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BERNADETTE RAMOS
Per PAS 1, the financial statements prepared must be fairly presented. The trial balance is the
source of data needed in the preparation of financial statements. However, this trial balance does not
show all information needed in the preparation of financial statements. Why? Because some elements
of the financial statements are not completely or fairly stated.
At this point, it is important to make the distinction between the accrual and the cash basis of
accounting.
Accrual accounting records the effect of each transaction as it occurs. . Income is recognized as
earned, meaning, as services or goods are delivered by the entity regardless of collection. Expenses is
recorded as it is incurred, meaning, as goods and services are consumed regardless of payment.
Cash-basis accounting records only cash receipts and cash payments. It ignores receivables,
payables, and depreciation.
GAAP requires that a business use the accrual basis accounting. Presented below are the basic
end of period adjustment of a service business , the objective of adjustment, and the pro-forma
adjusting entries to be made at the end of the covered accounting period:
The preparation of adjusting entries is perceived to be the most difficult topic in Basic
Accounting Part 1. But it is not. Actually, you just have to do it in a step by step procedure.
First, you have to know if its adjustment for an income or expense. Income is recognized under
accrual basis as earned, meaning there is delivery of goods and/or services. Expense is recorded as
incurred, meaning upon consumption of goods and services.
Next is to know whether it’s an accrual or deferral. So how do we differentiate accrual and
deferral?
Accrual Deferral
Recognition of income or Current period Current period
expense
Collection or payment Subsequent period. Subsequent period/s
Another way of distinguishing a deferral from accrual is that a deferral account as per
unadjusted trial balance is a mixed account. For example, supplies per unadjusted trial balance will be a
mixture of asset and expense since the consumed supplies is not yet recorded/adjusted in the
unadjusted trial balance. Upon adjustment the mixed account will be splitted. The consumed supplies
will be charged to expense and the unused supplies will remain an asset.
To illustrate recording and subsequent adjustments well use the following comprehensive
problem :
In December 2014, John Ramos started his own accounting practice in Macabebe, Pampanga.
The following are his transactions for the first month of operations.
December 2 –John invested cash of P20,000 and land and building worth P2,000,000. The land has an
appraised value of P1,000,000. He invested as well his accounting and taxation books worth P10,000
and a personal laptop worth P20,000.
2 – Borrowed P400,000 cash from the bank and issued 12% one year promissory note.
4- Purchased from Office Warehouse – office furniture P10,000 and office supplies P1,000 in cash.
4- Acquired a computer P15,000 and a printer P5,000 from Octagon Computers, payable on Dec.15
6- Hired one (1) assistant who will be paid P1,000 per day.
ACT1101 FAR EASTERN UNIVERSITY PROF. BERNADETTE RAMOS
9- Received P30,000 as payment from one client for accounting services to be rendered for the months
of December, January, and February.
Assets Income
101 Cash 401 Service Income
102 Accounts Receivable 402 Other income
102-A Allowance for Doubtful Accounts
103 Office Supplies Expenses
104 Research Resources 501 Salaries Expense
105 Land 502 Repairs & Maintenance
106 Building 503 Utilities Expense
106-A Accumulated Depreciation-Building 504 Communication Expense
107 Office Equipment 505 Taxes && Licenses
Accumulated Depreciation-Office
107-A Equipment 506 Depreciation Expense - Building
Depreciation Expense -Office
108 Furniture & Fixtures 507 Equipment
Accumulated Depreciation-Furniture & Depreciation Expense -Furniture &
108-A Fixtures 508 Fixtures
Liabilities 509 Office Supplies Expense
201 Accounts Payable 510 Interest Expense
202 Notes Payable 511 Doubtful Accounts Expense
203 Unearned Revenues
204 Interest Payable
205 Utilities Payable
ACT1101 FAR EASTERN UNIVERSITY PROF. BERNADETTE RAMOS
Capital
301 John Ramos, Capital
302 John Ramos, Drawing
303 Income Summary
Based on what we have discussed in Chapter 2, we will prepare the necessary entries in the
journal and ledger.
General Journal
2 Cash 101
400,000
Notes Payable 202
400,000
To record borrowing and issuance of promissory note.
