BM1705

The Adjusting Process

Accrual Vs. Cash-Basis Accounting
Income Measurement
One ultimate objective of putting a business is to earn a profit. Profit, however, means different things to different
people. Accountants prefer to use the term net income because it can be precisely defined as the net increase
in owner’s equity that results from a company’s operations (Needles, Powers, & Crosson, 2014).

• Net Income – this is accumulated in the Owner’s Capital account and reported on the income statement.
Management, owners, and others use it to assess a company’s progress in meeting the goal of profitability.
Readers of income statements need to understand net income and its strengths and weaknesses as an
indicator of a company’s performance. Net income results when revenue exceeds expenses; inversely,
when expenses exceed revenues, net loss occurs.

• Revenues – these are increases in owner’s equity resulting from the selling of goods, rendering services,
or performing other business activities. When a business delivers a product or provides a service to a
customer, it usually receives cash or a promise from customers to pay cash in the near future. In other
words, revenue may be earned through the sale of goods or services, even though the cash may not be
received until later. The promise to pay is recorded in either Accounts Receivable or Notes Receivable. The
total of these accounts and the total cash received from customers in an accounting period are the
company’s revenues for that period (Needles, Powers, & Crosson, 2014).

• Expenses – these are decreases in owner’s equity resulting from the cost of selling goods or rendering
services and the cost of the activities necessary to carry on a business, such as attracting and serving
customers. Examples include salaries expense, rent expense, advertising expense, utilities expense, and
depreciation (allocation of cost) of a building or office equipment. These expenses are often called the cost
of doing business or expired costs (Needles, Powers, & Crosson, 2014).

Not all increases in owner’s equity came from revenues, nor all decreases in owner’s equity came from
expenses. Owner’s investments increase owner’s equity but are not revenues, and withdrawals decrease
owner’s equity but are not expenses.

• Continuity – certain expense and revenue transactions are allocated over several accounting periods.
Choosing the number of accounting periods raises the issue of continuity.

• Periodicity – not all transactions can be easily assigned to specific periods. For example, when a company
purchases a building, it must estimate the number of years the building will be in use. The portion of the
cost of the building that is assigned to each period depends on this estimate and requires an assumption
about periodicity.

Fiscal and Calendar Years

Financial statements are prepared periodically by both small and large companies in order to assess their
financial condition and results of operations. Accounting time periods are generally a month, a quarter, or a
year. Monthly and quarterly time periods are called interim periods. Most large companies must prepare both
quarterly and annual financial statements (Weygandt, Kimmel, & Kieso, 2015).

Fiscal Year – an accounting time period that is one (1) year in length. This begins with the first day of a month
and ends 12 months later on the last day of a month.

Calendar Year – used by many businesses as accounting period (January 1 – December 31).

03 Handout 1 *Property of STI

Page 1 of 9
 BM1705

Two (2) Ways of Doing Accounting

Accrual-Basis Accounting

Often referred to as the matching rule, net income is measured by assigning revenues to the accounting period
in which the goods are sold or the services performed and expenses to the accounting period in which they are
used in producing the revenue.

A direct relationship between expenses and revenues is often difficult to identify. When there are no direct
means of connecting expenses and revenues, costs are allocated among the accounting periods that benefit
from the costs (Needles, Powers, & Crosson, 2014).

Cash-Basis Accounting

This is the practice of accounting for revenues in the period in which cash is received and for expenses in the
period in which cash is paid. With this method, taxable income is calculated as the difference between cash
receipts from revenues and cash payments for expenses. Although this method works well for some small
businesses and many individuals, it does not fit the needs of most businesses (Needles, Powers, & Crosson,
2014).

Other Accounting Principles

Revenue Recognition is the process of determining when revenue should be recorded. This principle tells
accountants the following:

o When to record revenue. That is when to make a journal entry for a revenue. The revenue recognition
principle says to record revenue when it has been earned – but not before. Revenue has been earned when
the business has delivered a good or service to the customer. The company has done everything required
by the sale agreement – that is, the earnings process is complete (Horngren, Harrison Jr., & Oliver, 2012).

o The amount of revenue to record. Record revenue for the actual value of the item or service transferred to
the customer.

