Module VIII

ADJUSTING ENTRIES
Introduction

At the end of the accounting period, some accounts in the general

ledger would require updating. The journal entries that bring the accounts up
to date are called adjusting entries. One purpose of adjusting entries is for
income and expenses to be reported in the correct period.

Adjusting entries ensure that both the revenue recognition and

matching principles are followed. Prior to your lecture, recall the previous
discussion on accounting principles and concepts, specifically the matching
principle. This concept explains that some costs are initially recognized as
assets and charged as expenses only when the related revenue is recognized.
While the Revenue Recognition principle in accounting standards requires that
revenue is recognized when it is earned and the amount can be measured
reliably.

Now on our 5th step in the accounting cycle, this chapter would help in the
preparation of entries in taking up unrecorded income and expenses for the
period, and to split mixed accounts into their real and nominal elements prior to
the preparation of financial statements.

Unit Learning Outcomes:

Study Objectives—after studying the chapter, you should be able to:

1. Explain the time period assumption.
2. Explain the accrual basis of accounting.
3. Explain why adjusting entries are needed.
4. Identify the major types of adjusting entries.
5. Prepare adjusting entries for deferrals (prepayments).
6. Prepare adjusting entries for accruals.
7. Describe the nature and purpose of an adjusted trial balance.
8. Prepare adjusting entries for the alternative treatment of prepayments.

Topic 1: Definitions and Key Concepts

Time Allotment: 2 hours

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 Activating Prior Learning

Take the following Quiz on Adjusting Entries and then check the answers after you
have studied this chapter:

1. T or F: Adjusting entries are made to apply the matching principle.

2. T or F: The Cash account is found in some adjusting entries.
3. T or F: All adjustments affect both the Balance Sheet and the
Income Statement.
Matching from types of Adjusting Entries: (1) Accrued expense; (2)
Accrued revenue; (3) Deferred expense; and (4) Deferred revenue:
4. ____ Unpaid salaries
5. ____ Rent received in advance
6. ____ Prepaid insurance
7. ____ Interest earned but not received
8. ____ Rent paid in advance
9. Subscriptions received in advance
10.____ Rent due to us
11. ____ Unpaid interest

Presentation of Content

I. Accrual Basis of Accounting applies these principles:

A. Define the cash basis and the accrual basis of accounting:
1. Cash basis—an accounting method in which an expense is recorded when
cash is paid and revenue is recorded when cash is received. Cash-basis
accounting is NOT in accordance with GAAP.
2. Accrual basis—an accounting method in which an expense is recorded when
it is incurred and revenue is recorded when it is earned. It is the basis of
accounting in which transactions that change a company’s financial
statements are recorded in the periods in which the events occur.

B. Define the matching principle.

1. Matching principle—the accounting principle that states that revenue earned
during an accounting period should be offset by the expenses that were
incurred in earning that revenue. The principle that efforts (expenses) be
matched with accomplishments (revenues).
2. How to apply the matching principle—at the end of the accounting period
expenses and revenues must be examined to find out what amounts belong
to the period regardless of when the related cash payments and receipts occur
which means you will need to adjust both expenses and revenues in order to
apply the matching principle.

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 3. To determine Accrual Net Income:
All Recognized Revenues
All Matched Expenses
Recognized Revenues - Matched Expenses = Accurate net income for the period

C. Define the time period assumption:

1. An assumption that the economic life of a business can be divided into
artificial time periods.
2. Owners and managers as well as other users need timely results of operations
of a business:
a) Management usually wants monthly financial statements.
b) Internal Revenue Service (IRS) requires all businesses to file annual tax
returns.
D. Fiscal and Calendar Years:
1. Accounting time periods are generally a month, a quarter, or a year.
Monthly and quarterly time periods are called interim periods—less than
one year.
2. Fiscal year—an accounting period that is one year in length. A fiscal year
usually begins on the first day of a month and ends twelve months later on
the last day of a month.
3. Calendar year—an accounting period that extends from January 1 to
December 31.
E. Define the revenue recognition principle:
1.The principle that revenue be recognized in the accounting period in which it
is earned.
2. In a service enterprise, revenue is considered to be earned at the time the
service is performed.
F. Define accruals and deferrals.
1. Accruals—Expenses incurred and revenue earned in the current accounting
period but not recorded as of the end of the period. To accrue means to build
up or to accumulate. Thus, an accrual is a buildup or accumulation of
revenue or an expense that has not been recorded by a routine journal entry.
2. Deferrals—Expenses and revenues that have been recorded in the current
accounting period but are not incurred or earned until a future period. To
defer means to put off or to postpone. Thus, a deferral is a putting off or a
postponement of revenue or an expense that has been recorded by a routine
journal entry but belongs to the future.
G. Define the Going Concern Concept—financial reports of a business are
prepared with the expectation that the business will remain in operation
indefinitely. Since this concept assumes that a business will continue indefinitely
into the future, by accruing expenses and revenues, it is understood that the
business has a future.
H. The Basics of Adjusting Entries:
1. Adjusting entries are entries made at the end of an accounting period to ensure
that the revenue recognition and matching principles are followed.

