FABM 1

Week 5: Accounting Cycle of a Service Business (Part II-A)

What would probably most likely to happen to the accounting of a business entity if: (a) advance payments to
rents, supplies and the likes have expired; (b) rendered service or delivered the goods which payment has
already received prior to the fulfilment of obligation; and (c) expenses already incurred but not yet paid at the
end of accounting period?
 
Those are common transactions and situations a business entity encounters in the day-to-day operation of the
business that can affect the overall performance of the entity. For this week, let us study how do businesses
treat these kinds of situations and how these events affect the accounting records of a business entity.
 
BUSINESS TRANSACTIONS AND THEIR ANALYSIS AS APPLIED TO
THE ACCOUNTING CYCLE OF A SERVICE BUSINESS (PART II-A)
 
In the previous chapters, analyzing business transactions, journalizing, posting to the ledger accounts, and the
preparation of the trial balance were discussed. Analyzing, journalizing, and posting are done all year-round.
Collectively, these steps constitute what is called the recording phase of the accounting process. The
summarizing phase starts with the preparation of the trial balance, where the ending balances of the ledgers are
taken and preparation of the trial balance, where the ending balances of the ledgers are taken and summarized
in a tabular presentation, together with the proper debit and credit balances.
 
This chapter will utilize the example used in week 4 lesson, Del Mundo Landscape Specialist. The result of the
processes discussed in the said lesson is the unadjusted trial balance, which is as follows:

Del Mundo Landscape Specialist

Trial Balance
November 2020

Cash ₱182,250  

Accounts Receivable 7,500  

Supplies 1,000  

Prepaid Rent 21,000  

Prepaid Insurance 24,000  

Vehicles 300,000  

Equipment 54,000  

Accounts Payable   ₱    1,000

Notes Payable   100,000

Unearned Revenues   13,500

Del Mundo, Capital   450,000

Del Mundo, Withdrawals 5,000  

Service Income   37,500

Salaries Expense 4,000  

Utilities Expense 1,500  

Advertising Expense 1,750  

  ₱602,000 ₱602,000
 Why is there a need for adjustments?
Accountants make adjusting entries to reflect in the accounts information on economic activities that have
occurred but have not yet been recorded. Adjusting entries assign revenue to the period in which they earned,
and expenses to the period in which they are incurred. These entries are needed to measure properly the
profit for the period, and to bring related asset and liability accounts to correct balances for the financial
statements.
In short, adjustments are needed to ensure that the revenue recognition and expense recognition principles
are followed thus resulting to financial statements reporting the effects of all transactions at the end of the
period.
Adjusting entries involve changing account balances at the end of the period from what is the current balance
of the account to what is the correct balance for proper financial reporting. Without adjusting entries, financial
statements may not fairly show the solvency of the entity in the balance sheet and the profitability in the
income statement.

·         Revenue recognition principle, revenue is recognized when it is probable that

economic benefits will flow to the enterprise and these economic benefits can be
measured reliably. It shall be measured at the fair value of the consideration received or
receivable. In most cases, revenue is earned in the accounting period when the services
are rendered or the goods sold are delivered.
·         Expense recognition principle is the basis for recording expenses. Expenses are
recognized in the income statement when it is probable that a decrease in future
economic benefits related to a decrease in an asset or an increase of a liability has
arisen, and that the decrease in economic benefits can be me
 

What are Deferrals and Accruals?

Accountants use adjusting entries to apply accrual accounting to transactions that cover more than one
accounting period. There are two general types of adjustments made at the end of the accounting period –
deferrals and accruals.

Each adjusting entry affects a balance sheet account (an asset or a liability account) and an income statement
account (income or expense account).

Deferral is the postponement of the recognition of “an expense already paid but not yet incurred,” or of “a
revenue already collected but not yet earned”. This adjustment deals with an amount already recorded in a
balance sheet account; the entry, in effect, decreases the balance sheet account and increases an income
statement account. Deferrals would be needed in two cases:
1. Allocating assets to expense to reflect expenses incurred during the accounting period
(e.g., prepaid insurance, supplies and depreciation).
2. Allocating revenues received in advance to revenue to reflect revenues earned during
the accounting period (e.g., subscription).

Accrual is the recognition “of an expense already incurred but unpaid”, or “revenue earned but uncollected”.
This adjustment deals with an amount unrecorded in any account; the entry, in effect, increases both a
balance sheet and an income statement account. Accruals would be required in two cases:
1. Accruing expenses to reflect expenses incurred during the accounting period that are unpaid and
unrecorded.
2. Accruing revenues to reflect revenues earned during the accounting period that are uncollected
and unrecorded.
 
The Del Mundo Landscape Specialist case is continued to illustrate the adjustment process. The letters
A, L, OE, OE:I and OE:E are still used to ensure a better understanding of the nature of the accounts
affected.

