FINANCIAL ACCTG 1&2

LESSON 5

Adjusting the Accounts

LEARNING OBJECTIVES
 Explain the accrual accounting and state how it
improves financial statements.
 Explain the importance of periodic reporting and time
period assumption.
 Explain the recognition and derecognition process .
 Identify the types of adjustments and their purposes.
 Illustrate how accounting adjustments link to financial
statements.
 Prepare and explain the adjusting entries.
 Interprets the effect of omitting adjustments in the
financial statements
 Prepare the adjusted trial balance.
 Explain the alternative methods of recording deferrals.
Accrual Basis
 The financial statements, except for the Cash flow
statement, are prepared on the accrual basis of
accounting in order to meet their objectives.

 Under the accrual basis, the effects of transactions

and other events are recognized when they occur and
not as cash is received or paid.

 Revenues are recorded as they are earned and

expenses as they are incurred.
 Illustration:
 A client paid the Sea Wind Resort in Boracay Island
₱9,000 on May 8, 2020 for a 1 day super deluxe
accommodation in Jun 13, 2020.
 Under accrual basis of accounting the receipt of
₱9,000 will be considered as revenues when the
business has rendered its services on June 13, 2020.

May 8 – Cash 9,000

Unearned Revenue 9,000

June 13 Unearned Revenue 9,000

Revenue 9,000
PERIODICITY CONCEPT
 Accounting information is valued when it is
communicated early enough to be used for economic
decision-making. To provide timely information,
accountants have divided the economic life of a
business into artificial time periods. This assumption
is called PERIODICITY CONCEPT.
 Accounting period are generally a Month, a Quarter,
or a Year.
 The most basic accounting period is one year.

.
 A Fiscal Year
 is a period of any twelve consecutive months.

 A Calendar Year
 is an annual period that ends on Dec. 31.

 A Natural Business Year

 is a twelve-month period that ends when a
business activities are at their lowest level of
annual sales.

 A period less than a year is called Interim

Period
 Recognition and Derecognition

 Recognition is the process of capturing for inclusion

in the Statement of Financial Position or the
Statement (s) of financial performance an item that
meets the definition of an asset, a liability, equity ,
income or expenses.

 The amount at which an asset, liability or equity is

recognized in the statement of financial position is
referred to as its “Carrying Amount”.
 Recognition links the elements, the Statement of
Financial Position and the Statement of Financial
Performance.
 The recognition of income occurs at the same

time as:
 The initial recognition of an asset, or an
increase in the carrying amount of an asset; or
 The derecognition of a liability, or a decrease
in the carrying amount of a liability.
 The recognition of expenses occurs at the same
time as:
 The initial recognition of a liability, or an

increase in the carrying amount of a liability;

or
 The derecognition of an asset, or a decrease in
the carrying amount of an asset.
 Derecognition is the removal of all or part of a
recognized assets or liability from an entity’s
statement of financial position.

 Derecognition normally occurs when that item no

longer meets the definition of an asset or of a
liability:
I. For an asset, derecognition normally occurs
when the entity loses control of all or part of the
recognized asset;
II. For a liability, derecognition normally occurs
when the entity no longer has present obligation
for all or part of the recognized liability.
THE NEED FOR ADJUSTMENTS

1. Accountants make adjusting entries to reflect in

the accounts information on economic activities
that have occurred but have not yet been recorded.

2. Adjusting entries assigned revenues to the period

in which they are earned and expenses to the
period which they are incurred.
THE NEED FOR ADJUSTMENTS
3. Adjusting entries are needed to measure properly
the profit for the period and to bring related asset
and liability accounts to correct balances for the
financial statements.

4. Adjustments are needed to ensure that the

Recognition and Derecognition principles are
followed thus resulting to financial statements
reporting the effects of all transactions at the end of
the period.
The General End of the period
Journal adjusting entries
recorded in the General
Journal
Prepaid Posting to the
Expenses Leger

Revenues
Expenses

Unearned
Revenues Adjuste
d Trial
Balanc
Payables e
DEFERRALS AND ACCRUALS

 Accountants use adjusting entries to apply accrual

accounting to the transactions that cover more than
one accounting period.

 Each adjusting entry affects a balance sheet account

and an income statement account.
DEFERRALS AND ACCRUALS
 Two General types of adjustments made at the end of
the period:
1. Deferrals
2. Accruals

 Deferral is the postponement of the recognition of “an

expense already paid but not yet incurred” or of
“revenue already collected but not yet earned”

 Accrual is the recognition of “an expense already

incurred but not yet paid”, or of “an income earned but
not yet collected”.
 Accruals would be required in 2 cases:
1. Accruing expenses incurred during the
accounting period that are unpaid and
unrecorded.