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 2. Adjusting entries are required every time financial statements are prepared
and are dated as of the balance sheet date.
3. Adjusting entries are needed because:
a) Some events are not journalized daily because it is inexpedient to do so.
Examples are the consumption of supplies and the earning of wages by
employees.
b) Some costs are not journalized during the accounting period because they
expire with the passage of time rather than through recurring daily
transactions. Examples are equipment deterioration, and rent and
insurance expiring.
c) Some items may be unrecorded. An example of a utility bill that will not
be received and/or paid until the next accounting period.
I. Types of Adjusting Entries :
1. Prepayments:
a) Prepaid Expenses—expenses paid in cash and recorded as assets (or
expenses as shown in the chapter appendix—alternative treatment of
prepaid expenses) before they are used or consumed.
b) Unearned Revenues—cash received and recorded as liabilities (or
revenues as shown in the chapter appendix—alternative treatment of
unearned revenues) before revenue is earned.
2. Accruals:
a) Accrued Revenues—revenues earned but not yet received in cash or
recorded.
b) Accrued Expenses—expenses incurred but not yet paid in cash or
recorded.

II. Accounting for Accrued Expenses—ADJUSTING ENTRIES

FOR ACCRUALS.

The accrual of expenses creates liabilities. Expenses that have been

incurred but not yet recorded at the end of an accounting period require an
adjusting entry to recognize both the proper amount of expense for the
period on the income statement and the proper amount of liabilities on the
balance sheet.

Accrued Expenses are also called Accrued Liabilities because accrued

expenses have not been paid as of the end of the period and thus represent a
liability of the firm. Helpful hint to remember what is done with Accruals:
The “A” in Accrual means add to expense or revenue as the adjusting entry
will be adding to expenses or to revenues.

A. Explain ACCRUED SALARIES and the adjustment needed :

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 1. How accrued salaries occur—accrued salaries occur only when the last day
of the payroll period and the last day of the accounting period are different
days.
2. Steps to accrue salaries:
a. Determine the days to accrue: BE CAREFUL determining the
number of days to accrue salaries. Best way to determine the number of
days to accrue is to set up a calendar of the week and notate what day the
year ends. YOU ARE ACCRUING THE EXPENSE FOR THE
CURRENT YEAR (2019) NOT THE FOLLOWING YEAR (2020). If
P20,000 is the weekly payroll, the daily amount for a five-day work
week would be P 4,000:
2019 2020
Dec. 29 30 31 Jan. 1 2
Monday Tuesday Wednesday Thursday Friday Total
P4,000 P4,000 P4,000 P4,000 P4,000 P20,000
P12,000 is Accrued P8,000 is NOT Accrued

b. Determine the amount to accrue: P20,000 is total payroll ÷ 5 days =

P4,000 per day x 3 days (Dec. 29 – Dec. 31) = P12,000.
c. Prepare the adjusting entry:
General Journal Page 1
Date Account Title P.R. Debit Credit
2014 Adjusting Entries
Dec. 31 Salaries Expense 12,000.00
Salaries Payable 12,000.00

3. An adjusting entry, such as one for an accrued expense, affects both the
income statement and the balance sheet) as it results in an increase (debit)
to an expense account and an increase (credit) to a liability account. In the
case of an accrued expense such as accrued salaries, the income statement is
affected because an expense account (Salaries Expense) is debited; a
balance sheet account is affected because a liability account (Salaries
Payable) is credited.

4. Affect if the adjusting entry for accrued expenses is OMITTED:

a. Expenses are understated as did not accrue the additional expense of
Salaries Expense.
b. Liabilities are understated as did not accrue the additional liability owed
of Salaries Payable.
c. Net income is overstated as did not accrue the additional expense of
Salaries Expense which would reduce the amount of net income as
expenses decrease income and owner’s equity.
5. TYPICAL STUDENT MISCONCEPTION: Students often want to use the
Cash account when making an adjusting entry for an accrual. This point
needs to be emphasized—Cash is NEVER involved in ANY adjusting entry.

