is to prove the equality of the total debit balances and the total
credit balances in the ledger after all adjustments have been made.

The accounts in the adjusted trial balance contain all data that are needed for the preparation of financial
statements.
Review Class for ACT111-0 and ACT112-0
E.T. Yuchengco School of Business and Management

Sample Theory Questions

1. Adjusting entries at the end of an accounting period would not be required for which of the following:
A. Multiperiod costs that must be split among two or more accounting periods.
B. Multiperiod revenues that must be split among two or more accounting periods.
C. Expenses that have been incurred in a given period but not as yet recorded in the accounts.
D. Revenue that has been earned and recorded in the accounting records.
2. At the end of the current accounting period, Johnson Company failed to record utilities consumed
during the period. Johnson will be billed for the utilities during the next accounting period. As a result,
current period assets, liabilities, equity, and income, respectively, are:
A. Overstated, overstated, correct, correct.
B. Correct, understated, overstated, overstated.
C. Overstated, understated, overstated, overstated.
D. Overstated, understated, correct, correct.
3. When a company purchases an asset that will be used for more than one accounting period,
A. The company should record the entire expense of the asset in the accounting period in which the
asset is purchased.
B. The purchase is not recognized as an expense when the asset is purchased.
C. The company should make monthly payments to the vendor to pay off the loan used to purchase
the asset.
D. The company should only record the asset on the balance sheet. There will be no expense
associated with this transaction.
4. When adjusting for revenue that has accrued (been earned) but has not been recorded, which of the
following will occur?
A. An asset account is increased and a revenue account is increased.
B. A revenue account is increased and an expense account is increased.
C. A revenue account is increased and a liability account is decreased.
D. A revenue account is increased and a liability account is increased.
5. The recognition of revenue before cash is received is an example of which of the following adjusting
entries:
A. Deferred expense. C. Deferred revenue.
B. Accrued expense. D. Accrued revenue.

Computational Drills
1. A review of the ledger of Remington Company at December 31, 2014, produces the following data
pertaining to the preparation of annual adjusting entries.
a. Salaries Payable, P0. There are eight salaried employees. Salaries are paid every Friday for the
current week. Five employees receive a salary of P800 each per week, and three employees
earn P600 each per week. Assume December 31 is a Tuesday. Employees do not work
weekends. All employees worked the last 2 days of December.
b. Unearned Rent, P324,000. The company began subleasing office space in its new building on
November 1. At December 31, the company had the following rental contracts that are paid in full
for the entire term of the lease.
Term Number of
Date (in months) Monthly Rent Leases
Nov.1 6 P4,000 5
Dec.1 6 P8,500 4
c. Prepaid Advertising, P15,000. This balance consists of payments on two advertising contracts.
The contracts provide for monthly advertising in two trade magazines. The terms of the contracts
are as follows.
Number of
Contract Date Amount Magazine Issues
A650 May 1 P5,400 12
B974 Oct.1 9,600 24
The first advertisement runs in the month in which the contract is signed.
d. Notes Payable, P120,000. This balance consists of a note for one year at an annual interest rate
of 9%, dated June 1.
2. The company purchased equipment amounting to 50,000 on May 31, 2014. Useful life is 9 years and
residual value is 5,000. How much is the depreciation expense on 2015?