2.

Financial Statement Preparation, Analysis, and Interpretation

(ACCTG 101 – CHAPTER 5 – ADJUSTING JOURNAL ENTRIES)

The need for adjustments

Adjusting Entries = are entries used to update the accounts prior to the preparation of Financial
Statements because they affect more than one accounting period. All adjusting entries affect at least one
income statement account (nominal) and one statement of financial account (real account). The accounts
affected are adjusted so that there will be no overstatement or understatement of balance sheet items and
income statement items.

2 Methods of Keeping the Books of Accounts:

 Cash Basis – income is recorded when the cash is received (no matter when it is earned) and
expenses are recognized when cash is paid (no matter when it is incurred). This is
commonly used by small businesses. It is not compliant with GAAP and is much
simpler than accrual basis but its financial statement results can be very misleading in
the short run.

 Accrual basis – Income is considered to be earned in the period of sale (that is, title to the
merchandise or goods passes on to the buyer or when the service has been rendered) even if
cash has not been received yet while expenses are considered to be incurred even if no cash has
been paid yet. GAAP require that a business use the accrual basis. Virtually all large companies
use this method.

__________________________________________________________________________________
ITEMS CONCERNED ACCRUAL-BASIS CASH-BASIS
----------------------------------------------------------------------------------------------------------------------------------------
1. Revenue is recognized in the period When earned When received
2. Expense is recognized in the period When incurred When paid

The cash basis records only cash transactions making the CASH account a crude measure of how well a
business is performing. The accrual basis gives a more accurate picture of profit or loss because it includes
all revenues and expenses, paid or unpaid.

Transaction1. Cash received from a customer for the reservation of a hotel room for two weeks.
Answer1: in Accrual-Basis accountant in Cash-basis accountant

Cash xxx Cash xxx

Unearned Income/Revenue xxx Income/Revenue xxx
To record advance payment from customer To record income from customer reservation

*once the service is rendered /revenue is earned,

above entry is then adjusted correspondingly:

Unearned Income/revenue xxx - no succeeding entry

Revenue/Income xxx

Transaction2. One-year insurance premium paid for the insurance of a house.

Answer2 : in Accrual-Basis accountant in Cash-basis accountant

Prepaid Insurance xxx Insurance Expense xxx

Cash xxx Cash xxx
to record advance payment of house insurance to record payment of house insurance

*once expense is incurred/used, above entry

Is then adjusted correspondingly - no succeeding entry
‘
 YEAR–END ADJUSTMENTS
1. Prepaid Expenses
/ Unexpired Expenses / deferred expenses (a.k.a. prepayments / advance payments)
- Current Asset
- are expenses paid before they are incurred / consumed / used up / utilized or expired.
(Ex: advance payments for supplies, rent, utilities; and others that are still to be consumed).

- Two (2) ways/ methods to record Prepaid Expenses:

1. Asset Method / Balance Sheet Method 2. Expense Method / Income Stm Method

Journal Entry upon payment: Journal Entry upon payment:

Prepaid Expense xxx Expense account xxx
Cash xxx Cash xxx
To record advance payment To record advance payment

Adjusting entry at the end of the acctg. period Adjusting entry at the end of the acctg. period
Expense xxx Prepaid Expense xxx
Prepaid Expense xxx Expense xxx
To record the expired expense acct To record the unexpired expense

Note: the amount on the adjusting journal entry Note: the amount on the adjusting journal entry
represents the used / expired portion of the represents the unused / unexpired portion of the
prepayment prepayment

Example1: Example1:

Supposed we order painting supplies and make Supposed we order painting supplies and make
advance payment though the item is not yet advance payment though the item is not yet
received/ used / consumed at P1,500: received/ used / consumed at P1,500:

Initial Entry at the time of cash payment:
Jan 1 Unused Painting Supplies 1,500
Cash 1,500
To record prepayments made or
Prepaid purchases
Supposed at the end of the month, 60% of the
supplies have been used and P600 remained
unused. The P900 must then be recognized as
expense since it has already been used.
Adjusting Entry:
Jan 31 Painting Supplies Expense 900
Unused Painting Supplies 900
To record painting supplies used
(note: our goal is to transfer the used portion of
the painting supplies paid into an expense.
Thus, adjusting entry should:
1. recognize the expense (debit expense acct)
2. decrease the asset initially recorded (since
some of it has already been used)
Initial Entry at the time of cash payment:
Jan 1 Painting Supplies Expense 1,500
Cash 1,500
To record advance payments/prepaid
purchases made
Supposed at the end of the month, 60% of the
supplies have been used and P600 remained
unused. If a portion of the advance payment
remains unexpired, we have to convert the
remaining unexpired/unused portion into asset.
Adjusting Entry:
Jan 31 Unused Painting Supplies 600
Painting Supplies Expense 600
To record unused painting supplies
(note: our goal is to convert the unused portion of
the painting supplies paid into an asset.
Thus the adjusting entry should:
1. recognize the unused portion, (debit asset
account)
2. decrease the balance (credit the expense
account)
NOTICE: that the resulting balances of the
accounts under the two (2) methods are the
same:
Cash paid : P1,500
Painting Supplies Expense : P 900
Unused Painting Supplies : P 600

