THE ACCOUNTING PROCESS: ADJUSTING THE ACCOUNTS
Cash versus Accrual Basis of Accounting
The cash basis of accounting recognizes revenue when cash is received; and recognizes
expenses when cash is paid. For example, under the cash basis, services rendered in 2020 for
which cash is collected in 2021 would be treated as 2021 revenues. Similarly, under the cash
basis, expenses incurred in 2020 for which cash for which cash is disbursed in 2021 are a 2021
expense. Because of these improper assignments of revenues and expenses, the cash basis of
accounting is generally considered unacceptable. There is no need for adjusting entries under
the cash basis of accounting.
The accrual basis of accounting recognizes revenues when sales are made or services
are performed, regardless of when cash is received. It also recognizes expenses as incurred,
whether cash is paid or not. For instance, when services are performed for a customer on
account, the revenue is recorded at that time even though cash has not been received. Later,
when they receive cash, no revenue is recorded because it has already been recorded. Under
the accrual basis, adjusting entries are used to bring the accounts up to date for economic
activity that has taken place but has not yet been recorded.
Accounting Period
Accounting period is the period of time, normally one month, one quarter, or one year
into which an entity’s life is arbitrarily divided for financial statement purposes. The length of a
company’s accounting period depends upon how frequent managers, investors, and other
interested people require information about the company’s performance. Every business
prepares annual financial statements.
The twelve-month accounting period used by an entity is called its fiscal year. The fiscal
year used by most companies coincides with the calendar year and ended on December 31.
Some businesses, however, elect to use a fiscal year which ended on some other date. It may
be convenient for a business to end its fiscal year during a slack season rather than during a
time of peak activity.
Revenue Principle
The revenue principle is the basis of recording revenues; tells the accountants when to
record revenue and the amount of revenue to record. The revenue principle says to record
revenue when it has been earned – but not before. In most cases, revenue is earned when the
businesses have delivered a good or service to the customer. It also says to record revenue
for the cash value of the item transferred to the customer.
The Framework for the preparation and Presentation of Financial Statements states
that “income or revenue is recognized in the income statement when an increase in future
economic benefit related to an increase in an asset or decrease of a liability has arisen that can
be measured. This means, in effect, that the recognition of increases in assets or decreases in
liabilities.” This procedure, however, restricts the recognition of revenue to those items that
can be measure reliably and have been a sufficient degree of certainty.
The Matching Principle
The matching principle guides accounting for expenses. It identifies all expenses
incurred during the period, measure the expenses, and match them against the revenues
earned during the same time period.
The Framework for the Preparation and Presentation of Financial Statements states
that “expenses are recognized in the income statement when a decrease in future economic
benefit related to decrease in an asset or an increase of a liability has arisen that can be
measured reliably. This means, in effect, that the recognition of expense occurs simultaneously
with the recognition of an increase in liabilities or a decrease in asset.”
Timing is an important factor in matching (offsetting) revenue with the related
expenses. For example, in preparing monthly income statements, it is important to offset this
month’s expenses against this month’s revenue. We should not offset this month’s expenses
against last month’s revenue, because there is no cause-and-effect relationship between the
two.
Periodicity Concept
Accounting periods are generally a month, a quarter or year. A period of less than a year
is an interim period. Most basic accounting period is one year. Accounting year may be fiscal,
calendar or natural.
a. Fiscal year – period of any twelve consecutive months. Fiscal year may start in any
month of the year as long as it covers 12 months
b. Calendar year – annual period ending on December 31
c. Natural year – twelve-month period that ends when business activities are at their
lowest level of annual cycle
The time-period concept ensures that information is reported at regular intervals. To
measure income accurately, companies update their accounts at the end of the period. Much
expenditure made by a business benefit two or more accounting periods. Fire insurance
policies, for example, usually cover a period of 12 months. If a company prepares monthly
income statements, a portion of the cost of such policy should be allocated to the cost of
insurance expense each month that the policy is in force. In this case, apportionment of the
cost of the policy by month is easy; just divide the total cost by 12 months.
