Our last discussion ended with the preparation of the trial balance.

We will not yet prepare financial statements because

some accounts in the trial balance must still be adjusted or updated.

Adjusting entries are entries prepared at the end of accounting period to update some accounts and ensure their
accuracy before preparing the financial statements.

These are the reasons why some accounts need to be changed or updated:

1. Accrued income – income already earned but were not collected nor recorded
2. Accrued expenses – expenses already expired but were not paid nor recorded
3. Unearned income – advance collection recorded as a liability, but a portion of which has already been earned.
4. Prepaid expense – advance payment recorded as an asset but a portion of which has already expired.
5. Bad Debts – client accounts/receivable from customers that may not be collected anymore or are doubtful of
collection
6. Depreciation Expense – transfer of asset cost to expense based on its declining utility value

What are the examples of transactions that need to be adjusted?

1. Purchased supplies, and these are recorded as assets. Once a portion of this has been used up, an entry is prepared
to decrease the asset and recognize an expense.
2. Cash received in advance for services not yet rendered, is recognized as a liability – Advances from Clients. We
need to adjust this once service has been rendered by decreasing the liability and recognizing an income.
3. When bills are received from utility companies for services received but unpaid at the end of the accounting
period, these must be already recorded as expenses and the outstanding obligations recorded as liabilities.
4. Another example for adjustment is depreciation of tangible assets when we decrease their amounts from cost to
book value.

ACCRUAL BASIS/ACCRUAL PRINCIPLE

- 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. Regardless when cash is received or paid.
- Generally accepted accounting principles (GAAP) favors the accrual basis of fairly measuring income and expenses,
because matching principle applies. Because the expense (representing effort of the business) should be matched
against the income (representing accomplishment of the business) during the period it was earned.

CASH BASIS

In cash basis accounting, however, the accountant does not record a transaction until cash is received or paid.

To illustrate: assume that Healthway Clinic referred a patient for laboratory examination to Makati Diagnostic Laboratory
and for which it is entitled to a commission or referral fee of P500. This amount was not yet collected as of December 31,
the end of its accounting period.

 From the viewpoint of Healthway Clinic, assets should be adjusted to include Referral Fee Receivable to increase
assets and a Referral Fee Income to increase owner’s equity. Thus:

Dec 31 :

Referral Fee Receivable P500

Referral Fee Income P500

- To adjust for referrals due from Makati Diagnostic Laboratory (due from/receivable, due to/liability)
From the viewpoint of Makati Diagnostic Laboratory: record a decrease in owner’s equity in Referral Fee Expense and
increase liability in Referral Fee Payable

Dec 31:

Referral Fee Expense P500

Referral Fee Payable P500

- To adjust for referral fee due to Healthway Clinic

Take note of two new accounts: Accrued Income called Referral Fee Receivable which is a current asset representing
account to be collected and Accrued Expense called Referral Fee Payable which is a current liability representing account
to be paid. Just as revenue creates a receivable account, an expense creates a payable account.

Another illustration: Healthway Clinic issued a 45-day, 18% note for a P100,000 cash loan received from RP Finance. The
note is dated December 1, 2014 and since 30 days has lapsed as of December 31, this should be recognized as an expense
(interest expense) and a liability (interest payable) should be recorded since no payment was as yet made for this.

The adjusting entry will appear as follows:

Dec. 31:

Interest Expense P1,500

Interest Payable P1,500

- To accrue interest for 30 days due to RP Finance

From the viewpoint of RP Finance: increase in assets for interest receivable and recognize an interest income to increase
owner’s equity. Thus:

Dec. 31:

Interest Receivable P1,500

Interest Income P1,500

- To accrue interest for 30 days due for 30 days due from Healthway Clinic

Computation: determine the period that has transpired from the date of the note (December 1) to the end of the
accounting period (December 31) which is 30 days.

