Business

Transactions
&
The Accounting
Cycle
The Accounting Cycle
5. PREPARATION OF THE WORKING PAPER WITH
ADJUSTMENTS

UNEARNED INCOME (DEFERRED INCOME) – items

already COLLECTED but remain UNEARNED as at
end of the period

Ex. (1) Unearned rent income; (2) Unearned interest

income; (3) Advance collections from customers for
the future delivery of goods or services

METHODS OF ACCOUNTING FOR PREPAYMENTS

1. Income Method
2. Liability Method
The Accounting Cycle
5. PREPARATION OF THE WORKING PAPER WITH ADJUSTMENTS

UNEARNED INCOME – Income Method of Accounting

Under this method, an INCOME account is credited at the time of
collection.

Pro-forma Journal Entries:

Entry to record the advance collection:

Dr. Cash xx
Cr. Income xx

Entry to adjust for the unearned portion of the advance collection

as at end of the period:

Dr. Income xx
Cr. Liability (Unearned income) xx
The Accounting Cycle
5. PREPARATION OF THE WORKING PAPER WITH ADJUSTMENTS

UNEARNED INCOME – Income Method of Accounting

Illustration: On October 01, 2020, the business received rentals of
P120,000 covering 1 – year rent which runs from October 01, 2020 to
October 01, 2021. The accounting year of the business ends every
December 31.

Entry made by the business on October 01, 2020 (for illustration

purposes only, not part of the actual adjusting entry at year-end):
Cash P 120,000
Rent income P120,000

Adjusting journal entry as at December 31, 2020

Rent income P 90,000
Unearned rent P 90,000
The Accounting Cycle
5. PREPARATION OF THE WORKING PAPER WITH ADJUSTMENTS

UNEARNED INCOME – Income Method of Accounting

Explanation of the adjustment:
Adjusting journal entry as at December 31, 2020
Rent income P 90,000
Unearned rent P 90,000

NOTE: Prior to the preparation of the adjusting entry, the amount of

RENT INCOME for the year 2020 is overstated since the entire
P120,000 was recorded by the business as RENT INCOME on October
01, 2020 (time of payment). But as at cut-off date for reporting
(December 31, 2020), only 3 months of rent have been EARNED by
the business, hence, the RENT INCOME should only amount to
P30,000 for the period ended December 31, 2020 (P120,000 x 3/12).
Accordingly, RENT INCOME for the year must be reduced by P90,000
and an UNEARNED RENT (liability) account must be established
equal to the P90,000, the UNEARNED portion of the advance
collection as at year – end.
The Accounting Cycle
5. PREPARATION OF THE WORKING PAPER WITH ADJUSTMENTS

UNEARNED INCOME – Income Method of Accounting

Explanation of the adjustment:
Adjusting journal entry as at December 31, 2020
Rent income P 90,000
Unearned rent P 90,000

NOTE:
1. The adjusting entry involving unearned income accounted for
under the INCOME METHOD includes a DEBIT to an INCOME account
and a CREDIT to a LIABILITY (unearned income) account equal to
the UNEARNED portion of the advance collection.

2. Note also that the adjustment involves only two accounts, LIABILITY
and INCOME accounts. The DEBIT in the adjusting entry is always the
same as the method. Hence, if the method used is INCOME method,
the DEBIT in the entry is always an INCOME account. Needless to
say, the CREDIT is the opposite of the method (LIABILITY account)
The Accounting Cycle
5. PREPARATION OF THE WORKING PAPER WITH ADJUSTMENTS

UNEARNED INCOME – Liability Method of Accounting

Under this method, a LIABILITY account is credited at the time of
collection.

Pro-forma Journal Entries:

Entry to record the advance collection:

Dr. Cash xx
Cr. Liability (Unearned income) xx

Entry to adjust for the earned portion of the advance collection as at

end of the period:

Dr. Cr. Liability (Unearned income) xx

Cr. Income xx
The Accounting Cycle
5. PREPARATION OF THE WORKING PAPER WITH ADJUSTMENTS

UNEARNED INCOME – Liability Method of Accounting

Illustration: On October 01, 2020, the business received rentals of
P120,000 covering 1 – year rent which runs from October 01, 2020 to
October 01, 2021. The accounting year of the business ends every
December 31.

Entry made by the business on October 01, 2020 (for illustration

purposes only, not part of the actual adjusting entry at year-end):
Cash P 120,000
Unearned rent P120,000

Adjusting journal entry as at December 31, 2020

Unearned rent P 30,000
Rent income P 30,000
The Accounting Cycle
5. PREPARATION OF THE WORKING PAPER WITH ADJUSTMENTS

UNEARNED INCOME – Liability Method of Accounting

Explanation of the adjustment:
Adjusting journal entry as at December 31, 2020
Unearned rent P 30,000
Rent income P 30,000

NOTE: Prior to the preparation of the adjusting entry, the amount of

UNEARNED RENT (liability) for the year 2020 is overstated since the
entire P120,000 was recorded by the business as UNEARNED RENT on
October 01, 2020 (time of payment). But as at cut-off date for
reporting (December 31, 2020), 3 months of rent have already been
EARNED by the business, hence, RENT INCOME of P30,000 for the
period ended December 31, 2020 (P120,000 x 3/12) must be
recognized. Accordingly, UNEARNED RENT (liability) must be
reduced by P30,000 and a RENT INCOME account must be
established equal to the P30,000, the EARNED portion of the
advance collection as at year – end.
The Accounting Cycle
5. PREPARATION OF THE WORKING PAPER WITH ADJUSTMENTS

UNEARNED INCOME – Liability Method of Accounting

Explanation of the adjustment:
Adjusting journal entry as at December 31, 2020
Unearned rent P 30,000
Rent income P 30,000

NOTE:
1. The adjusting entry involving unearned income accounted for
under the LIABILITY METHOD includes a DEBIT to a LIABILITY
(unearned) account and a CREDIT to an INCOME account equal to
the EARNED portion of the advance collection.

2. Note also that the adjustment involves only two accounts, LIABILITY
and INCOME accounts. The DEBIT in the adjusting entry is always the
same as the method. Hence, if the method used is LIABILITY method,
the DEBIT in the entry is always a LIABILITY (unearned) account.
Needless to say, the CREDIT is the opposite of the method (INCOME
account)