Not all transactions can be precisely divided by the accounting periods. The purchase
of building, furniture and fixtures, machine and equipment provide benefits to the business
over all the years in which such an asset is used. In measuring the net income of a business for
a period of one year or less, the accountant estimate what portion of the cost of the building
and other long-lived assets is applicable to the current year. Since the allocations of these
cost are estimates rather than precise measurements, it follows that income statements
should be regarded as useful approximations of net income rather than an exact
measurement.
For some expenditures, such as advertising or employee training programs, it is not
possible to estimate objectively the number of accounting periods over which revenue is likely
to be produced. In such cases, generally accepted accounting principles require that the
expenditure be charge immediately to expense.
The Need for Adjustment
The balances of the accounts shown in the trial balance prepared after posting are not
up to date. Some of these accounts do not reflect economic activities that have taken place
but the enterprise has not properly recorded. These activities are not yet recorded because it
is more convenient and economical to wait until the end of the period to record it. Another
reason is that no source documents concerning the activity have yet to come to the attention
of the accountant.
Adjusting entries are entries prepared at the end of the accounting period to update
or to adjust the balance of the accounts. It assigns revenues to the period in which they are
earned and expenses to the period in which they are incurred. Adjusting entries are needed to
(a) measure properly the period’s income and (b) to bring related asset and liability accounts
to correct balances for financial statements. This end-of-period process of updating the
accounts is called adjusting the accounts, making the adjusting entries, or adjusting the
books. The two basic categories of adjustments are prepayments or deferrals and accruals.
In prepayment or deferral, the cash transaction occurs before an expense or revenue is
recorded. Accrual is the opposite of deferral. Accruals record an expense or revenue before
the cash settlement. Adjusting entries can be further divided into six categories:
 Accrued expense
 Accrued revenues
 Prepaid Expenses
 Unearned revenues
 Depreciation
 Bad debts or Uncollectible or Doubtful Accounts
 Subsequent measurement in the assets and liabilities
Effects on the financial statements will be if adjusting entries are omitted
Type of Adjusting
Entry
Deferred Expenses
What Adjusting
Entry Does
Increase expense
Understates
expense
Overstates net
income
Decrease asset
Overstates asset
Overstates total
assets
Increase revenue
Understate
revenue
Understate net
income
Decrease liability
Overstate liability
Increase expense
Understate
expense
Overstate total
liabilities
Overstates net
income
Increase liability
Understate liability
Increase revenue
Understate
revenue
Deferred Revenues
Accrued Expenses
Accrued Revenues
Effect of Omitting Adjusting Entry
On Account
On Financial
Balance
statements
Understate total
liabilities
Understate net
income
Prepaid Expenses or Deferred Expense
Prepaid Expenses are advanced payment of expenses. It includes supplies and
advance payment of expenses such as rent, insurance, and property taxes. The portion of the
asset that they have used during the period will become an expense; the remainder will
become an expense in the future. It is because of this deferral benefits that they sometimes
call these prepaid expenses deferred charges.
The two methods of accounting for prepaid expenses are the asset method and the
expense method. The asset method is used when prepaid expense is recorded initially as an
asset, and the asset account is debited at the date of purchase.
The expense method is used when the prepaid expense is recorded initially as an
expense, and an expense account is debited at the date of purchase.
Prepaid expenses are analyzed at the end of the period to determine the expired
portion and the unexpired portion, and adjusting entries are made. In summary form, the
methods of recording prepaid expenses are as follows:
Asset Method
Record the payment by
debiting the asset account.
Initial entry:
Adjusting entry:
Transfer the amount used to
the appropriate expense
account.
Expense Method
Record the payment by
debiting the expense
account.
Transfer the amount unused
to the appropriate asset
account.
Illustration 1: AA Company purchased office supplies on August 1, 2020, amounting to
P100,000 in which the company paid in cash. At December 31, 2020 which coincides to be the
end of the accounting period, inventory records show that the amount of remaining supplies
amount to P40,000.