Principal x Interest Rate x Time = Interest

100,000 x 18% x 30/360 = P1,500

What will happen if accrued expense and accrued income are not recognized? The following tables will show the effects
on the financial statements:

Viewpoint of Healthway:

Accounting Value Affected Statement of Financial Position Statement of Income

Current Liabilities Understated
Owner's Equity Overstated
 Expenses Understated
Net Income Overstated

Viewpoint of RP Finance:

Accounting Value Affected Statement of Financial Position Statement of Income

Current Assets Understated
Owner's Equity Understated
Revenue Understated
Net Income Understated

Take note of the effects of the omitted adjustments on owner’s equity. Recall that net income is added to owner’s equity,
therefore it is understated if net income is understated or overstated if net income is overstated.

DEFERRALS

Prepaid Expense – prepayment is the opposite of accrual. A prepaid expense represents advance payment for service to
be received (expense to be incurred in the future).

ASSET METHOD: The advance payment is recorded as an asset Prepaid Expense. This represents a right to receive service
for cash already paid. 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. To illustrate, assume Marciano Drugstore issued
a check on Nov. 1 for P9,000 as advance payment for six months store rental.

Nov. 1:

Prepaid Rent P9,000

Cash In Bank P9,000

With the above entry, on December 31, end of the accounting period, the trial balance will show among others,
an account Prepaid Rent P9,000. This is a current asset account representing service to be received for an advance
payment made. Remember that assets are economic resources generating future discernible benefits for the business.
But since the store space has already been used for two months (November and December), the prepaid account should
be decreased by P3,000 and an expense should be recognized. Thus:

Dec. 31:

Rent Expense P3,000

Prepaid Rent P3,000

Analysis: Decrease in assets for prepaid rent and decrease in owner’s equity for the expense. What if no adjustment is
made for this? Rent expense will be understated, which in turn will overstate net income and owner’s equity. Assets
(prepaid rent) will also be overstated.

EXPENSE METHOD:

- An alternative method to record the advance payment is to immediately debit it to an expense account. Using the
above illustration, it will appear as follows:

Nov. 1
Rent Expense P9,000

Cash in Bank P9,000

- To record advance payment for six months

Based on the above entry, on December 31, end of the accounting period, the trial balance will show among others, an
account Rent Expense, P9,000. But from Nov. 1 to Dec. 31, only two months have expired, rent expense should only be
P3,000. Decrease the expense by P6,000 for the unexpired portion and record this to an asset account, Prepaid Rent.
Therefore, adjust:

Dec. 31:

Prepaid Rent P6,000

Rent Expense P6,000

Analysis: Increase in asset for the prepaid rent and decrease in owner’s equity for the expense.

Note that balances are the same regardless of method used.

What if accountant fails to make an adjusting entry? Rent expense will be overstated, which in turn will understate net
income and owner’s equity. Assets (prepaid rent) will also be understated.

PREFERABLE METHOD. The asset method is preferable since it follows the conceptual flow of cost. Anything with future
discernible benefit should first be recognized as asset until a portion is expired then it is recorded as expense.

DEFERRED OR UNEARNED REVENUE

- Some companies require their clients/customers to pay in advance. 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 Revenue. It is a
liability of the company to render service for cash that was advanced by the client. If, before the end of the year, service
has been rendered, decrease the liability and increase the revenue account.

To illustrate, assume that on October 1, Healthway Clinic sublet a building to Mercurio Drugstore who paid P60,000 rent
in advance for four months. Entry on this day:

Oct. 1:

Cash on Hand P60,000

Unearned Rent Income P60,000

- To record advance collection for four months

Analysis: Increase in assets and liabilities

Based on the above entry, the December 31 trial balance will show, among others, an account Unearned Rent Income for
P60,000. However, from October 1 to December 31, since the tenant has already used up the building space for three
months or P45,000, this amount should be recognized as income. To adjust:

Dec. 31:

Unearned Rent Income P45,000

Rent Income P45,000

 - To adjust for three months rent earned

Analysis: Decrease in liabilities and increase in owner’s equity

The diagram will show:

Collected Oct Nov Dec Jan

P60,000

15,000 15,000 15,000 15,000 (Unearned)

-----------------------------------------------earned-----------------------------

