COLLEGE OF ACCOUNTANCY

C-AE13: Financial Accounting and Reporting

First Semester | AY 2020-2021

Module 7

A. Course Code – Title : C-AE13: Financial Accounting and Reporting

B. Module No – Title : M07 – The Need for Adjusting Journal Entries, Part 1
C. Time Frame : 1 week (Week 7) – 6 hrs
D. Materials : Course Syllabus

1. Overview
This learning material provides a discussion of accrual accounting and the adjusting
entries that are usually prepared at the end of the accounting period for deferrals and
depreciation.
You should read clearly and understand well the topics explained herein. It is also
expected that you answer the assigned problems and exercises. Please read Chapter 4 of
your textbook.

2. Desired Learning Outcomes

At the end of the learning session, you should be able to:
a) Discuss accrual accounting and its importance;
b) Analyze closely the deferrals and depreciation;
c) Formulate the correct adjusting journal entries; and,
d) Explain the purpose of each adjusting entry made.

3. Content/Discussion

Lesson 1 – Accrual Accounting

Following generally accepted accounting principles, business entities follow the
accrual basis of accounting, which means that income is recognized or recorded at the
time when it is earned, not when cash is received (revenue recognition principle), and
expenses are recorded or recognized at the time when they are incurred, that is, when
the asset is used up or when the service is utilized, not when they are paid (expense
recognition principle). The financial statements are, therefore, also prepared on the
accrual basis of accounting, with the exception of the Cash Flow Statement, which is
prepared on the cash basis, because this statement shows the actual cash received and
cash paid during a period of time.
Financial statements prepared on the accrual basis are more useful to the users or
stakeholders because they are informed not only of past transactions involving the cash

Faculty: SISINIA T. QUIZON 1 | Page

 COLLEGE OF ACCOUNTANCY
C-AE13: Financial Accounting and Reporting
First Semester | AY 2020-2021

receipts and cash payments, but also of future obligations to pay cash as well as assets
expected to be received in cash in the subsequent accounting period.

Lesson 2 – Adjusting Journal Entries for Deferrals and Depreciation

The use of accrual accounting necessitates that adjusting journal entries be made
at the end of each accounting or reporting period in order to reflect the correct balance of
certain accounts. As you have already learned, the accounting period followed by
business firms is the one-year period, which may either be the calendar year or a fiscal
year. The calendar year follows the calendar, so it always begins on Jan 1 of a year and
ends on Dec 31 of the same year. On the other hand, a fiscal year is a twelve-month period
that does not begin on Jan 1, and therefore, does not end on Dec 31. An example is UA,
which follows the school year as its accounting or reporting period. So, if the academic
year starts on June 1, 2020, it will end on May 31, 2021, not on the same year as the start
of the period.
What is the significance of the accounting period? It is at the end of the accounting
period that the financial statements are prepared, so that the various stakeholders can be
informed about the financial condition as well as the financial performance of the
business during the one-year period. It is incumbent upon the accountant to assure the
stakeholders that what is presented in the financial statements truly and accurately
reflect the correct financial condition and financial performance of the entity. How can
the accountant do this? By carefully analyzing the asset, liability, income and expense
accounts to determine if they are presented at their correct balances at the end of the
period. If there are accounts which do not reflect their correct balances, the accountant
has to make the necessary adjustments to bring these accounts to their correct or updated
balances.
Adjustments are commonly needed for deferrals, accruals, depreciation, and bad
debts.
The root word of deferrals is defer. What does defer mean? It simply means to postpone.
So, a deferral is the postponement of the recognition of (a) an expense which has already
been paid, but which has not yet been incurred or used up (called prepaid expense) or of
(b) an income which has already been received or collected, but which has not yet been
earned (called precollected or unearned income). On the other hand, an accrual is income
which has already been earned but not yet received and recognized (called accrued
income), or an expense which has already been incurred but not yet paid and recorded
(called accrued expense).
Why is there a need to make adjusting entries for these items? As you will learn
later, there are items that span more than one accounting period. Therefore, you have to