8/1/2020
ASSET METHOD
Prepaid Office Supplies
Cash
100,000.00
(To record purchase of office supplies)
Office Supplies bought on 8/1/2020
Cash
(To record purchase of office supplies)
100,000.00
(40,000.00)
Supplies used
Prepaid Office Supplies
100,000.00
100,000.00
100,000.00
Remaining supplies
12/31/2020 Office Supplies Expense
EXPENSE METHOD
Office Supplies Expense
60,000.00
60,000.00
(To adjust prepaid office supplies)
60,000.00
Prepaid Office Supplies
Office Supplies Expense
40,000.00
(To adjust office supplies expense)
40,000.00
It is easier to determine the inventory of supplies (supplies at hand) at the end of the
period than to keep a record of the supplies used during the period. To determine the amount
of supplies used, subtract the inventory of supplies at the end of the period from the balance
of the supplies account. The effects of these entries are illustrated in the following T-accoun
Prepaid Office Supplies
100,000.00
ASSET METHOD
60,000.00
Office Supplies Expense
60,000.00
40,000.00
Office Supplies Expense
100,000.00
60,000.00
EXPENSE METHOD
40,000.00
Prepaid Office Supplies
40,000.00
Illustration 2. BB Company purchase an insurance policy amounting to P12,000 on July 30,
2020, coverage of which is until July 30, 2022, what is the balance of the prepaid insurance
and insurance expense?
07/30/2020 Prepaid Insurance
ASSET METHOD
Cash
12,000.00
12,000.00
(To record purchase of insurance)
Cash
12,000.00
12,000.00
(To record purchase of insurance)
Insurance purchased
12,000.00
Insurance remaining (12000*19/24)
(9,500.00)
Insurance used (12000*5/24)
2,500.00
12/31/2020 Insurance Expense
2,500.00
Prepaid Insurance
Prepaid Insurance
2,500.00
(To adjust prepaid insurance)
9,500.00
Insurance Expense
9,500.00
(To adjust insurance expense)
Prepaid Insurance
12,000.00
Insurance Expense
EXPENSE METHOD
ASSET METHOD
2,500.00
Insurance Expense
2,500.00
9,500.00
Insurance Expense
12,000.00
EXPENSE METHOD
9,500.00
Prepaid Insurance
9,500.00
2,500.00
Some accountants prefer to use the first methods; others prefer the second method,
and still others use the first method for prepayments of certain types of expenses and the
second method for other types. For example, they may use the first method for prepayment
of insurance and supplies, while they may use the second method for other expenses like
rent, taxes, or interest.
Regardless of which method the accountant employed in any particular case, the
amount reported as expense in the income statement, and the amount reported as an asset
in the balance sheet will be the same. To avoid confusion and waste of time, the accountant
must consistently follow the method adopted for each particular type of prepaid expense
from year to year.
Unearned Revenue or Deferred Revenue
Unearned Revenue is revenue received in advance that represents a liability. The
amount of revenue that the company had earned during the period represents the portion of
goods delivered or services that has been performed; the remainder will be earned in the
future. It is because of this deferment that accountants frequently call unearned revenues
deferred credits. For example, landlords ordinarily receive advance payment for rent
extending to periods ranging from a few months to several years. At the end of the accounting
period, the portion of the receipts applicable to future periods the company has not earned
should appear in the balance sheet as liability. They call this liability account Unearned
Revenue, Revenue Received in Advance, Advances by Customers, or some similar titles. The
earned portion appears in the income statement.
As in the case of prepaid expenses, there are two methods of recording unearned
revenue: liability method, and the revenue method. Under the liability method, a liability
account is credited when the revenue is received in advance. In the revenue method, a
revenue account is credited when the revenue is received in advance. At the end of the
accounting period, the amount earned and unearned is determined for proper adjusting
entry.