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 The reason is that the Cash account should already be reconciled BEFORE
adjusting entries are made. If an adjusting entry is made to the Cash
account, the account WILL NO LONGER BE RECONCILED to the
balance per the bank statement.

B. Explain accrued interest and the adjustment needed. Helpful hint to

remember what is done with Accruals: The “A” in Accrual means add to
expense or revenue as the adjusting entry will be adding to expenses or to
revenues. Thus, with accrued interest, additional interest will be added to the
interest expense account.
1. How to calculate the due date of a note:

Determine Due Dates of Notes

(a) 90 days from May 8:
Begin with last day of month that the note was dated May 31
Subtract the date of the note May -8
Days in the first month May
23

Add the total days in the following month June 30 84 days

Add the total days in the following month July 31
Days needed in the next month for a total of 90 days Aug 6 Due Date of
Note
Total days of note 90

2. How to calculate interest: Interest (I): The cost of borrowing money that
accumulates with the pages of time or the charge for credit; calculated as
principal (P) x rate (R) x time (T).
Bankers’ interest uses a 360-day year if the note is by days but if notes are by
months, then the denominator will use 12 for months in a year.
3. Accrued interest arises when the accounting period ends BEFORE THE
NOTE REACHES ITS MATURITY DATE. The interest from day of note to the
end of the accounting period is an expense and a liability and must be
recorded with an adjusting entry.
4. Steps to make an adjusting entry for accrued interest:
a. Determine the days from the date of the note to the end of the accounting
period. Refer to the example: Assume that on November 1, 20--, Bluff
City Supply Company borrowed P12,000 on a 90-day, 14% note (the day
after the note is signed is the first day when counting days).
Begin with last day of month that the note was dated Nov. 30
Subtract the date of the note Nov. -1
Days in November Nov.
29

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 Add the total days in December Dec. 31
Total days from the date of the note to end of period 60
b. Calculate the interest from the date of the note to the end of the
accounting period.
Principal x Rate x Time = Interest
P12,000 X 14% X 60/360 = P280
c. Make the adjusting entry:
General Journal Page 1
Date Account Title P.R. Debit Credit
20-- Adjusting Entries
Dec. 31 Interest Expense 280.00
Interest Payable 280.00

5. Affect if the adjusting entry for accrued expenses is OMITTED:

a. Expenses are understated as did not accrue the additional expense of
Interest Expense.
b. Liabilities are understated as did not accrue the additional liability owed
of Interest Payable.
c. Net income is overstated as did not accrue the additional expense of
Interest Expense which would reduce the amount of net income as
expenses decrease income and owner’s equity.

C. Describe other types of accrued expenses—the adjusting entry always involves

a debit to an expense and a credit to a liability.
1. To accrue rent that is owed but unpaid at the end of the accounting
period—debit Rent Expense and credit Rent Payable.
2. To accrue taxes that are owed but unpaid at the end of the accounting
period—debit Taxes Expense and credit Taxes Payable.
3. To accrue utilities that are owed but unpaid at the end of the accounting
period—debit Utilities Expense and credit Utilities or Accounts Payable.

III. Accounting for Accrued Revenue

The accrual of revenue creates assets. Accrued revenue has been earned
in the current accounting period but the cash will NOT BE RECEIVED until
the next period. Accrued revenue is also called an Accrued Asset as the debit
will be to a Receivable (an asset) account when accrued revenue is credited).
Helpful hint to remember what is done with Accruals: The “A” in Accrual
means add to expense or revenue as the adjusting entry will be adding to
expenses or to revenues in this case.

Adjusting entries to accrue revenue will affect both an income statement

(credit to a revenue) and a balance sheet (debit to a receivable) account ALL
adjusting entries effect one Income Statement account and one Balance Sheet
account.

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 A. Explain accrued rent revenue and the adjustment needed.
1. Accrued rent revenue—revenue earned but not yet received.
2. Steps to prepare the adjusting entry:
a. Calculate the amount of rent earned.
b. Prepare the adjusting entry—an adjusting entry for accrued revenues
results in an increase (debit) to an asset account and an increase (credit) to
a revenue:
General Journal Page 1
Date Account Title P.R. Debit Credit
20-- Adjusting Entries
Dec. 31 Rent Receivable 1,200.00
Rent Income 1,200.00

3. Affect if the adjusting entry for accrued revenues is OMITTED:

a. Revenues are understated as did not accrue the additional revenue of
Rent Income.
b. Assets are understated as did not accrue the additional receivable owed to
the company of Rent Receivable.
c. Net income is understated as did not accrue the additional revenue of
Rent Income which would increase the amount of net income as revenues
increase income and owner’s equity.