9 Cash 101
20,000
Service Income 401
20,000
Rendered services for cash
9 Cash 101
30,000
Unearned Revenues 203
30,000
To record collection for services not yet delivered
22 Cash 101
40,000
ACT1101 FAR EASTERN UNIVERSITY PROF. BERNADETTE RAMOS
12/24 20,000
12/26 10,000
12/31 400,000
Office Supplies
12/31 1,000
Land
ACT1101 FAR EASTERN UNIVERSITY PROF. BERNADETTE RAMOS
Building
Accumulated Depreciation-Building
12/2 2,050,000
12/31 2,050,000
Office Equipment
12/2 20,000 John Ramos, Drawing Depreciation Expense -Furniture & Fitures
Interest Expense
And the ledger will be summarized in a trial balance. The following is the trial balance of John
Ramos, CPA:
Debit Credit
101 Cash 419,000
102 Accounts Receivable 20,000
102-A Allowance for Doubtful Accounts
103 Office Supplies 1,000
104 Research Resources 10,000
105 Land 1,000,000
106 Building 1,000,000
106-A Accumulated Depreciation-Building
107 Office Equipment 40,000
ACT1101 FAR EASTERN UNIVERSITY PROF. BERNADETTE RAMOS
At year end the following data are made available prior to the preparation of financial statements:
1 Salary of assistant is P1,000 per day. Last payment of her salary was made December 26. She
went to work Dec. 29 and 30.
2 P15,000 worth of accounting services were rendered but not yet recorded.
3 Unused supplies, P200
4 Out of the P30,000 advance collection from a client, at Dec. 31, P10,000 was earned.
5 The furniture & fixtures , building and office equipment had the following estimated values
6 Interest on the 12% note payable. The P400,000 note was issued to bank on December 2 and
will be due a year after.
7 5% of Accounts Receivable is deemed uncollectible.
We should take a step by step procedure or a slow but sure analysis of the adjustments to be
made. First we classify the type of adjustment that we need to do:
1. Using the perspective of the entity, salaries is always an expense. It’s an expense because there
is consumption of services. And the incurred expense is not yet paid, therefore, this is classified
as Accrued Expense.
2. An income must be recognized because there is delivery of services and since it is not yet
collected a receivable must be recorded. This is Accrued Income.
3. Supplies is always a deferral because as of the unadjusted trial balance, its balance is a mixture
of asset and expense. This is an example of a prepaid expense.
4. Unearned revenue or deferred revenue is a deferral.
5. The data gave us property, plant & equipment which is subject to depreciation.
6. Interest incurred in the notes payable is another example of accrued epense.
So what will be the adjusting entries of John Ramos, CPA? Let’s do more of our careful analysis.
Let us start with the accruals.
Accrued Expense/Accrued Liability – an accrued expense is an expense already incurred but not yet
paid by the entity. Because it was not yet paid, it was not yet recorded in the books
Omission of this adjustment will misstate Profit or Loss Statement Expense will be understated,
profit will be overstated. The Statement of Financial Position’s Liability will be understated. In the
preceding problem we have classified no 1 & no 6 as accrual of expense, so to correct the
understatement in expense, we’ll debit expense and to correct the understatement in liability, we
increase payables by credit.
Accrued Income/Accrued Asset – an accrued income is an income already earned but not yet
collected by the entity. Because it was not yet collected, it was not yet recorded in the books
ACT1101 FAR EASTERN UNIVERSITY PROF. BERNADETTE RAMOS
Omission of this adjustment will misstate Profit or Loss Statement - Income will be understated,
profit will be understated. The Statement of Financial Position’s Asset will be understated. In the
preceding problem we have classified no 2 as accrual of income, so to correct the understatement in
income, we’ll credit income and to correct the understatement in asset, we increase receivables by
debit.
Deferred Expense/Prepaid Expense – Prepaid expense or prepayments are expenses not yet
incurred but already paid. (Note that this is the opposite of accrued expense)
The adjustment for deferred expense depends on the initial recognition of the deferral. We have
classified adjustment no 2 as a prepaid expense . In the trial balance what was recorded is Office
Supplies, P2,000 meaning the entity used asset method. In asset method, asset is initially recorded,
so the amount to be adjusted is that of expense,P800.