ADJUSTMENTS FOR DEFERRALS

Allocating Assets to Expenses
 
Entities often make expenditures that benefit more than one period. These expenditures are generally debited to
an asset account. At the end of each accounting period, the estimated amount that has expired during the
period or that has benefited the period is transferred from the asset account to an expense account. Two of the
more important kinds of adjustments are prepaid expenses, and depreciation of property and equipment.

What are Prepaid Expenses?

Some expenses are customarily paid in advance. These expenditures (e.g., supplies, rent and insurance) are
called prepaid expenses. Prepaid expenses are assets, not expenses. At the end of the accounting period, a
portion or all of these prepayments may have expired. The portion of an asset that has expired becomes an
expense. Prepaid expenses expire either with the passage of time or through use and consumption. The flow of
costs from the balance sheet to the income statement is illustrated below:

If adjustments for prepaid expenses are not made at the end of the period, both the balance sheet and the
income statement will be misstated. First, the assets of the entity will be overstated; second, the expenses of
the entity will be understated. For this reason, owner’s equity in the balance sheet and profit in the income
statement will both be overstated. Besides prepaid rent, Del Mundo Landscape Specialist has prepaid expenses
for supplies and insurance, both accounts need adjusting entries.

Prepaid Rent (Adjustment A). Del Mundo makes an adjusting entry to record the expiration of one month of
the three months’ advance rent paid on November 1.

Transaction: Expiration of one month’s rent.

Analysis: Assets decreased. Owner’s equity decreased.
Entries:
  Dr. Cr.

Rent Expense (OE:E) ₱7,000  

Prepaid Rent (A)   ₱7,000

After adjustments, the prepaid rent account has a balance of ₱14,000 (prepayment of ₱21,000 less the ₱7,000
expired portion); the rent expense account reflects the ₱7,000 (₱21,000/3 months) expense for the month.

Prepaid Insurance (Adjustment B). Del Mundo records the expiration of one-twelfth of the entity’s one-year
insurance policy taken last November 5.
 
Transaction:     Expiration of one month’s insurance.
Analysis:          Assets decreased. Owner’s equity decreased.
Entries:

  Dr. Cr.

Insurance Expense (OE:E) ₱2,000  

Prepaid Insurance (A)   ₱2,000

The prepaid insurance account has a balance of ₱22,000 (₱24,000 prepayment less ₱2,000) and insurance
expense reflects the expired cost of ₱2,000 (₱24,000/12 months) for the month.

Supplies (Adjustment C). Del Mundo discovers that he used ₱500 worth of supplies during November. He
makes the necessary adjusting entry.
 
Transaction:     Consumption of supplies.
Analysis:          Assets decreased. Owner’s equity decreased.
Entries:

  Dr. Cr.

Supplies Expense (OE:E) ₱500  

Supplies (A)   ₱500

The asset account supplies now reflect the adjusted amount of ₱500 (November 8 supplies purchase of
₱1,000 less ₱500). In addition, the amount of supplies expensed during the accounting period is reflected as
₱500.

What are Depreciations of Property and Equipment?

 
When an entity acquires long-lived assets such as buildings, service vehicles, computers or office furniture, it is
basically buying or prepaying for the usefulness of that asset. These assets help generate profit for the entity.
Therefore, a portion of the cost of the assets should be reported as expense in each accounting period. Proper
accounting requires the proper allocation of the cost of the asset over its estimated useful life. The estimated
amount allocated to any one accounting period is depreciation or depreciation expense. Three factors are
involved in computing depreciation expense:

1. Asset cost is the amount an entity paid to acquire the depreciable asset.

2. Estimated salvage value is the amount that the asset can probably be sold for at the end of its
estimated useful life.
3. Estimated useful life is the estimated number of periods that an entity can make use of the
asset. Useful life is an estimate, not an exact measurement.

Accountants estimate periodic depreciation. They have developed a number of methods for estimating
depreciation. The simplest procedure is called the straight-line method. The formula for determining the
amount of depreciation expense for each period using this method is:

Asset Cost xx

Less: Estimated Salvage Value (xx)

Depreciable Cost xx

Divided by: Estimated Useful Life xx

Depreciation Expense for each Time Period xx

 
When recording depreciation expense, the asset account is not directly reduced. Instead, the reduction is
recorded in a contra account called accumulated depreciation. A contra account is used to record reduction in
a related account and its normal balance is opposite that of the related account. Use of the contra account –
accumulated depreciation – allows the disclosure of the original cost of the related asset in the balance sheet.
The balance of the contra account is deducted from the cost to obtain the book value of the property and
equipment.
 