Matching Principle – guides accounting for expenses. Recall that expenses—such as salaries, rent, utilities,
and advertising—are assets used up and liabilities incurred in order to earn revenue. The matching principle
measures all the expenses incurred during the period and matches the expenses against the revenues of the
period (Horngren, Harrison Jr., & Oliver, 2012).

Categories of Adjusting Entries

In order for revenues to be recorded in the period in which services are performed and for expenses to be
recognized in the period in which they are incurred, companies make adjusting entries. Adjusting entries ensure
that the revenue recognition and expense recognition principles are followed. Adjusting entries are necessary
because the trial balance – the first pulling together of the transaction data – may not contain updated and
complete data. This is true for several reasons (Weygandt, Kimmel, & Kieso, 2015):
1. Some events are not recorded daily because it is not efficient to do so. Examples are the use of supplies
and the earning of wages by employees.
2. Some costs are not recorded during the accounting period because these costs expire with the passage of
time rather than as a result of recurring daily transactions. Examples are charges related to the use of
buildings and equipment, rent, and insurance.
3. Some items may be unrecorded. An example is a utility service bill that will not be received until the next
accounting period.
Adjusting entries are required every time a company prepares financial statements. The company analyzes
each account in the trial balance to determine whether it is complete and updated for financial statement
purposes. Every adjusting entry will include one (1) income statement account and one (1) balance sheet
account (Weygandt, Kimmel, & Kieso, 2015). Adjusting entries are classified as either deferrals or accruals.

03 Handout 1 *Property of STI

Page 2 of 9
 BM1705

Deferrals. These are postponements of the recognition of an expense already paid or of revenue received in
advance. The cash payment or receipt is recorded before the adjusting entry is made.

o Prepaid Expenses – these are expenses paid in advance before they are used or consumed. At the
end of an accounting period, a portion or all of the prepaid services or goods will have been used. An
adjusting entry is required to reduce the asset and increase the expense. The amount of the adjustment
must equal the cost of the goods or services used or expired. If adjusting entries for prepaid expenses
are not made at the end of an accounting period, both the balance sheet and the income statement will
present incorrect information. The company’s assets will be overstated, and its expenses will be
understated. Thus, owner’s equity on the balance sheet and net income on the income statement will
be overstated (Needles, Powers, & Crosson, 2014).

Example: ABC Studio paid its rent for two (2) months in advance at the beginning of July. The advance
payment resulted in an asset – the right to occupy the office for two (2) months. As each day in the month
passed, part of the asset’s cost expired and became an expense. By July 31, half of the asset’s cost
(P1,600) had expired.

Analysis:  Decreases the asset account, Prepaid Rent

 Increases the expense account, Rent Expense
Rules of Debit and Credit Application
Assets = Liabilities + Owner’s Equity
Prepaid Rent Rent Expense
Dr. Cr. Dr. Cr.
7-3 3,200 7-31 1,600 7-31 1,600
Bal. 1,600
Adjusting Journal Entry
DATE PARTICULARS DEBIT CREDIT
July 31 Rent Expense P 1,600
Prepaid Rent P 1,600
To record expensed rent for the month of July.

o Depreciation – plant assets are long-lived tangible assets used in the operation of a business. Examples
include land, buildings, equipment, furniture, and automobiles. As a business uses the assets, their
value and usefulness decline. The decline in usefulness of a plant asset is an expense, and accountants
systematically spread the asset’s cost over its useful life. The allocation of a plant asset’s cost to
expense is called depreciation (Horngren, Harrison Jr., & Oliver, 2012).

Example: On July 31, ABC Studio records P300 of depreciation of office equipment.

Analysis:  Increases the contra asset account, Accumulated Depreciation – Office Equipment
 Increases the expense account, Depreciation Expense – Office Equipment
Rules of Debit and Credit Application
Assets = Liabilities + Owner’s Equity
Office Equipment Depreciation Expense - OE
Dr. Cr. Dr. Cr.
7-6 16,320 7-31 300

Accumulated Depreciation - OE
Dr. Cr.
7-31 300

03 Handout 1 *Property of STI

Page 3 of 9
 BM1705

Adjusting Journal Entry

DATE PARTICULARS DEBIT CREDIT
July 31 Depreciation Expense – Office Equipment P 300
Accumulated Depreciation – Office Equipment P 300
To record depreciation of office equipment for the month of July.

