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

Effect of Omitting Adjusting Entry

Type of Adjusting What Adjusting On Account On Financial
Entry Entry Does Balance statements

Increase expense U n d e rs ta te s Overstates net

expense income
Deferred Expenses
Decrease asset Overstates asset Overstates total
assets
Increase revenue Understate Understate net
revenue income
Deferred Revenues

Decrease liability Overstate liability Overstate total

liabilities
Increase expense Understate Overstates net
Accrued Expenses expense income

Increase liability Understate liability Understate total

liabilities
Increase revenue Understate Understate net
Accrued Revenues revenue 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 Expense Method
Initial entry: Record the payment by Record the payment by
debiting the asset account. debiting the expense
account.
Adjusting entry: Transfer the amount used to Transfer the amount unused
the appropriate expense to the appropriate asset
account. 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.

ASSET METHOD EXPENSE METHOD

8/1/2020 Prepaid Office Supplies 100,000.00 Office Supplies Expense 100,000.00
Cash 100,000.00 Cash 100,000.00
(To record purchase of office supplies) (To record purchase of office supplies)

Office Supplies bought on 8/1/2020 100,000.00

Remaining supplies (40,000.00)
Supplies used 60,000.00

12/31/2020 Office Supplies Expense 60,000.00 Prepaid Office Supplies 40,000.00

Prepaid Office Supplies 60,000.00 Office Supplies Expense 40,000.00
(To adjust prepaid office supplies) (To adjust office supplies expense)

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
ASSET METHOD
Prepaid Office Supplies Office Supplies Expense
100,000.00 60,000.00 60,000.00
40,000.00

EXPENSE METHOD
Office Supplies Expense Prepaid Office Supplies
100,000.00 40,000.00 40,000.00
60,000.00
following T-accoun
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?

ASSET METHOD EXPENSE METHOD

07/30/2020 Prepaid Insurance 12,000.00 Insurance Expense 12,000.00
Cash 12,000.00 Cash 12,000.00
(To record purchase of insurance) (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 9,500.00

Prepaid Insurance 2,500.00 Insurance Expense 9,500.00
(To adjust prepaid insurance) (To adjust insurance expense)

ASSET METHOD
Prepaid Insurance Insurance Expense
12,000.00 2,500.00 2,500.00
9,500.00

EXPENSE METHOD
Insurance Expense Prepaid Insurance
12,000.00 9,500.00 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 Revenue Method

Initial entry: Record the receipt of cash to
the appropriate liability
account
Adjusting entry: Transfer the amount earned to
the appropriate revenue
account
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.
 LIABILITY METHOD REVENUE METHOD
11/1/2020 Cash 150,000.00 Cash 150,000.00
Unearned Service Revenue 150,000.00 Service Revenue 150,000.00
(To record payment received in advance) (To record payment received in advance)

Advance payment 150,000.00

Income still unearned (150000x4/6) (100,000.00)
Income earned (150000x2/6) 50,000.00

12/31/2020 Unearned Service Revenue 50,000.00 Service Revenue 100,000.00

Service Revenue 50,000.00 Unearned Service Revenue 100,000.00
(To adjust unearned service revenue) (To adjust service revenue)

LIABILITY METHOD
Unearned Service Revenue Service Revenue
50,000.00 150,000.00 50,000.00
100,000.00

REVENUE METHOD
Service Revenue Unearned Service Revenue
100,000.00 150,000.00 100,000.00
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 50,000

Service Revenue 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 5,000

Interest Income 5,000
(100,000x6%x10/12)

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 Tuesday Wednesday Thursday Friday

December 28 December 29 December 30 December 31 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 24,000
Salaries Payable 24,000
(10x3,000x4/5)

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 16,000

Interest Payable 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 = Depreciation

Estimated Useful Expense
Life 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 = P90,000 annual
5 years depreciation

FURNITURE AND FIXTURES

P800,000 x 85% = P68,000 annual
10 years 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 90,000

Accumulated Depreciation – Equipment 90,000
 Depreciation Expense – Furniture and Fixture 45,333
Accumulated Depreciation – F and F 45,333
(68,000x8/12)

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.