B. Describe other types of Accrued Revenue:

1. Notes Receivable are covered and should be considered as the mirror
image of Notes Payable. Calculations of due date and interest are identical
for notes payable and notes receivable and where one company’s interest
expense is another company’s interest income. To accrue interest income:
a. Calculate interest earned from the date of the note until the end of the
accounting period—P x R x T.
b. Record the adjusting entry:
Debit—Interest Receivable
Credit—Interest Income
2. Any unbilled revenues such as fees earned or sales made but where the cash
has not yet been received needs to be accrued to accounts receivable.
Normally the name of the receivable account will match the name of the
revenue account as shown in the above examples (i.e. Rent Receivable/Rent
Income; Interest Receivable/Interest Income, etc.) unless the revenue is for the
regular income for the business. The example of fees earned, but not yet
recorded example:
Debit—Accounts Receivable
Credit—Fees Earned

Application
Congratulations! You have just completed Chapter 8.

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 I prepared some activities for you to assess your learning. Please
answer/accomplish the following activity/ies.

MATCHING TYPE

a) unearned revenue
b) cash-basis accounting
c) revenue principle
d) accrual-basis accounting
e) accrued expense
f) matching principle
g) accrued revenue
h) depreciation
i) contra account
j) book value

1. An accounting system that records only transactions in which cash is

received or paid
2. An accounting system that records the impact of a business event as it
occurs, regardless of whether the transaction affected cash
3. An expense that has been incurred but not yet paid in cash
4. A revenue that has been earned but not yet received in cash
5. An asset cost less accumulated depreciation
6. An account that always has a companion account, and whose normal
balance is opposite that of the companion account
7. _______ The basis for recording revenues
8. _______ A liability created when a business collects cash from customers in
advance of doing work for a customer
9. _______ Expense associated with allocating the cost of a plant asset over its
useful life
10. _______ The basis for recording expenses

II. State the effect on net income, total assets and total liabilities if the following
adjustments were not made.
a) Depreciation on buildings, 26,000.
b) Utilities expense incurred but not yet recorded, 2,200.
c) Unearned revenue earned during the period, 3,600.
d) Supplies used during the period, 1,700.
e) Service revenue earned, but not yet collected, 2,400.

Item Effect on Net Income Effect on Total Effect on Total

Assets Liabilities
a)
b)

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 c)
d)
e)

III. Wilson Company initially records all prepaid expenses as expenses and all unearned
revenues as revenues. Given the following information, prepare the necessary
adjusting entries at year-end, December 31, 20X9.

a) On January 3, 20X9, P3,500 of supplies were purchased. A count revealed P900

still on hand at December 31, 20X9.
b) On January 4, 20X9, a P21,000 payment was made to an insurance agency for
three years of insurance.
c) On June 30, 20X9, received nine months rent in advance from a tenant, P8,100.
d) On August 1, 20X9, received six months rent in advance from a tenant, P5,400.

Unit Summary

● Adjusting entries are made prior to the preparation of financial statements to

update certain accounts so that they reflect correct balances as of designated time.
● Adjusting entries normally involve the following: 1. Accruals of income and
expenses. 2. Recognition of depreciation expense and bad debts expense and; 3.
Deferrals of income and expenses (splitting of ‘mixed accounts’)
● The three expense recognition principles are; 1. Matching 2. Systematic and
rational allocation; and 3. Immediate recognition.
● Accounts are also classified into the following; 1. Real Accounts 2. Nominal
accounts and 3. Mixed accounts
● Advanced collections of income are recorded using either the 1. Liability method
or 2. Income method
● Prepayments of expenses are recorded using either the 1. Asset method or 2.
Expense method.

Retake opening Quiz and then check your answers as follows:

1. True
2. False. The cash account NEVER appears as an adjusting entry.
3. True
4. (1) Accrued expense
5. (4) Deferred revenue
6. (3) Deferred expense
7. (2) Accrued revenue
8. (3) Deferred expense
9. (4) Deferred revenue

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10. (2) Accrued revenue
11. (1) Accrued expense

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