If instead the entity used the expense method, meaning, Supplies Expense is initially recorded
(therefore the P1,000 was shown as Office Supplies Expense in the trial balance) the amount to be
adjusted is that of asset,P200 and the adjustment will be:
Deferred Income/Unearned Income – Unearned revenues are income not yet earned but already
collected. (Note that this is the opposite of accrued income)
ACT1101 FAR EASTERN UNIVERSITY PROF. BERNADETTE RAMOS
The adjustment for deferred income depends on the initial recognition of the deferral. We have
classified adjustment no4 as a unearned revenue . In the trial balance what was recorded is
Unearned Revenue (Liability), P30,000 meaning the entity used Liability method. In Liability
method, liability is initially recorded, so the amount to be adjusted is that of income,P10,000.
If instead the entity used the income method, meaning, Service Income is initially recorded
(therefore the 30,000 was added to the P80,000 balance of Service Income and will be shown as
Service Income P110,000 in the trial balance) the amount to be adjusted is that of liability,P20,000
and the adjustment will be:
Depreciation – The decrease in value of property, plant and equipment (except land) because of
usage and passage of time . Also, it is the systematic and rational allocation of cost less any
estimated residual value over its estimated useful life. From this definition we can come up with
the formula of depreciation:
Since the entity started only in December, we are to provide for a one month depreciation:
40,000 10,000
Building /10 8333
1,000,000 100,000
Doubtful Accounts Expense – or bad debts are possible losses from non-collection of accounts
receivable. Provision for doubtful accounts can be based on balance sheet approach (aging or doubtful
accounts as a percentage of accounts receivable) or income statement approach (doubtful accounts as a
percentage of income). Why is it balance sheet approach and income statement approach, observe the
following:
It is called balance sheet approach because if we use balance sheet account (AR)as a factor in the
formula, the yield is also a balance sheet account (ADA). On the other hand, it is called income
statement approach because if we use income statement account (Income)as a factor in the formula,
the yield is also an income statement account (ADA).
Will the two approaches provide the same amount of adjustment, the answer is no. Let us assume
the following data:
BS Approach
10% x 10,000 = 1,000 ADA
ACT1101 FAR EASTERN UNIVERSITY PROF. BERNADETTE RAMOS
IS Approach
10% x 10,000 = 1,000 DAE
Observe that amounts for Doubtful Accounts Expense and Allowance for Doubtful Accounts are
different in both approaches. Adjusting entries are also not the same.
In the problem, John estimated that 5% of Accounts Receivable will be uncollectible. That will be
P20,000 x .05 = P1,000. There is no beginning balance for Allowance for Doubtful Accounts, so the
adjusting entry will be
Take note that all entries in the journal must be recorded in the ledger. So if the adjusting entries
will be posted, ledger will be
12/3 12/3
12/24 20,000 1 167 1 105,000
12/26 10,000 Other income
12/9 30,000
12/3 12/3
12/31 1,000 1 10,000 1 30,000
12/3
12/31 1,000 1 20,000
Interest Payable Utilities Expense
12/3 12/1
Office Supplies 1 4,000 6 4,000
12/3 12/3
12/4 1,000 12/31 800 1 4,000 1 4,000
12/3
1 200
Communication Epense
12/1
Research Resources Utilities Payable 6 1,000
12/3
12/2 10,000 1 1,000
12/3
1 10,000
Taxes && Licenses
1 20,000
12/3
Office Equipment 1 167
12/3
12/2 20,000 Income Summary 1 167
12/4 20,000
12/3
1 40,000 Office Supplies Expense
12/3
1 800
12/3
Accumulated Depreciation-Office Equipment 1 800
12/31 833
Accou
nt Trial Balance Adustment Adjusted trial balance
Code Account titles Debit Credit Debit Credit Debit Credit
Accumulated Depreciation-Office
107-A Equipment 833 833
15,000
401 Service Income
80,000 105,000
10,000
402 Other income
From this adjusted trial balance, we can now prepare the financial statements of John Ramos, CPA.
Service Income
Less Expenses:
Current Assets
Cash
Accounts Receivable
35,000
Research Resources
Land
Building 1,000,000
Current Liabilities
Notes Payable
Unearned Revenues
Interest Payable
Salaries Payable
Total current liabilities
John Ramos, Capital
Total liabilities & owner's equity
Please take note that the financial statements are prepared in the following order: