Professional Documents
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GATHER THE
DOCUMENTS
PREPARE A TRIAL
BALANCE
END OF THE
ACCOUNTING PERIOD?
NO
YES
PREPARE A WORKSHEET
FOR ADJUSTMENTS AND
FINANCIAL STATEMENTS
PREPARE AN ADJUSTED
TRIAL BALANCE
PREPARE FINANCIAL
STATEMENTS
PREPARE A POST
CLOSING TRIAL BALANCE
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TIMING ISSUES
It cannot be helped that sometimes revenues and expenses transcend more than one accounting period. For example: a one-year
insurance paid in advance on March 1, 2017 should be expensed only for ten months in 2017 (March to December) and for two
months in 2018 (January to February). Another example: started a consultancy firm and received an advance consultation fee of
P30,000 good for three months starting December 1, 2017. Only one-month revenue of P10,000 should be recognized in 2017 and
the remaining P20,000 in 2018.
Adjusting entries – entries prepared at the end of the accounting period to update some accounts and ensure their accuracy before
preparing the financial statements.
Accrual Principle
Under the cash basis, if the business rendered a service to a client in 2017 but cash was collected only in 2018, the service income
will be recognized in 2018. Or, assume the business paid in 2017 for insurance applicable for 2018, the insurance expense will be
recognized in 2017. Under the accrual basis, income is recognized as earned at the time service is rendered and this is recorded
regardless of when cash is collected. In like manner, expense is recognized as incurred at the time service is received or used up
regardless of when cash is paid. This is also referred to as the matching principle. The GAAP favors the accrual basis of fairly
measuring income and expenses, thus adjustments should be made along this rule.
Illustrations
Assume that Healthway Clinic referred a patient for laboratory examination to Makati Diagnostic Laboratory and for which it is entitled
to a commission or referral fee of P500. This amount was not yet collected as of December 31, the end of its accounting period.
From the viewpoint of Healthway Clinic, assets should be adjusted to include Referral Fee Receivable to increase assets and a
Referral Fee Income to increase owner’s equity. Thus:
From the viewpoint of Makati Diagnostic Laboratory: record a decrease in owner’s equity in Referral Fee Expense and increase
liability in Referral Fee Payable.
Take note of two new accounts: Accrued Income called Referral Fee Receivable which is a current asset representing account to
be collected and Accrued Expense called Referral Fee Payable which is a current liability representing account to be paid.
Healthway Clinic issued a 45-day, 18% note for a P100,000 cash loan received from RP Finance. The note is dated December 1,
2018 and since 30 days has lapsed as of December 31, this should be recognized as an expense (interest expense) and a liability
(interest payable) should be recorded since no payment was as yet made for this.
What will happen if accrued expense and accrued income are not recognized? The following tables will show the effects on the
financial statements:
Viewpoint of Healthway:
Viewpoint of RP Finance:
Prepaid Expense
A prepayment is the opposite of accrual. A prepaid expense represents advance payment for service to be received (expense to be
incurred in the future).
Asset Method: The advance payment is recorded as an asset Prepaid Expense. This represents a right to receive service for cash
already paid. At the end of the year, if there is already an expired portion or if service has been received, transfer this amount from
the already expired portion or if service has been received, transfer this amount from the prepaid expense account to the expense
account.
Illustration
Assume Marciano Drugstore issued a check on November 1 for P9,000 as advance payment for six months store rental.
At year end, an adjustment will be made to correct the Prepaid Expense account and recognize the rent expense for two months.
At year end, an adjustment will be made to correct the Rent Expense account.
Note that the balances of Cash in Bank, Rent Expense and Prepaid Rent are the same regardless of the method used.
Preferable Method: The asset method is preferable since it follows the conceptual flow of cost. Anything with future discernible
benefit should first be recognized as asset until a portion is expired then it is recorded as expense.
Liability Method: The advance collection is credited to a liability account called Unearned or Deferred Revenue. It is a liability of
the company to render service for cash that was advanced by the client. If, before the end of the year, service has been rendered,
decrease the liability and increase the revenue account.