Vehicle and Equipment (Adjustments D and E). Del Mundo bought a truck and lawn mowers last November
2 and 3, respectively. Del Mundo allocates a full month’s depreciation for property and equipment bought on or
before the 15th day of the month; otherwise, it is half-month’s depreciation. It is estimated that the truck will
have a useful life of five years and a salvage value of ₱30,000, while the lawn mowers, four-and-a-half years
useful life without salvage value. Del Mundo then computes the depreciation expenses for the truck as ₱4,500 a
month [(₱300,000 - ₱30,000) / 60 months] and for the lawn mowers, ₱1,000 (₱54,000/54 months).

Transaction: Recording depreciation expense.

Analysis: Assets decreased. Owner’s equity decreased.
Entries:

  Dr. Cr.

Depreciation Expense-Vehicles (OE:E) ₱4,500  

Accumulated Depreciation-Vehicles (A)   ₱4,500

     

Depreciation Expense-Equipment (OE:E) ₱1,000  

Accumulated Depreciation-Equipment (A)   ₱1,000

 
After adjustments, the property and equipment section of the balance sheet for Del Mundo Landscape Specialist
will be:

Del Mundo Landscape Specialist

Partial Balance Sheet
November 30, 2020

Property and Equipment (Net):    

Service Vehicle ₱300,000  

Less: Accumulated Depreciation (4,500) ₱295,500

Office Equipment ₱54,000  

Less: Accumulated Depreciation (1,000) ₱53,000

   ₱348,500
 

Allocating Revenues Received in Advance to Revenues

There are times when an entity receives cash for services or goods even before service is rendered or goods
are delivered. When such is received in advance, the entity has an obligation to perform services or deliver
goods. The liability referred to is unearned revenue.
For example, publishing entities usually receive payments for magazine subscriptions in advance. These
payments must be recorded in a liability account. If the entity fails to deliver the magazines for the subscription
period, subscribers are entitled to a refund. As the entity delivers each issue of the magazine, it earns a part of
the advance payments. This earned portion must be transferred from the unearned subscription revenues
account to the subscription revenues account.

Unearned Referral Revenues (Adjustment F). On November 20, Del Mundo received a ₱13,500
prepayment for six future visits. Since Del Mundo completed one of these visits in November, he makes an
adjusting entry to reflect this.
Transaction:     Recognition of income where cash is received in advance.
Analysis:          Liabilities decreased. Owner’s equity increased.
Entries:

  Dr. Cr.

Unearned Revenues (L) ₱2,250  

Service Income (OE:I)   ₱2,250

The liability account unearned revenues reflects the lawn cutting revenues still to be earned, ₱11,250. The
revenues account reflects the amount of lawn cutting already completed and considered as revenues during
the month, ₱2,250 (₱13,500/6 visits).

ADJUSTMENTS FOR ACCRUALS

What are Accrued Expenses?
An entity often incurs expenses before paying for them. Cash payments are usually made at regular intervals
of time such as weekly, monthly, quarterly or annually. If the accounting period ends on a date that does not
coincide with the scheduled cash payment date, an adjusting entry is needed to reflect the expense incurred
since the last payment. This adjustment helps the entity avoid the impractical preparation of hourly or daily
journal entries just to accrue expenses. Salaries, interest, utilities (e.g., electricity, telecommunications and
water) and taxes are examples of expenses that are incurred before payment is made.

Accrued Salaries (Adjusting G). Del Mundo records an expense for the salaries of his part-time employee
who earned ₱1,600 during the last four days of November but will not be paid until December 10.
Transaction:     Accrual of unrecorded expense
Analysis:          Liabilities increased. Owner’s equity decreased.
Entries:

  Dr. Cr.

Salaries Expense (OE:E) ₱1,600  

Salaries Payable (L)   ₱1,600

The liability of ₱1,600 (₱400 daily rate x 4 days) is now correctly reflected in the salaries payable account. The
actual expense incurred for salaries during the month is ₱5,600 (November 26 salaries payment of ₱4,000 +
₱1,600).
Interest is a charge for the use of money over time. Interest expense is matched to a particular period during
which the benefit – the use of borrowed money – is received. The interest is a fixed obligation and accrues
regardless of the results of the entity’s operations. Interest rates are expressed and annual rates, so if interest
is being calculated for less than a year, the calculation must express time as a portion of a year. Interest
calculations usually exclude the day that loans occur and include the day that loans are paid off.

Accrued Interest (Adjustment H). Del Mundo’s ₱100,000 notes payable, which he signed on November 2,
carries an 18% interest rate. Del Mundo uses the formula (for simple interest) below to calculate how much
interest expense accrued during the final 28 days of November.
Interest = Principal x Interest Rate x Length of Time
Interest = ₱100,000 x 18% per year x 28/360 of a year
Interest = ₱1,400

Transaction:     Accrual of unrecorded expense.

Analysis:          Liabilities increased. Owner’s equity decreased.
Entries:

  Dr. Cr.