o Unearned Revenues – these are cash received before service is performed. Hence, a company now
has a performance obligation (liability) to transfer a service to one of its customers. Items like rent,
magazine subscriptions, and customer deposits for future service may result in unearned revenues.
Unearned revenues are the opposite of prepaid expenses. Indeed, unearned revenue on the books of
one company is likely to be a prepaid expense on the books of the company that has made the advance
payment. For example, if identical accounting periods are assumed, a landlord will have unearned rent
revenue when a tenant has prepaid rent (Weygandt, Kimmel, & Kieso, 2015).

Example: During July, ABC Studio received P1,400 from another firm as advance payment for a series of
brochures. By the end of the month, it had completed P800 of work on the brochures, and the other firm
had accepted the work. On July 31, ABC would record the performance of services for which P800 cash
was received in advance.

Analysis:  Increases the owner’s equity account, Design Revenue

 Increases the liability account, Unearned Design Revenue
Rules of Debit and Credit Application
Assets = Liabilities + Owner’s Equity
Unearned Design Revenue Design Revenue
Dr. Cr. Dr. Cr.
7-31 800 7-19 1,400 7-24 2,800
Bal. 600 15 9,600
31 800
Bal. 13,200
Adjusting Journal Entry
DATE PARTICULARS DEBIT CREDIT
July 31 Unearned Design Revenue P 800
Design Revenue P 800
To record earned portion of the design revenue.

Accruals. These are the recognition of an expense or a revenue that has arisen but not been recorded during
the accounting period. The cash payment or receipt occurs in a future accounting period, after the adjusting
the entry has been made.

o Accrued Revenues – these are revenues for services performed but not yet received in cash or recorded.
Businesses can earn revenue before they receive the cash which creates an accrued revenue. Any
revenues earned but not recorded during an accounting period require an adjusting entry that debits an
asset account and credits a revenue account. For example, the interest on a notes receivable is earned day
by day but may not be received until another accounting period. In this case, Interest Receivable should be
debited and Interest Income should be credited for the interest accrued at the end of the current period.
When a company earns revenue by performing a service – such as designing a series of brochures – but
will not receive the revenue until a future accounting period, it must make an adjusting entry. This type of
adjusting entry involves an asset account and a revenue account (Needles, Powers, & Crosson, 2014).

Example: During July, ABC Studio agrees to create two (2) advertisements for Maggio’s Pizza Company
and to finish the first advertisement by July 31. By the end of July, ABC has earned P400 for completing
the first advertisement, but it will not bill Maggio’s until the entire project has been completed. On July 31,
ABC records the accrual of P400 of unrecorded revenue.

03 Handout 1 *Property of STI

Page 4 of 9
 BM1705

Analysis:  Increases the owner’s equity account, Design Revenue

 Increases the asset account, Accounts Receivable
Rules of Debit and Credit Application
Assets = Liabilities + Owner’s Equity
Accounts Receivable Design Revenue
Dr. Cr. Dr. Cr.
7-15 9,600 7-22 5,000 7-10 2,800
31 400 15 9,600
10,000 5,000 31 800
Bal. 5,000 31 400
Bal. 13,600
Adjusting Journal Entry
DATE PARTICULARS DEBIT CREDIT
July 31 Accounts Receivable P 400
Design Revenue P 400
To record rendered services on account.

o Accrued Expenses – these are expenses incurred but not yet paid in cash or recorded. At the end of an
accounting period, some expenses are usually incurred during the period but have not been recorded.
Consider an employee’s salary. The salary expense grows as the employee works, so the expense is said
to accrue. Another accrued expense is interest expense on a note payable. Interest accrues as time passes
on the note. An accrued expense always creates a liability.

Example: Suppose ABC Studio has two (2) pay periods a month rather than one (1). In July, its pay periods
end on the 12th and the 26th, as indicated in the calendar below.