2. Accruing revenues to reflect revenues earned

during the accounting period that are
uncollected
 Accruals increase both balance sheet and income
statement accounts.

1. Accruing expenses incurred during the

accounting period that are unpaid and
unrecorded.

2. Accruing revenues to reflect revenues earned

during the accounting period that are
uncollected
Exercise 1 - Types of accounts affected

Account Debit Account Credit

Deferrals
Prepaid Expenses:
Asset Method
Expense Method

Unearned
Revenues:
Liability Method
Income Method

Accruals
Accrued Expenses
Accrued Revenues

Required: Complete the table by filling in the accounts to

be debited and to be credited in preparing the adjusting
entries.
Exercise 2.
The following are some of the transactions made by Cedric
Naranjo Cleaners during 2021:
April 1 - Acquired cleaning supplies in the amount of
₱260,000. A count of the supplies on Dec. 31,
2020 amounted to ₱110,000.
Aug 1 - Received ₱360,000 from Cebu Manpower for
cleaning janitorial uniforms over the next 3 years.
Nov 1 - Paid ₱240,000 for annual rent.
Required:
1. Assumed that Naranjo records these transactions using
the following accounts, record the adjusting entries on
Dec. 31, 2021.
Cleaning Supplies
Prepaid Rent
Unearned Cleaning Revenues
2. Now assumed that Naranjo records these
transactions using the following accounts, what
will the adjusting entries on Dec. 31, 2021?
Cleaning Supplies Expense
Rent Expense
Cleaning Revenues
3. If Naranjo were to use reversing entries, which
set of entries, 1 or 2 would have to be reversed?
Why?
ADJUSTMENT FOR DEFERRALS
 Prepaid Expenses – these are expenses paid but not
yet incurred. They are assets and not expenses, the
portion of these assets that have expired become
expenses.
 Illustration:
Cost of As insurance policies
insurance expire and supplies Income Statement
Balance Sheet
policies or are used

supplies Assets -
Revenues
that will Expenses
Prepaid
Insurance
benefit Insurance
Expense
future Supplies
Supplies
period Expense
 Depreciation of Property and Equipment
 When an entity acquires long-lived assets such as
buildings, service vehicles, computers or office furniture, it
is basically buying or repaying for the usefulness of that
asset.
 These assets help generate income for the entity, therefore
a portion of the cost of the assets should be reported as
expense in each accounting period. The estimated amount
allocated to any one accounting period is called
Depreciation or Depreciation Expense.
 Depreciation of Property and Equipment

 Three factors that are involved in calculating

Depreciation Expense:
1. Asset Cost
2. Estimate Salvage Value
3. Estimated Useful life
 Allocating Revenues Received in Advance
 There are times when an entity receives cash for
services or goods even before service is rendered
or goods are delivered. When this happen, the
entity has an obligation to perform services or
deliver the goods. The entity then records the
liability which is called Unearned Revenues.

 As the goods or services are provided then the

entity records the revenue and decrease the
liability account.
 Accrued Expenses

 There are expenses incurred by the entity but

have not yet been paid.

 As the expenses are incurred the entity records

the Expenses and its corresponding liability
account that is called Accrued Expenses.

 When the entity pays the accrued expenses it

Debits the Accrued Expenses account.
 Accrued Revenues
 An entity may provide services during the period
that are neither paid for by the clients nor billed
at the end of the period.
 The value of these services represents revenue
earned by the entity.
 Any revenue that has been earned but not
recorded during the accounting period calls for
adjusting entry that debits an asset and credits
an income accounts.
 Accrual for Uncollectible Accounts
 Entities often allow clients to purchase goods or
avail of services on credit. Some of these
accounts will never be collected;
 So there is a need to reflect these as charges
against income.
 The entry will by:
Uncollectible Accounts Expense xxx
Allowance for Uncollectible Accounts xxx
 Effects of Omitting Adjustments
 When an accountant failed to include proper
adjusting entries, the resulting financial
statements will not accurately reflect the
financial position and the performance of an
entity.
 Inaccuracies in one accounting period can cause
further inaccuracies in the statements of
subsequent periods.
 Illustration
 On July 1, 2021 Carabao Manpower Corporation
owned by Wanny Blanco borrowed ₱100,000 by
signing an 18 month note at 16% interest per
annum. The principal and interest are to be
repaid when the note matures on Dec. 31, 2022.
As at Dec. 31,2021, the entity incurred interest
expense of ₱8,000. The accountant failed to record
the adjustment for the accrued interest.
What would have been the effect of this omission
in the Dec. 2021 financial statements?