Remember that we are making the adjustment on December 31 which is the end of the accounting period otherwise
known as the cut-off period. The cut-off period must be considered when making any kind of adjustment

What if no adjustment is made? Unearned rent will be overstated by P45,000, rent income will be understated and so
will owner’s equity

INCOME METHOD

- An alternative method is to record the advance collection immediately with a credit to an income account. Using
the same illustration:

Oct 1:

Cash on Hand P60,000

Rent Income P60,000

- To record advance rent for four months

Analysis: increase in assets for cash collected and increase in owner’s equity for rent income

Based on the above entry, the trial balance on December 31, end of the accounting period will show an account Rent
Income of P60,000. As of Dec. 31, since the business has rendered service for three months only then income should only
be P45,000 with P15,000 recognized as Unearned Income for the unearned portion. Thus:

Dec. 31

Rent Income P15,000

Unearned Rent Income P15,000

Analysis: Decrease in owner’s equity and increase in liability

Note that whatever is the method used, you should come up with the same balances for the income P45,000 and for the
unearned income P15,000. Again, the cash should not be adjusted

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

No matter how efficient the credit department is in screening customers, some of them may still not be able to pay. Losses
from uncollectible accounts are considered part of the risk the entity assumes and should therefore be considered part of
operating expenses.
There are two methods of recognizing bad debts:

1. Direct write off method – recognizes bad debts expense when it is certain that the company will not be able to
collect the account anymore.
Example:

Assume Carla Auto Repair recorded P80,000 accounts receivable for services rendered in 201 with collection of
P50,000. The following year another P120,000 were recorded for account services rendered with collections of
P60,000 from previous and present accounts. Mr. Deena Balance, a 2016 customer who owed the company
P10,000 became insolvent in 2017 and could not pay his account anymore. The bookkeeper cancelled his account
as authorized by the business owner and prepared the following entry, in 2014, recording an expense for the bad
account of 2016.

Date Accounts Debit Credit

2017
Dec. 31 Bad Debts Expense 10,000.00
Accounts Receivable 10,000.00
To write off the account of Mr. Deena

The T-accounts for accounts receivable and bad debts will show the following:

Accounts Receivable Bad Debts

2016 Services 80,000.00 2016 collections Dec. 31, 2017
Jan. 1, 2017
Balance 30,000.00 2017 collections 60,000.00 Adjustment 10,000.00
2017 services 120,000.00 Dec. 31 Adjustment 10,000.00
Balance on Dec.
31, 2017 80,000.00

Note: Bad Debts Expense will be shown in the operating expense section of the 2017 income statement and the accounts
receivable which has a balance of P80,000 will be shown in the current asset section of the statement of financial position.

2. Allowance method – provides for bad debts or doubtful accounts during the period the sale of service is recorded.
- How can this be possible if one does not know who among the customers who will not be able to pay? 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.
- To arrive at an estimate, a certain percentage or ratio is derived between the bad debts expense of the company
and its outstanding receivable for the previous year.

Example:

Using the same illustration, but assume that based on past experience on bad debts, it is estimated that 5% of its
outstanding accounts receivable will be doubtful of collection. The entries will appear, thus:

General Journal
Date Particulars Debit Credit
2016 Accounts Receivable 80,000
Service Income 80,000
Billed clients for services rendered
 Cash on Hand 50,000
Accounts Receivable 50,000
Collected the accounts of clients

Doubtful Accounts 1,500

Allowance for Doubtful Accounts 1,500
To adjust 5% of the receivable balance as bad debts

Accounts Receivable 120,000

Service Income 120,000
Billed clients for services rendered

Cash on Hand 60,000

Accounts Receivable 60,000
Collected the accounts of clients

Doubtful Accounts 3,000

Allowance for Doubtful Accounts 3,000
To adjust 5% of the receivable as doubtful

Accounts Receivable Doubtful Accounts Expense

2016 Services 80,000.00 2016 collections 50,000.00 2016
Jan. 1, 2017
Balance 30,000.00 2017 collections 60,000.00
2017 services 120,000.00 Dec. 31 Adjust 1,500.00
Balance on Dec. 2017
31, 2017 90,000.00