Illustration
Assume that on October 1, Healthway Clinic sublet a building to Mercurio Drugstore who paid P60,000 rent in advance for four
months. Entry on this day:
From October 1 to December 31, since the tenant has already used up the building space for three months or P45,000,
this amount should be recognized as income. To adjust:
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Income Method: An alternative method is to record the advance collection immediately with a credit to an income account. Using
the same illustration:
Since the business has rendered service for three months only, then income should only be P45,000 with P15,000 recognized as
Unearned Income for the unearned portion. Thus:
Note that whatever is the method used, you should come up with the same balances for the income P45,000 and for
the unearned income P15,000.
Preferable Method: The liability method is preferred, again because it follows the conceptual flow of recognizing first the liability
until the amount is earned.
Bad Debts
Losses from uncollectible accounts are considered part of the risk the entity assumes and should therefore be considered part of
operating expenses. There are two methods of recognizing bad debts: the direct write off method and the allowance method.
Direct Write Off Method: This method recognizes bad debts expense only when it is certain that the company will not be able to
collect the account anymore.
Illustration
Assume Carla Auto Repair recorded P80,000 accounts receivable for services rendered in 2017 with collections of P50,000. The
following year, another P120,000 were recorded for account services rendered with collections of P60,000 from previous and present
accounts. Mr. Decena, a 2017 customer who owed the company 10,000 became insolvent in 2018 and could not pay his account
anymore. The bookkeeper cancelled his account as authorized by the business owner and prepared the following entry, in 2018,
recording an expense for the bad account of 2017:
Bad Debts Expense will be shown in the operating expense section of the income statement.
Allowance Method: Provides for bad debts or doubtful accounts during the period the sale of service is recorded. The doubtful
accounts are determined by estimation based on the company’s past experience or the experience of other companies within the
same business industry. To arrive at an estimate, a certain percentage or ratio is derived between the bad debts expense of the
company and its outstanding receivable for the previous year.
Illustration
Using the same illustration but assume that based on past experience on bad debts, it is estimated that 5% of its outstanding
accounts receivable will be doubtful of collection. The entries will appear, thus:
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Date Particulars F Debit Credit
2017
Jul 31 Accounts Receivable 80,000
Service Income 80,000
Billed clients for services
rendered.
2018
May 10 Accounts Receivable 120,000
Service Income 120,000
Billed clients for services rendered.
Note that the real accounts are brought forward but not the nominal accounts.
Depreciation
Properties such as land, building, furniture and machinery are used for a long period of time to support business operation. Except
for land, the utility value (ability to yield service) will decrease over time because of wear and tear, obsolescence (becomes outdated)
and inadequacy (cannot cope up with demands for more volume or better quality of service). Depreciation is therefore recognizing
part of the asset as an expense because of its decreasing utility value.
Illustrations
Cost of machine is P300,000 acquired January 2015, and can be used for five years. Table analyzing decline in utility value will appear
as follows:
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Depreciation Expense in the Income Statement
In the Statement of Financial Position:
Asset Cost – Accumulated Depreciation = Net Book Value
There are three factors to be considered in determining depreciation: cost, useful life and scrap value or disposal value at the end of
the useful life. The formula is:
Assume that Carla Motor Repair Service has the following accounts, among others, in its trial balance as of December 31, 2017, the
end of its accounting period:
Debit Credit
Machinery & Equipment ₱ 750,000
Accumulated Depreciation - Machinery & Equipment ₱ 125,000
Building 1,000,000
Furniture & Fixtures 300,000
Additional Information:
1. The machinery and equipment were acquired Jan. 1, 2016 with an estimated life of 6 years, no scrap value.
2. The building was newly constructed on March 1, 2017 with an estimated life of 10 years, scrap value of P100,000.
3. The furniture and fixtures were acquired January 1, 2017 with a useful life of 10 years, scrap value of P30,000.
Building ₱ 1,000,000
Less: Accumulated Depreciation 75,000
Book Value ₱ 925,000
Take note of another contra asset account Accumulated Depreciation, which is a decrease in the cost of the asset. Book value,
which is the difference between the cost and the accumulated depreciation, represents the unexpired cost or the net utility value of
the asset. Also, note that the accumulated depreciation for the machinery and equipment is a cumulative figure of the 2016 balance
(which means that depreciation was already provided for that year in the amount of P125,000) and the 2017 provision of P125,000
while the depreciation expense in the income statement represents only the current provision for the year 2017 which is P125,000.