Faculty: SISINIA T. QUIZON 2 | Page

 COLLEGE OF ACCOUNTANCY
C-AE13: Financial Accounting and Reporting
First Semester | AY 2020-2021

separate, for example, the income earned in one year from the income earned in another
year, or the expense incurred in one year from the expense incurred in another year. This
conforms to the matching principle, in which only the expenses incurred in a year should
be matched against or deducted from the income earned during the same year. It would
be illogical or a mismatch to deduct salaries incurred in 2019 from the income earned in
2020.
How can you formulate the correct adjusting entry? Of course, you have to analyze
closely the item that needs to be adjusted or updated. Remember, the purpose of an
adjusting entry is to bring certain account balances up to date or to their correct balances.
An adjusting entry always has one balance sheet account and one income statement
account. The balance sheet accounts (assets, liabilities and capital) are real or permanent
accounts, because these accounts are not closed or brought to a zero balance at the end
of the accounting period. On the contrary, the balances of these accounts are carried
forward to the next accounting period, since they do not relate to only one accounting
period. The income statement accounts (income, expenses, gains, losses) as well as the
income summary and drawing accounts are nominal or temporary accounts. These
accounts relate only to the specific accounting period during which the income was
earned or the expense was incurred, and not to any other accounting period; hence, these
accounts are closed or brought to a zero balance at the end of the accounting period. At
the start of the next accounting period, these accounts start with a clean slate or a zero
balance.
Note: Cash is not debited or credited when you make the adjusting entries, so don’t even
consider it.
Let us now analyze closely the following transactions. Again, bear in mind that adjusting
entries are prepared to bring certain account balances up to date at the end of the
accounting period, not during the accounting period.

a) Prepaid expense – an expense that has been paid but not yet incurred. This is an advance
payment.
On June 1, 2020, Express Internet Shop paid P72,000 to the building owner for 12
months’ rental of the space occupied by the shop.
How will you record this transaction? Of course, the journal entry to record it on June
1, 2020 is:

Debit: Prepaid Rent P72,000

Credit: Cash P72,000
To record the advance payment of rent

Faculty: SISINIA T. QUIZON 3 | Page

 COLLEGE OF ACCOUNTANCY
C-AE13: Financial Accounting and Reporting
First Semester | AY 2020-2021

How do you classify Prepaid Rent? It is an asset, right? Because the business expects
to benefit from the advance payment for the next 12 months, from June 1, 2020 until
May 31, 2021, which is already the following year. Assume that the entity follows the
calendar year as its accounting or reporting period. Therefore, its cut-off date for the
preparation of the financial statements is December 31 of each year. Now, analyze
the asset account Prepaid Rent, which actually means advance payment. At the time
of payment on June 1, 2020, the entire P72,000 is an advance payment, an asset, right?
However, at the end of the accounting period, Dec 31, that is, after the business has
used the office space for 7 months, the asset Prepaid Rent is now a mixed account,
meaning, part of it or the P30,000 (the remaining 5 months, Jan 1 to May 31, 2021) is
still an asset or an advance payment. However, the other part, P42,000 (the 7 months
already used, from June 1 until Dec 31, 2020) is no longer an asset or advance
payment, simply because the business has already used the rented space for the past
7 months, so this portion has now become an expense, Rent Expense.
So, what must be done to remove from the recorded asset, Prepaid Rent of P72,000,
the used or the expired portion of P42,000, because this amount is now an expense
that is still included in the asset account? We do it by making the following adjusting
entry on Dec 31, the end of the accounting period:

Debit: Rent Expense P42,000

Credit: Prepaid Rent P42,000
To record rent incurred for 7 months

After this adjusting entry is done, the Prepaid Rent account now has a remaining
balance of P30,000, which represents the correct advance payment as of Dec 31, 2020
for the first five months of the next accounting period, Jan 1 until May 31, 2021. When
the balance sheet as of Dec 31, 2020 is prepared, the asset Prepaid Rent will now be
reported at only P30,000. In the Income Statement for the year ended Dec 31, 2020,
Rent Expense can now be reported at P42,000, the actual expense incurred during the
period.

Going back to the original entry, the asset account, Prepaid Rent, was debited, which
means that the advance payment was originally recorded as an asset. This method of
recording prepaid expenses is called the Asset Method. This is the preferred method of
recording prepaid expenses. Observe: Under this method, what we recorded in the
adjusting entry is the expense, not the asset. Why did we not record the asset in the
adjusting entry? Because the asset is already recorded in the original entry, isn’t it? We

Faculty: SISINIA T. QUIZON 4 | Page

 COLLEGE OF ACCOUNTANCY
C-AE13: Financial Accounting and Reporting
First Semester | AY 2020-2021

don’t have to record what is already recorded. The expense is not yet recorded, that is
why we have to record the expense because it has already been incurred.

The other method of recording prepaid expenses is the Expense Method. The advance
payment is initially recorded as an expense. Using the same example above, the journal
entry on June 1, 2020, upon payment of the P72,000 would be:

Debit: Rent Expense P72,000

Credit: Cash P72,000
To record the advance payment of rent
On Dec 31, 2020, what we should record in the adjusting entry is now the asset Prepaid
Rent in the amount of P30,000, the advance payment for the first 5 months of the next
year, 2021. So, the adjusting entry is:

Debit: Prepaid Rent P30,000

Credit: Rent Expense P30,000
To record the unused advance payment

After the above adjusting entry is made, Rent Expense will now have a remaining balance
of P42,000 equal to the 7 months’ advance payment that has already been used up or
expired. This is what will be reported in the Income Statement for the year 2020, and in
the Balance Sheet, Prepaid Rent can now be reported at P30,000, the advance payment
for the next 5 months from Dec 31, 2020.

Notes:
- Whatever method of accounting is used to record Prepaid Expenses, the effects will
be the same.
- In the Asset Method, the prepaid expense is originally recorded as an asset; that is, at
the time of payment. In the adjusting entry, what you must record is the expense.
- In the Expense Method, the prepaid expense is originally recorded as an expense;
however, in the adjusting entry, what you must record is the asset.

Faculty: SISINIA T. QUIZON 5 | Page

 COLLEGE OF ACCOUNTANCY
C-AE13: Financial Accounting and Reporting
First Semester | AY 2020-2021

b) Unearned or Pre-collected Income – income which has already been received, but not yet
earned. This is an advance collection.

On Sept 1, 2019, ABC Publishing House received P30,000 as advance payment from
ten clients for 6 consecutive monthly subscriptions to the Executive Digest, beginning
on the same month until Feb 29, 2020.

The journal entry to record this transaction is:

Debit: Cash P30,000

Credit: Unearned Subscription Fees P30,000
To record the advance collection

Observe: How did we record the advance collection? How do we classify Unearned
Subscription Fees? This is a liability account. Why is it a liability? Well, the business,
upon receipt of the P30,000 advance payment from its clients has an obligation to
them, right? Is it an obligation to pay back the cash it received, also in the form of
cash? No, not in the form of cash, but in the form of the magazines that the business
has to give to its ten clients for six months, from Sept 2019 until Feb 29, 2020. In other
words, the obligation of the business is to do, not to pay.
At the end of the accounting period, Dec 31, 2019, is the entire amount of P30,000
received on Sept 1 still a total liability? Obviously, it is not; however, part of it is still
a liability, because the business has not yet fully complied with its obligation to give
the magazines for the first two months of 2020, Jan & Feb or P10,000. The other
portion, P20,000, is no longer a liability. Why? Well, the business has sent to its ten
clients the magazines for the last 4 months (Sept to Dec, 2019), isn’t it? So, the business
has settled this portion of its liability to its ten clients. Therefore, of the P30,000
original liability, only P10,000 remains a liability as of Dec 31, 2019; the other portion,
P20,000, has already been earned by the business because it has sent the magazines
to its clients for the last four months of the year, Sept to Dec.
What is the adjusting entry needed to remove the P20,000 from the liability account?
It is:

Debit: Unearned Subscription Fees P20,000

Credit: Subscription Fees Earned P20,000
To record fees earned

Faculty: SISINIA T. QUIZON 6 | Page

 COLLEGE OF ACCOUNTANCY
C-AE13: Financial Accounting and Reporting
First Semester | AY 2020-2021

Analyze the adjusting entry. What did we record? We recorded the portion of the
liability that has been earned; in other words, the income. Why did we record the
income, not the liability? We recorded the income because a portion of the fees has
been earned, but it is not yet recorded. How about the liability? We do not have to
record the liability, because it is already recorded in the original entry, right? To
reiterate, we do not have to record again what is already recorded.
After this adjusting entry has been done, what is the remaining balance of the liability
account, Unearned Subscription Fees? It is now only P10,000, which represents the
fees received for the magazines to be given in the first two months of 2020, the next
accounting period. So, this is the amount of Unearned Subscription Fees that will be
shown in the Balance Sheet as of Dec 31, 2019. And of course, in the Income Statement
for the year 2019, Subscription Fees Earned can now be reported at the amount
actually earned, P20,000.
Let us go back to the original entry. How did we record the advance collection? We
recorded it as a liability in the form of Unearned Subscription Fees. This method of
recording unearned or precollected income is the Liability Method, which is the
preferred method.

The other method of recording unearned or precollected income is the Income or Revenue
Method
Under this method, the advance collection is initially recorded as income or revenue.
Using the same example, the entry on Sept 1 is:

Debit: Cash P30,000

Credit: Subscription Fees Earned P30,000
To record the advance collection

On Dec 31, 2019, the end of the accounting period, the adjusting entry needed is:

Debit: Subscription Fees Earned P10,000

Credit: Unearned Subscription Fees P10,000
To record unearned subscription fees

Analysis: On the date of the transaction, the entire collection was recorded as income. In
the adjusting entry at the end of the period, what was recorded is the portion that has
not yet been earned, which is the liability. The balance of the income account,
Subscription Fees Earned, after adjustment is now only P20,000, the portion that has been

Faculty: SISINIA T. QUIZON 7 | Page

 COLLEGE OF ACCOUNTANCY
C-AE13: Financial Accounting and Reporting
First Semester | AY 2020-2021

actually earned up to Dec 31, 2019. So, this will be reported in the Income Statement. And
because the liability, Unearned Subscription Fees, has been recorded, it can now be
shown in the Balance Sheet on Dec 31, 2019.
Remember: The preferred method of recording advance collections is the liability
method, but whichever method is used, the effects on the financial statements will be the
same.
In the Liability method, the advance collection is originally recorded as a liability, but in
the adjusting entry at the end of the period, what we record is the portion earned, the
income.
In the Income or Revenue method, the advance collection is initially recorded as income
or revenue, but in the adjusting entry, what needs to be recorded is the portion that is
still unearned, the liability.

c) Depreciation
A business entity buys property and equipment items, such as land, buildings,
machinery, computers, furniture and fixtures, and other similar assets for the
purpose of utilizing these assets in order to generate income. These assets are
expected to be of use to the business for a relatively long period of time, that is, for
more than a year. Since the business benefits from the use of these assets, proper
accounting requires that the cost of each of these long-lived assets be allocated over
the periods or years which are expected to benefit from their use. Because these assets
are used throughout the years, their usefulness or utility value decreases (with the
exception of land). The estimated amount allocated to each accounting period is
called depreciation, which is an expense. It represents the decrease in the usefulness
or utility value of the asset.
Depreciation is measured and recorded on a periodic basis, usually at the end of the
period under consideration, and not on a daily basis.
In computing depreciation, the following factors are considered:
1) Cost of the asset – the amount or consideration paid to acquire the asset
2) Salvage or scrap value – the estimated amount at which the asset can probably
be sold at the end of its estimated useful life, that is, when the asset is said to
be fully depreciated
3) Estimated useful life – the estimated number of accounting periods or the
length of time that the entity expects to benefit from the use of the asset. The
estimated useful life is usually expressed in years.

Faculty: SISINIA T. QUIZON 8 | Page

 COLLEGE OF ACCOUNTANCY
C-AE13: Financial Accounting and Reporting
First Semester | AY 2020-2021

The formula to compute depreciation is:

Cost of the asset P60,000
Less: Salvage or scrap value 10,000
Depreciable asset cost P50,000
Divided by estimated useful life 10 yrs_
Depreciation Expense for each period P 5,000

This is the straight-line method of computing depreciation. Other methods of

computing depreciation will be discussed in a higher accounting course.

Assume that on April 1, 2020, the business bought five computers for office use,
P160,000. These have an estimated useful life of five years, after which they have
an estimated scrap value of P10,000. The annual depreciation is computed as
follows:
Cost of the computers P160,000
Less: Estimated scrap value 10,000
Depreciable asset cost P150,000
Divided by estimated useful life 5 years
Depreciation expense for every year of use P 30,000

Question: For the year 2020, can we recognize the total depreciation expense of
P30,000, report this in the Income Statement among the expenses, and deduct it
from the income of the business? The answer is No. Why? Because during 2020,
the computers were not used during the whole year, but only for 9 months,
starting April 1, 2020, the date the computers were bought. So, we recognize
depreciation expense on the computers for 2020 only for 9 months. Compute the
depreciation for 9 months: 9/12 x P30,000 = P22,500. Now, we are ready to record
depreciation. The adjusting journal entry to record the depreciation on the five
computers for 9 months on Dec 31, 2020 is:

Debit: Depreciation Expense-Office Equipment P22,500

Credit: Accumulated Depreciation-Office Equipment P22,500
To record depreciation for 9 months on the computer units

Faculty: SISINIA T. QUIZON 9 | Page

 COLLEGE OF ACCOUNTANCY
C-AE13: Financial Accounting and Reporting
First Semester | AY 2020-2021

In the following year, 2021, the computers will now be used during the whole year.
So, depreciation to be recorded on Dec 31, 2021 should now be for the entire year
or 12 months. The adjusting journal entry at the end of 2021 would be:

Debit: Depreciation Expense-Office Equipment P30,000

Credit: Accumulated Depreciation-Office Equipment P30,000
To record one year depreciation on the computers

Notice that the account credited in the adjusting entry to record depreciation is
Accumulated Depreciation. What does this account represent? How is it
classified? This account represents the total decline or decrease in the usefulness
or utility value of the related asset from the time that it was acquired up to the
balance sheet date. Its balance increases each time depreciation is recorded. It is a
contra-asset account; that is why it is credited for increases. Needless to say, its
normal balance is credit.

Note: Depreciation is recognized only from the time the asset is acquired, and it
pertains to only one accounting period.
If no salvage or scrap value is given, then it is zero; do not assume an estimated
salvage or scrap value.
Accumulated Depreciation increases every accounting period, because the
recorded depreciation in each year is carried forward to the following year and it
is added to the account balance. It is presented in the Balance Sheet or Statement
of Financial Condition as a deduction from the related long-lived asset. The
resulting amount is the book value of the asset. To repeat, book value is the excess
of the asset cost over its accumulated depreciation. As the Accumulated
Depreciation account balance increases, the book value of the related asset
decreases.
Depreciation Expense and Accumulated Depreciation are equal in amount only on
the first year of recording depreciation.

Faculty: SISINIA T. QUIZON 10 | Page

 COLLEGE OF ACCOUNTANCY
C-AE13: Financial Accounting and Reporting
First Semester | AY 2020-2021

Balance Sheet presentation:

Dec 31, 2020 Dec 31, 2021
Office Equipment P160,000 P160,000
Less: Accumulated Depreciation 22,500 52,500
Book value P137,500 P107,500

4. Progress Check
a) What are adjusting entries? Why are they needed?
b) Discuss the two kinds of deferrals.
c) What are the methods of recording these deferrals? Briefly explain each method.
d) What is depreciation? What is its main purpose?

5. Assignment (Optional)
Answer end-of- Chapter 4 problems 7 & 8, 9 except Item a, & 10 except Items b & f.

6. Assessment
There will be one assessment problem in Module 8 for all the topics in Modules 7
& 8.

7. References

Manuel, Zenaida Vera-Cruz (2018) 21st Century Accounting Process, Basic Concepts and
Procedures, Manila, Philippines: Zenaida Vera-Cruz Manuel.

Ballada, Win. (2020) Basic Financial Accounting and Reporting, Cavite, Philippines:
Dom Dane Publishers & Made Easy Books.

Cabrera, Ma. Elenita B. & Cabrera, Gilbert Anthony B. (2018) Financial Accounting and
Reporting,Manila, Philippines: GIC Enterprises & Co., Inc.

Ferrer, Rodiel C. & Millan, Zeus Vernon B. (2017) Fundamentals of Accountancy,

Business and Management, Part 1, Baguio City, Philippines: Bandolin Enterprise.

Warren, Carl S., Reeve, James M., & Duchac, Jonathan E. ((2015) Accounting 25th
Edition, Pasig City, Philippines: Cengage Learning Asia Pte Ltd (Philippine Branch).

Faculty: SISINIA T. QUIZON 11 | Page

 COLLEGE OF ACCOUNTANCY
C-AE13: Financial Accounting and Reporting
First Semester | AY 2020-2021

Gilbertson, Claudia B., Lehman, Mark W., & Gentene, Debra H. (2017) Century 21
Accounting Multi-column Journal 10th Edition, Boston, MA 02210 USA: Cengage
Learning.

Wild, John; Kwok, Winston; Venkatesh, Sundar; Shaw, Ken W. & Chiappetta,
Barbara. (2016) Fundamental Accounting Principles 2nd Edition, 2 Penn Plaza, New York:
McGraw-Hill Education.

Faculty: SISINIA T. QUIZON 12 | Page