JULY By the end of business on July 31, ABC’s assistant will have worked
three (3) days (Monday, Tuesday, and Wednesday) beyond the last
Sun M T W Th F Sa
pay period. The employee has earned the wages for those days but
1 2 3 4 5 6 will not be paid until the first payday in August. The wages for these
7 8 9 10 11 12 13 three (3) days are rightfully an expense for July, and the liabilities
14 15 16 17 18 19 20 should reflect that the company owes the assistant for those days.
Because the assistant’s wage rate is P2,400 every two (2) weeks, or
21 22 23 24 25 26 27 P240 per day (P2,400 ÷ 10 working days), the expense is P720
28 29 30 31 (P240 ÷ 3 days). On July 31, ABC would record the P720 accrual of
unrecorded wages.

Analysis:  Increases the owner’s equity account, Wage Expense

 Increases the liability account, Wage Payable
Rules of Debit and Credit Application
Assets = Liabilities + Owner’s Equity
Wages Payable Rent Expense
Dr. Cr. Dr. Cr.
7-31 720 7-24 4,800
31 720
Bal. 5,520
Adjusting Journal Entry
DATE PARTICULARS DEBIT CREDIT
July 31 Wages Expense P 720
Wages Payable P 720
To record expensed wages for the month of July.

03 Handout 1 *Property of STI

Page 5 of 9
 BM1705

Adjusted Trial Balance

After a company has journalized and posted all adjusting entries, it prepares another trial balance from the
ledger accounts. This trial balance is called adjusted trial balance. It shows the balances of all accounts
including those 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.
Because the accounts contain all the data needed for financial statements, the adjusted trial balance is the
primary basis for the preparation of financial statements (Weygandt, Kimmel, & Kieso, 2015).

After posting the adjusting entries, the values of some of the items in the unadjusted trial balance will change.

Sample unadjusted trial balance from Mac Co.:

MAC CO.
Unadjusted Trial Balance
December 31, 2018
Balance
Particulars PR Debit Credit
Cash P 402,500
Accounts Receivable 70,000
Supplies 80,000
Equipment 350,000
Accounts Payable P 80,000
Mac, Capital 750,000
Mac, Drawing 65,000
Service Revenue 235,000
Advertising Expense 12,500
Rent Expense 30,000
Salaries Expense 45,000
Utilities Expense 10,000
TOTAL P 1,065,000 P 1,065,000

At the end of the period, the following adjusting entries were made:
Particulars PR Debit Credit
Dec. 31 Accounts Receivable 30,000
Service Revenue 30,000

31 Utilities Expense 18,000

Utilities Payable 18,000

31 Supplies Expense 9,000

Supplies 9,000

31 Depreciation Expense – Equipment 7,200

Accumulated Depreciation – Equipment 7,200

After posting the above entries, the values of some of the items in the unadjusted trial balance will change with
the use of a partial worksheet.

Worksheet is a columnar form on which the financial condition of a business enterprise is summarized. This is
not similar to the general journal or the general ledger. This facilitates only the preparation of financial
statements. The following shows a partial portion of the worksheet (Rante, 2013):

03 Handout 1 *Property of STI

Page 6 of 9
 BM1705

NAME OF THE COMPANY

Worksheet
Date
Trial Balance Adjustments Adjusted Trial Balance
Account Title Debit Credit Debit Credit Debit Credit

Steps in the preparation of partial worksheet:

1. Normally, the worksheet has 10-money columns. The first two (2) money columns are for unadjusted trial
balance; the 2nd pair of money columns is for adjustments; the 3rd pair is for adjusted trial balance; the 4th
pair is for income statement; and the last two (2) pairs are for the balance sheet.

WORKSHEET
Adjusted Trial Income
Trial Balance Adjustments Balance Sheet
Balance Statement
Account
Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
Title

2. Copy the unadjusted trial balance on the first two (2) money columns captioned as Unadjusted Trial Balance
(Debit, Credit). These are the balances of the accounts before preparing the adjusting entries.
3. Analyze and journalize the data for adjustment and transfer the adjusting entries to the second pair money
columns captioned as Adjustments (Debit, Credit). Check the equality of debits and credits. At the same
time, post the adjusting entries to the general ledger.
4. Determine the adjusted balances by combining the trial balance and the adjustments. Enter the adjusted
balances on the 3rd pair of money columns captioned as Adjusted Trial Balance (Debit, Credit). Take the
total of each debit and credit column. Also, check the equality of debits and credits. (The next steps will be
discussed on the next topic)