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WORKSHEET
It is a columnar paper where the first two columns are provided for the trial balance, which is the starting point for the preparation
of the financial statements. The next two columns are for the adjustments and from which adjusted balances are determined. From
the adjusted balances, the income statement and the statement of financial position are prepared. A ten-column worksheet has the
following money columns:
Trial Balance Adjustments Adjusted Trial Balance Income Statement Financial Position
Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
Sometimes, the column for the adjusted trial balance is omitted in which case we have an eight-column worksheet.
WORKSHEET ILLUSTRATED
A trial balance and additional information for adjustments appear below for Carla Auto Repair Shop after one year of operation:
Debit Credit
Cash on Hand ₱ 25,000
Cash in Bank 45,000
Accounts Receivable 49,000
Notes Receivable 30,000
Office Supplies 600
Prepaid Insurance 15,000
Machinery & Equipment 150,000
Furniture & Fixtures 25,000
Accounts Payable ₱ 26,000
Notes Payable 50,000
Carla, Capital 132,850
Carla, Drawings 5,000
Repair Income 275,000
Referral Income 15,000
Salaries Expense 45,000
Rent Expense 55,000
Taxes & Licenses Expense 7,250
Utilities Expense 46,750
Interest Expense 250
Totals 498,850 498,850
Computations:
1. 10% x P49,000 = P4,900
2. Expired portion is from September to December or 4 months therefore P15,000 x 4/6 = P10,000 (Asset Method was used)
3. Decrease Supplies by P400. (Asset Method was used)
4. Accrue interest from November 16 to December 31 or 45 days.
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P30,000 x 12% x 45/360 = P450
5. Depreciate the machinery from April 1 to December 31 or 9 months.
P150,000-P50,000 = P10,000 x 9/12 = P7,500
10
6. Depreciate the furniture and fixtures for one year since it was acquired on January 1:
P25,000-2500 = P2,250
10
7. Accrue interest from December 1 to 31: P50,000 x .18 x 30/360 = P750
8. P50,000 x 3% = P1,500 taxes payable
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Steps in preparing the worksheet:
1. Enter the worksheet heading which consists of three lines:
2. Enter the column headings, providing the first two money columns for the trial balance, and the next two money columns
for each of the following: Adjustments, Adjusted Trial Balance, Income Statement and Statement of Financial Position.
3. Copy the trial balance in the first two money columns. Do not copy the totals. Prove the trial balance by footing again. Rule
and double rule the totals.
4. Enter the adjustments in the next two money columns. If the account to be adjusted exists in the trial balance, just write
the figure alongside the account. If no account exists in the trial balance, then create an account below it. Identify each
adjustment by using key letters or numbers for easy reference. Prove the equality of what you did by footing the debit and
credit columns, then rule and double rule.
5. Take the adjusted balances of all accounts and extend to the Adjusted Trial Balance column. Accounts with no adjustments
are extended in their original amounts.
A debit account in the trial balance with a debit adjustment is added (refer to interest expense) while a credit adjustment
is deducted to arrive at the adjusted balance (refer to prepaid insurance). If the result is a debit, extend to the debit column
of the adjusted trial balance, if a credit, extend to the credit column of the adjusted trial balance. A credit account in the
trial balance with a credit adjustment is added while a debit adjustment is deducted to arrive at the adjusted balance. Again,
extend the balance to the debit or credit side of the adjusted trial balance.
All new accounts below the trial balance are extended directly to appropriate column of the adjusted trial balance.
6. From the adjusted balances, extend all income and expense accounts to the income statement column. Total the debit
column and credit column. The debit total represents the expenses and the credit total represents the income. If the credit
total is more than the debit total, the difference represents a net income from operation and should be placed on the debit
side of the income statement and extended to the credit side of the balance sheet. Using the illustrated worksheet:
Income Statement
Sub total ₱ 181,550 ₱ 290,450
Net Income 108,900
Totals ₱ 290,450 ₱ 290,450
7. Extend all assets, liabilities, capital and drawing accounts to the financial position column. Subtotal the debit and the credit
columns. Entering the net income on the credit side balances the total debit and the total credit. Using the worksheet, it
will appear thus:
If the debit total in the income statement column is more than the credit total, the result is a net loss figure which should
be entered on the credit column. This in turn is extended to the debit column of the balance sheet. Care should be taken in
preparing the worksheet.
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