Painting Supplies Painting Supplies Expense

(Asset Method /Balance Sheet acct) (Expense Method / Income Stm account)
Debit Credit Debit Credit
Increases an asset decreases an asset decreases an asset increases an asset

Initial 1,500 initial 1,500

Adjusting (used) 900 adjusting (unused) 600
Correct bal. 600_ correct bal 900

=the balance is the unused /unexpired portion = the balance is the used/consumed portion/
corrected expense at the end of the
accounting period

Note: In real practice you decide which to use,

as long as the asset account balance is equal to
the unexpired or unused cost as of the balance
sheet date. Both require adjusting entries at the
end of the accounting cycle. However, during
exams, you will be asked either of the methods.

Activity1: Activity1:

On April 30, 2016, XCo. Paid P36,000 worth of On April 30, 2016, XCo. Paid P36,000 worth of
insurance premium for 2 years. Give Adjusting insurance premium for 2 years. Give Adjusting
Journal entry on June 30, 2016 Journal entry on June 30, 2016

2016 2016
Apr30 Prepaid Insurance 36,000 Apr30 Insurance Expense 36,000
Cash 36,000 Cash 36,000
To record payment of 2-yr insurance To record payment of 2-yr insurance

Jun30 Insurance Expense 3,000 Jun30 Prepaid Insurance 33,000

Prepaid Insurance 3,000 Insurance Expense 33,000
To record the expired insurance To record the unexpired insurance
(36,000/24 x 2mos = P3k) (36,000/24 x 2mos = P3k
36,000 – 3,000 = 33k or
36,000/24 x 22mos = 33k)

Activity2: On July 4, the business paid P1,800 Activity2: On July 4, the business paid P1,800
for a 1-yr insurance policy effective July1. On for a 1-yr insurance policy effective July1. On July
July 31, the end of the accounting period an 31, the end of the accounting period an adjusting
adjusting entry is prepared. entry is prepared.

July 4 Prepaid Insurance 1,800 July 4 Insurance Expense 1,800

Cash 1800 Cash 1800
To record payment of annual insurance policy To record payment of insurance premium

July 31 Insurance Expense 150 July 31 Prepaid Insurance 1,650

Prepaid Insurance 150 Insurance Expense 1,650
To record expired insurance To record unexpired insurance
Premium for one month premium for 11 months
(1800/12 x 1 = 150) (1800/12 x 11 = 1,650)
Activity3: On Sept.1, 2016, XCo. Paid a 1-yr Activity3: On Sept.1, 2016, XCo. Paid a 1-yr
advance rent for P30,000. Give the adjusting advance rent for P30,000. Give the adjusting
journal entry on Dec.31, 2016 journal entry on Dec.31, 2016

Sept.1 Prepaid Rent 30,000 Sept.1 Rent Expense 30,000

Cash 30,000 Cash 30,000
Paid rent for 1year Paid rent for 1year

Dec31 Rent Expense 10,000 Dec31 Prepaid Rent 20,000

Prepaid Rent 10,000 Rent Expense 20,000
To record expired rent To record unexpired rent
(30,000/12 x 4mos. = 10,000) (30,000/12 x 8mos = 20,000)

Activity4: Supplies account showed a balance Activity4: Supplies account showed a balance
of P4,000. Supplies used during the year of P4,000. Supplies used during the year amounted
amounted to P2,300. Give the adjusting journal to P2,300. Give the adjusting journal entry on
entry on Dec.31, 2016. Dec.31, 2016.

Adjusting entry: Adjusting entry:

Dec.31 Supplies Expense 2,300 Dec.31 Supplies Expense 2,300
Supplies 2,300 Supplies 2,300
To record supplies used for the year To record supplies used for the year

There is no computation necessary because the There is no computation necessary because the
P2,300 supplies used during the year was already P2,300 supplies used during the year was already
given in the problem. given in the problem.

Activity5: Supplies account on January 1, Activity5: Supplies account on January 1,

2016, showed a balance of P8,000. On Dec.31, 2016, showed a balance of P8,000. On Dec.31,
2016, supplies on hand amounted to P3,500. 2016, supplies on hand amounted to P3,500.

Adjusting entry: Adjusting entry:

Dec.31 Supplies Expense 4,500 Dec.31 Supplies Expense 4,500
Supplies 4,500 Supplies 4,500
To record supplies used for the year To record supplies used for the year
(8,000-3,500 = 4,500) (8,000-3,500 = 4,500)