The two methods of recording unearned revenue and the related entries at the end of
the period may be summarized as follows:
Liability Method
Initial entry:
Adjusting entry:
Record the receipt of cash to
the appropriate liability
account
Transfer the amount earned to
the appropriate revenue
account
Revenue Method
Record the receipt of cash to
the appropriate revenue
account
Transfer the amount unearned to
the appropriate liability account
Illustration 1. CC Tax Consultancy received P150,000 representing advanced payment for six
(6) months tax compliance and consultancy service from their clients on November 1, 2020. The
accounting period of the entity ends on December 31, 2020.
11/1/2020
Cash
LIABILITY METHOD
150,000.00
Unearned Service Revenue
150,000.00
(To record payment received in advance)
Advance payment
Cash
Service Revenue
150,000.00
(To record payment received in advance)
(100,000.00)
Income earned (150000x2/6)
50,000.00
50,000.00
Service Revenue
Service Revenue
50,000.00
(To adjust unearned service revenue)
100,000.00
Unearned Service Revenue
100,000.00
(To adjust service revenue)
LIABILITY METHOD
Unearned Service Revenue
50,000.00
150,000.00
150,000.00
Income still unearned (150000x4/6)
12/31/2020 Unearned Service Revenue
REVENUE METHOD
Service Revenue
150,000.00
50,000.00
100,000.00
Service Revenue
100,000.00
REVENUE METHOD
150,000.00
Unearned Service Revenue
100,000.00
50,000.00
As was explained in connection with prepaid expenses, the results obtained are the
same under both methods. The accountant must consistently follow the method adopted for
each particular kind of unearned revenue from year to year.
Accrued Revenues (Assets)
Accrued revenues are revenues earned but not yet received at the end of the period. An
example of this type of adjustment would be services that have been performed but have not
been billed or collected. To present an accurate picture of the affairs of the business, the
revenue earned must be recognized on the income statement and the asset on the balance
sheet.
Illustration 1. CC Tax Consultancy rendered year-end tax compliance and consultancy to
XYZ Company on December 15-19, 2020, amounting to P50,000. It was ascertained that XYZ
Company will be paying CC Tax Consultancy on the first quarter of 2021. The journal entry
will be:
Dec. 31
Accounts Receivable
Service Revenue
50,000
50,000
The service revenue appears in the income statement, and the asset, accounts
receivable, appears on the balance sheet.
Illustration 2. DD Corporation invested P100,000 in a certificate of deposit that paid 6%
annual interest on March 1, 2020. The certificate carried a 1-year term to maturity. The journal
entry will be:
Dec. 31
Interest Receivable
Interest Income
(100,000x6%x10/12)
5,000
5,000
Accrued Expenses (Liabilities)
Some expenses accrue from day to day, but the company ordinarily records them only
when they are paid. Accrued expenses are expenses incurred but are not yet paid at the end
of the fiscal period. They are both an expense and a liability. Hence, they are referred to as
accrued liability, accrued payable, or accrued expense.
Illustration 1. The most common example of accrued expense is the accrued salaries.
Companies paying their employees every end of the week instead of the end of the month
usually have accrued salaries, since the end of the week normally does not coincide with the
end of the month. For example, CC Tax Consultancy pays their liaison officers on a weekly basis.
The company has ten (10) liaison officers receiving P3,000 weekly, every Friday. The last day of
the year, December 31, 2020, fell on a Thursday.
Monday
December 28
Tuesday
December 29
Wednesday
December 30
Thursday
December 31
Friday
January 1
If the company prepares financial statements on December 31, they will understate the
balance of salaries expense account because salaries recorded are only up to December 31
but payment is made every Friday. The entry required updating the salaries expense account
would be:
Dec. 31
Salaries Expense
Salaries Payable
(10x3,000x4/5)
24,000
24,000
Illustration 2. CC Tax Consultancy borrowed P200,000 from a bank evidenced by a note of
promise to pay on May 1, 2020, with an interest rate of 12%. Both the interest and the principal
are payable after one year.