Dec. 31 Adjust 3,000.00

Balance 4,500.00

Allowance for Doubtful Accounts

2016
Dec. 31 Adjust 1500
Balance 1500
2017 Beg balance * 1500
Dec. 31 Adjust 3000
Balance 4500

The computations for the adjusting entries are as follows:

2016 accounts receivable balance 30,000.00

Multiply by 5%
Adjust to recognize required 2016 allowance 1,500.00

2017 accounts receivable balance 90,000.00

 Multiply by 5%
Required 2017 allowance 4,500.00
Less: 2016 allowance balance 1,500.00
Adjust to increase allowance by 3,000.00

Financial Position Presentation: (Current Assets) 2016 2017

Accounts Receivable 30,000.00 90,000.00

Less: Allowance for Doubtful Accounts 1,500.00 3,500.00

Net Realizable Value 28,500.00 85,500.00

Income Statement Presentation:

Operating Expense
Doubtful Accounts 1,500.00 3,000.00

Note: The Allowance for Doubtful Accounts is a contra asset account which is deducted from the principal account
(Accounts Receivable). Net realizable value shows that although total accounts receivable is P30,000 in 2016, the amount
that may be collectible is only P28,500. Net realizable value is the difference between the accounts receivable and the
allowance for doubtful accounts.

 Take note of the difference in the amount of doubtful accounts and allowance for doubtful accounts in 2017.
Recall that financial position accounts being real accounts/permanent accounts and that their balances are always
brought forward and will change based on the additional transaction that will affect them during a given period.
On the other hand, nominal accounts are always for one accounting period after which these are absorbed by the
capital account.

To summarize, the following are the differences in the adjusting entries prepared under both methods:

1. The direct write off method recognizes bad debts only when it is certain that the account will not be collected
anymore whereas the allowance method recognizes doubtful accounts every accounting period based on an
estimate of accounts not collected as experienced in the previous years by the entity.
2. The direct write off method credits the accounts receivable to decrease it directly while the allowance method
credits the account receivable to decrease it indirectly by using a contra asset account which is the allowance for
doubtful accounts.
3. Under the allowance method, there are some other ways of estimating bad debts such as:
a. Increase the allowance by a certain percentage of revenue.
b. Increase the allowance by a certain percentage of outstanding accounts receivable.

DEPRECIATION

Properties such as land, building, furniture and machinery are used for a long period of time to support business operation.
EXCEPT for LAND, the utility value (ability to yield service) will decrease over time because of: wear and tear, obsolescence
(becomes outdated) and inadequacy (cannot cope up with demands for more volume or better quality of service)

Depreciation is therefore recognizing part of the asset as an expense because of its decreasing utility value. Market value
is not the same as utility value. Market value is the realizable value if the asset is to be sold. Depreciation is not an
adjustment for market value.
 To illustrate: cost of machine is P300,000 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 Depreciation Net Book Value

Jan. 2015 300,000.00

Dec. 31, 2015 60,000.00 60,000.00 240,000.00
Dec. 31, 2016 60,000.00 120,000.00 180,000.00
Dec. 31, 2017 60,000.00 180,000.00 120,000.00
Dec. 31, 2018 60,000.00 240,000.00 60,000.00
Dec. 31, 2019 60,000.00 300,000.00 --

Note that 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. These two accounts will appear as follows:

Depreciation Expense in the Income Statement

In the Statement of Financial Position

Asset Cost – Accumulated Depreciation = Net Book Value

There are three factors to be considered in determining depreciation: Cost, Useful Life, and Scrap Value or Disposal Value
at the end of the useful life. The formula is:

Cost - Scrap Value, if any

= Depreciation **
Useful life stated in no. of years

To illustrate: Assume that Carla Motor Repair Service has the following accounts, among others, in its trial balance as of
December 31, 2017, the end of its accounting period:

Debit Credit
Machinery & Equipment 750,000.00
Accumulated Depreciation - Machinery & Equipment 125,000.00
Building 1,000,000.00
Furniture & Fixtures 300,000.00

Additional information:

1. The machinery and equipment were acquired Jan. 1, 2016 with an estimated life of 6 years, no scrap value.
2. The building was newly constructed on March 1, 2017 with an estimated life of 10 years, scrap value of P100,000.
3. The furniture and fixtures were acquired January 1, 2017 with a useful life of 10 years, scrap value of P30,000.