Interest Expense (OE:E) ₱1,400  

Interest Payable (L)   ₱1,400

 

At the end of November, Del Mundo owed the bank ₱1,400 for interest in addition to the ₱100,000 loan.

What are Accrued Revenues?

An entity may provide services during the period that are neither paid for by clients nor billed at the end of the
period. The value of these services represents revenue earned by the entity. Any revenue that has been
earned but not recorded during the accounting period calls for an adjusting entry that debits an asset account
and credits an income account.
Accrued Service Income (Adjustment I). During the afternoon of November 30, Del Mundo cuts one lawn,
and he agrees to mail the customer a bill for ₱2,500 which he does on December 2. Del Mundo makes an
adjusting entry in accordance with the revenue recognition principle.
Transaction:     Accrual of unrecorded revenue.
Analysis:          Assets increased. Owner’s equity increased.
Entries:
   Dr. Cr.

Accounts Receivable (A) ₱2,500  

Service Income (OE:I)   ₱2,500

 

A total of ₱42,250 (₱37,500 + ₱2,250 + ₱2,500) in consulting revenues was earned by the entity during the
month.

The Del Mundo Landscape Specialist illustration did not tackle entries related to uncollectible accounts.
 
SUMMARY OF ADJUSTING ENTRIES

Account Balances Before Adjustments Adjusting Entry

Type of Adjustment
Balance Sheet Income Statement
Account Debited Account Credited
Account Account

Prepaid Expenses:        
     Asset Method Assets Overstated Expenses Understated Expense Prepaid Expense (A)
     Expense Method Assets Understated Expenses Overstated Prepaid Expense (A) Expense

Depreciation Assets Overstated Expenses Understated Expense Contra Asset

Unearned Revenues:        
     Liability Method Liabilities Overstated Income Understated Unearned Revenues (L) Revenues
     Income Method Liabilities Understated Revenues Overstated Revenue Unearned Revenues (L)

Accrued Expenses Liabilities Understated Expenses understated Expense Payable (L)

Accrued Revenues Assets Understated Income Understated Receivable (A) Revenues

ADJUSTMENTS ARE JOURNALIZED AND POSTED

The adjustment process is a key element of accrual basis accounting. The worksheet helps in the identification
of the accounts that need adjustments. The adjusting entries are directly entered in the worksheet. Most
accountants prepare the financial statements immediately after completing the worksheet. The adjustments
are journalized and posted as the closing entries are made. This step in the accounting cycle brings the ledger
into agreement with the data reported in the financial statements.
 
Illustration. The adjustments pertinent to the Del Mundo Landscape Specialist illustration follow:

Date Account Title and Explanation P.R. Debit Credit

2020        

November 30 Rent Expense 530 ₱7,000  

  Prepaid Rent 140   ₱7,000

         

30 Insurance Expense 540 ₱2,000  

  Prepaid Insurance 150   ₱2,000

         
 30 Supplies Expense 520 ₱500  

  Supplies 130   ₱500

         

30 Depreciation Expense – Vehicles 580 ₱4,500  

  Accumulated Depreciation – Vehicles 165   ₱4,500

         

30 Depreciation Expense – Equipment 590 ₱1,000  

  Accumulated Depreciation – Equipment 175   ₱1,000

         

30 Unearned Revenues 250 ₱2,250  

  Service Income 410   ₱2,250

         

30 Salaries Expense 510 ₱1,600  

  Salaries Payable 230   ₱1,600

         

30 Interest Expense 570 ₱1,400  

  Interest Payable 240   ₱1,400

30 Accounts Receivable 120 ₱2,500  

  Service Income 410   ₱2,500

SAMPLE EXERCISE

Prepare the adjusting entry for Sonnie Ramos Tours under each of the following situations. The last day of the
accounting period is December 31.
1. The payment of the ₱19,000 insurance premium for two years in advance was originally recorded
as prepaid insurance. One year of the policy has now expired.
2. All employees earn a total of ₱10,000 per day for a five-day week beginning on Monday and
ending Friday. They were paid for the workweek ending December 26. They worked on Monday,
December 29, Tuesday, December 30 and Wednesday, December 31.
3. The supplies account had a balance of ₱4,4800 on January 1. During the year, ₱11,000 of
supplies were bought. A year-end inventory showed that ₱6,400 worth of supplies are still on hand.
4. Equipment costing ₱588,000 has a useful life of five years with an ₱80,000 salvage value at the
end of five years. record the depreciation for the year.

GENERALIZATION
Adjusting entries are prepared at the end of an accounting period to unrecorded revenue that has been earned
and unrecorded expenses that have been incurred during the accounting period. Each adjusting entry has the
following characteristics: (1) each entry is recorded at the end of an accounting period; (2) each entry has at
least one balance sheet account and at least one income statement account; and (3) each entry has no cash
account in either the debit of the credit side.