Interest is a charge for the use of money over time. Interest expense is match to the
period during which the benefit- the use of the money- is received. The interest is a fixed
obligation and accrues regardless of the result of the company’s operation.
Interest rates are expressed at annual rates, so if the interest is being calculated for
less than a year, the calculation must express time as portion of the 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
= P200,000 x 12% x 8/12
= P16,000
The adjusting entry to record the interest expense incurred in December is as follows:
Dec 31
Interest Expense
Interest Payable
16,000
16,000
Depreciation of Property, Plant and Equipment
Depreciation of Property, Plant and Equipment are tangible assets, which are
relatively fixed or permanent nature, use in the business and not held for sale. These assets,
such as buildings, equipment, furniture and fixtures, provide service to the business. The value
of these assets gradually decreases over time. Depreciation is the decrease in the value of
assets through wear and deterioration and the passage of time.
Just as prepaid expenses indicate gradual using up of a previously recorded asset, so
does depreciation. However, the time involved in using up a depreciable asset such as building,
for example, is much longer than for prepaid expenses. A prepaid expense generally involves
fairly small amount of money; depreciable assets usually involve larger sums of money.
The three factors involved in the computation of depreciation expense are:
a. Asset cost. The cost of an asset is the amount paid by the company to purchase the
depreciable asset.
b. Estimated residual value/salvage value/scrap value. The estimated residual value
is the amount that the company can probably sell the asset at the end of its estimated
useful life. The other terms used for residual value are salvage value, scrap value, and
trade-in value.
c. Estimated useful life. The estimated useful life of an asset is the estimated number of
time periods that a company can make use of the asset.
The equation for determining the amount of depreciation expense for each time period is:
Asset Cost – Estimated Residual Value =
Estimated Useful
Life
Depreciation
Expense
for Each Period
Accountants use different methods of computing depreciation. The straight-line
method is the most common type of depreciation. Straight-line depreciation assigns the
same amount of depreciation expense to each accounting period over the life of the asset.
Illustration 1. EE Company purchased equipment on January 1, 2020, amounting to P500,000
with a residual value of P50,000 and a life of five (5) years. On May 1, 2020, the company
bought furniture and fixtures amounting to P800,000 and the residual value is estimated to
be 15% of its cost with a useful life of ten (10) years.
EQUIPMENT
P500,000 – P50,000
5 years
=
P90,000 annual
depreciation
FURNITURE AND FIXTURES
P800,000 x 85%
10 years
=
P68,000 annual
depreciation
The asset’s depreciable amount is the difference between as asset’s cost and its salvage
value. The accountant must allocate the depreciable amount as an expense to the various
periods in the asset’s useful life to satisfy the matching principle.
Depreciation is then recorded in the journal as follows:
Dec. 31
Depreciation Expense – Equipment
Accumulated Depreciation – Equipment
90,000
90,000
Depreciation Expense – Furniture and Fixture
Accumulated Depreciation – F and F
(68,000x8/12)
45,333
45,333
The Depreciation Expense account is reported in the income statement while the
accumulated depreciation is reported in the balance sheet as a deduction from the related
asset.
The accumulated depreciation account is a contra asset account that shows the total
of all charges recorded on the asset up through the balance sheet date.
A contra asset account is a deduction from the asset to which it relates in the balance
sheet. The purpose of a contra asset account is to reduce the original cost of asset down on
its undepreciated cost or book value.
Book value is the cost not yet allocated to an expense. The depreciation is credited
to an Accumulated Depreciation account instead of directly to the asset account because they
have recorded the assets correctly using historical cost. To provide more complete balance
sheet information to the users of financial statements, the original acquisition cost is shown
with the accumulated depreciation. For example, on January 31 balance sheet, the
Accumulated Depreciation is shown as a deduction from the asset Equipment.
The accumulated depreciation account balance increases each period by the amount
of depreciation expense recorded until it finally reaches the amount equal to the original cost
of the asset less estimated residual value.