General Journal
Date Particulars Debit Credit
2017 Depreciation & Expense - Machinery & Equipment 125,000
Dec.
31 Accumulated Depreciation - Machinery & Equipment 125,000
To provide depreciation for machinery and equipment

Depreciation Expense - Building 75,000

Accumulated Depreciation - Building 75,000
To provide depreciation for building
 Depreciation Expense - Furniture & Fixtures 27,000
Accumulated Depreciation - Furniture & Fixtures 27,000
To provide depreciation for furniture & fixtures

Financial Position Presentation (Non-Current Assets):

Machinery & Equipment 750,000.00

Less: Accumulated Depreciation 250,000.00
Book Value 500,000.00
Building 1,000,000.00
Less: Accumulated Depreciation 75,000.00
Book Value 925,000.00
Furniture & Fixtures 300,000.00
Less: Accumulated Depreciation 27,000.00
Book Value 273,000.00

Income Statement Presentation:

Operating Expenses:
Depreciation - Machinery & Equipment 125,000.00 *
Depreciation - Building 75,000.00
Depreciation - Furniture & Fixtures 27,000.00

Take note of another contra-asset account which is Accumulated Depreciation, a decrease in the cost of the asset. Book
value, which is the difference between the cost and the accumulated depreciation, represents the unexpired cost or the
net utility value of the asset. Also, note that accumulated depreciation for the machinery and equipment is a cumulative
figure of the 2016 balance (which means that depreciation was already provided for that year in the amount of P125,000)
and the 2017 provision of P125,000 while the depreciation expense in the income statement represents only the current
provision for the year 2017 which is P125,000.

Computations:

Machinery depreciation: P750,000/6years = P125,000

Accumulated Depreciation Beginning 125,000.00
Add: Depreciation provided for the year 125,000.00
Total Accumulated Depreciation 250,000.00

Building depreciation: P1,000,000-P100,000

= P90,000 per year
10 years

90,000 x 10/12 = 75000 for 10 months

Note that the depreciation for a year is P90,000 but since the building was constructed only March 1, it can only be
depreciated for 10 months in 2017. A full year depreciation will be provided the following year. Entry and presentation
will appear thus:

Date Particulars Debit Credit

2018 Depreciation Expense - Building 90,000

 Dec.
31 Accumulated Depreciation - Building 90,000
To provide depreciation for building

Statement of Financial Position:

Building 1,000,000.00
Accumulated depreciation 165,000.00
Book Value 835,000.00

Income Statement:
Depreciation Expense 90,000.00

Note again that the depreciation expense and the accumulated depreciation are not of the same amounts.

Furniture & Fixtures

depreciation:
P300,000 - P30,000
P27,000 per year
10 years =

This time a full year depreciation may be provided since it was acquired January 1. The amounts for depreciation expense
and accumulated depreciation are the same since this is the first year of depreciation.

The following rules should be observed in depreciation accounting:

1. Start depreciating the asset from acquisition date.

2. Like bad debts, whatever is the provision is also the same amount presented in the income statement as an
operating expense.
3. Accumulated depreciation, from the title itself, means that the depreciation amount is increasing as additional
provisions are recorded every year. Only in the first year of acquisition will the depreciation expense in the income
statement and the accumulated depreciation in the Statement of Financial Position be of the same amount.
4. The scrap value is deducted from cost in determining the depreciable cost of the asset. Scrap value is not recorded
unless it is sold for that amount nor it is presented in the Statement of Financial Position until the end of the useful
life of the asset when the book value will then be equal to the scrap value of the asset.