Applying the partial worksheet for Mac Co.:

MAC CO.
Worksheet
December 31, 2018
Trial Balance Adjustments Adjusted Trial Balance
Account Title Debit Credit Debit Credit Debit Credit
Cash 402,500 402,500
Accounts Receivable 70,000 30,000 100,000
Supplies 80,000 9,000 71,000
Equipment 350,000 350,000
Accounts Payable 80,000 80,000
Mac, Capital 750,000 750,000
Mac, Drawing 65,000 65,000
Service Revenue 235,000 30,000 265,000
Advertising Expense 12,500 12,500
Rent Expense 30,000 30,000
Salaries Expense 45,000 45,000
Utilities Expense 10,000 18,000 28,000
Total 1,065,000 1,065,000
Utilities Payable 18,000 18,000
Supplies Expense 9,000 9,000
Depr’n. Expense – Equip. 7,200 7,200
Accum. Depr’n. – Equip. 7,200 7,200
Total 64,200 64,200 1,120,200 1,120,200

03 Handout 1 *Property of STI

Page 7 of 9
 BM1705

The new adjusted trial balance for Mac Co.:

MAC CO.
Adjusted Trial Balance
December 31, 2018
Balance
Particulars PR Debit Credit
Cash P 402,500
Accounts Receivable 100,000
Supplies 71,000
Equipment 350,000
Accumulated Depreciation – Equipment P 7,200
Accounts Payable 80,000
Utilities Payable 18,000
Mac, Capital 750,000
Mac, Drawing 65,000
Service Revenue 265,000
Advertising Expense 12,500
Rent Expense 30,000
Salaries Expense 45,000
Utilities Expense 28,000
Supplies Expense 9,000
Depreciation Expense – Equipment 7,200
P 1,120,200 P 1,120,200

Preparing the Financial Statements

Companies can prepare financial statements directly from the adjusted trial balance. The adjusted trial balance
facilitates the preparation of the income statement, the statement of owner’s equity, and the balance sheet.

The financial statements should be prepared in the following order:

1. Income statement – this is to determine net income or net loss. The income statement should list expenses
in descending order by amount.
2. Statement of owner’s equity – this needs net income or net loss from the income statement to compute
ending capital.
3. Balance sheet – this needs the amount of ending capital to achieve its balancing feature.

It is important for accountants to prepare accurate and complete financial statements because other people rely
on the data to make decisions.

MAC CO.
Income Statement
For the month ended December 31, 2018
Revenue:
Service Revenue P 265,000
Expenses:
Advertising Expense P 12,500
Rent Expense 30,000
Salaries Expense 45,000
Utilities Expense 28,000
Supplies Expense 9,000
Depreciation Expense – Equipment 7,200 131,700
Net Income P 133,300

03 Handout 1 *Property of STI

Page 8 of 9
 BM1705

MAC CO.
Statement of Changes in Owner’s Equity
For the month ended December 31, 2018
Mac, Capital, beginning 750,000
Add: Net income 133,300
883,300
Less: Mac, Drawing 65,000
Mac, Capital, ending 818,300

MAC CO.
Balance Sheet
December 31, 2018
Assets
Cash P 402,500
Accounts Receivable 100,000
Supplies 71,000
Equipment 350,000
Accumulated Depreciation – Equipment (7,200) 342,800
Total Assets P 916,300

Liabilities and Owner’s Equity

Accounts Payable 80,000
Utilities Payable 18,000
Total Liabilities 98,000

Mac, Capital 818,300

Total Liabilities and Owner’s Equity P 916,300

References:
Horngren, C. T., Harrison Jr., W. T., & Oliver , M. (2012). Accounting (9th ed.). Upper Saddle River, New Jersey:
Prentice Hall.
Needles, B. E., Powers, M., & Crosson, S. V. (2014). Principles of Accounting. The United States of America:
Cengage Learning.
Rante, G. A. (2013). Fundamentals of accounting (Accounting for service, merchandising, and manufacturing
entities). Mandaluyong: Millenium Books, Inc.
Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2015). Accounting principles (12th ed.). United States of America:
John Wiley & Sons, Inc.

03 Handout 1 *Property of STI

Page 9 of 9