CHAPTER 6

ADJUSTING ENTRIES

Adjusting entries are prepared at the end of accounting period to bring records or balances of
accounts updated and to properly match income against expense during the period. It is called “ end of the
period adjustments”.

The following are the usual items which require adjusting entries at the end of an accounting
period:
1. Accruals
a. Accrued Expense
b. Accrued Income
2. Deferrals
a. Prepayment of Expenses
b. Pre-collection of Income
3. Provision for Depreciation of Fixed Assets
4. Provision on for Estimated Doubtful Accounts (Bad Debt)
5. Adjustments on Inventories
6. Correction of erroneous Journal Entries

ACCRUALS

a. Accrued Expense- This is an expense already incurred by the business but not yet paid at the end of
the period. To recognize the expense at the end of the period though not yet paid , adjusting entry shall
be prepared as follows:

Expense xx
Accrued Expense xx

Failure to prepare the adjusting entry will overstate the Net Income, Liability will be understated
while Owner’s
Equity will be overstated.

Example: Office rental for the month of December were incurred but not yet paid as of
December
31,2013, P 5,000

The adjusting entry that should be prepared on December 31, 2013 to record the Rent Expense
incurred and
recognize the corresponding liability account is as follows:

Rent Expense P 5,000

Accrued Rent expense P 5,000
To set-up unpaid rental for the month of December 2013.

b. Accrued Income- This is an income already earned by the business but not yet collected at the end of
the period. To
record the income actually earned during the period though not yet collected , an adjusting entry
should be
prepared as follow:

Accrued Income xx
Income xx
 Failure to prepare the adjusting entry will understate the Net Income, Assets as well as the Owner’s
Equity.
Example: The business received a P15,000 6%-90 day note from a customer dated December
5, 2013.

The adjusting entry that should be prepared on December 31, 2013 to record the interest income
actually
earned from December 5 to December 31 and to recognize the corresponding receivable account
will be as
follows:

Accrued Interest Income P 65

Interest Income P 65
To record interest earned from Dec 5 to Dec 31.
(15,000 x 6% x 65/360)

DEFERRALS:

Prepayments of Expenses

Prepaid Expense- This is an expense already paid but not yet incurred. There are two methods that can
be used in
recording prepayments:

1. Expense Method-under this method, an expense account is debited upon payment of the
prepaid expense.
2.Asset Method- under this method, an Asset Account is debited upon payment of a prepaid
expenses.

The adjusting entries that should be prepaid at the end of accounting period to split-up the real
account and
nominal account are as follows:

If Expenses Method is used:

Prepaid Expense xx
Expense xx

If Asset Method is used:

Expense xx
Prepaid Expense xx

Example: On May1, 2013 a one-year comprehensive insurance coverage on the service vehicle
was paid, P
12,000.
Expense Method:

Using the Expense Method, the entry to record the prepayments on May 1, 2013 is as follows:

Insurance Expense P12,000

Cash P 12,000
To record payment of one-year insurance
coverage effective May 1, 2013 to May 1, 2014.
 By December 31, 2013, adjusting entry to set-up the asset portion ( Insurance Account)
representing 4
months period covering January 1, 2014 to May 1, 2014, shall be prepared as follows:

Prepaid Insurance P 4,000

Insurance Expense P 4,000
To record the unexpired portion of insurance
premium.

With the above adjusting entry, Insurance Expense will have a balance of P8,000 while Prepaid
Insurance will
have P4,000 balance as of December 31, 2013.

Asset Method

Using the Asset method, the entry to record the prepayments on May 1, 2013 is as follow:

Prepaid Insurance P 12,000

Cash P 12,000
To record payment of one-year insurance
coverage effective May 1, 2013 to May 1, 2014.

On December 31, 2013 adjusting entry to recognize the expense portion representing 8- months
period from
May 1, 2013 to December 31, 2013 should be prepared as follows:

Insurance Expense P 8,000

Prepaid Insurance P 8,000
To record the expired portion of the insurance
premium

With the above adjusting entry, Prepaid Insurance account will be reduced to its correct balance
of P4,000
while Insurance Expense will have a balance of P 8,000.

Pre-collection of Income

Pre-collected Income- is an income already collected by the business but not yet earned at the end of
the period.

Like the prepaid expenses, there are two methods of accounting for pre-collections , as follows:

1 . Income Method- Under this method, an Income account is credited upon collection or receipt
of cash.

2.Liability Method- Under this method, a Liability account is credited upon collection or receipt
of cash.

The adjusting entries that should be prepaid at the end of accounting period to split-up the real
account and
nominal account are as follows:

If Income Method is used, the adjusting entry will be as follow:

Income xx
 Unearned Income xx

Failure to prepare the above adjusting entry will overstate the Net Income, understate the liability
while
Owner’s Equity will be overstated.

If Liability Method is used, the adjusting entry will be as follow:

Unearned Income xx
Income xx

Failure to record the above adjustment will understate the Net Income, overstate the liability while
Owner’s
Equity will be understated.

Example: On Nov.1, 2013, the company received P 15,000 from customer for services to be
rendered during the month of November, December and January.

Income Method:

Using the Income Method, the entry to record the receipt of cash on Nov. 1, 2013 is as follows:

Cash P 15,000
Service Income P 15,000
To record receipt of service Income
to be rendered for Nov.
Dec. & Jan.

By December 31, 2013, adjusting entry to set-up the unearned or liability portion should be
prepared, as
follows:

Service Income P 5,000

Unearned Service Income P 5,000
To record the unearned portion of the
service income collected in advance

With the above adjusting entry, Service Income will have a balance of P 10,000 representing the
November &
December earned Service Income while Unearned Service Income will have a balance of P 5,000
representing the month of January advance collection.

Liability Method

Using the liability method, the entry to record the collection of the 3 month Advance Service
Income on Nov.
1 is as follows:

Cash P 15,000
Unearned Service Income P 15,000
To record the collection of Service
Income for the month of Nov., Dec. & Jan
 On December 31, 2013, adjusting entry should be made to record the earned Service Income
representing the month of November and December as follows:

Unearned Service Income P 10,000

Service Income P 10,000
To record the earned portion of the Service
Income collected in advance.

With the above adjusting entry, Unearned Service Income will have a balance of P 5,000 while
Service
Income will have a balance of P 10,000.

Note that after posting the adjusting entry, the Income Method or Liability Method will yield the
same balances , P 10,000 for Service Income while P 5,000 for Unearned Service Income.

PROVISION FOR DEPRECIATION OF FIXED ASSETS

All fixed assets or property and equipment when acquired, are capitalized or treated as an asset
not as an expense. But considering that fixed assets help generate income for the entity, a portion of the
cost of the assets should be reported as expense in each accounting period. “Depreciation Accounting”
requires the allocation of the cost to its estimated useful life. The estimated amount allocated to any one
accounting period is called depreciation expense. All fixed asset except Land is subject for depreciation.

There are several methods of determining depreciation. The Straight -line method is commonly
used because of its simplicity . This is computed by the formula presented below:

Depreciation Expense = Cost- Salvage Value where,

Estimated useful life

Cost- represent the amount an entity paid to acquire the depreciable asset.
Estimated salvage value – is the amount that the asset can probably be sold for at the end
of its
estimated useful life.
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.

The adjusting entry for depreciation , is presented below:

Depreciation xx
Accumulated Depreciation xx

Accumulated Depreciation Account is a balance sheet account, a contra-account to the fixed asset
account. The book value of the property and equipment is obtained by deducting accumulated depreciation
from its cost.

Failure to record the adjusting entry will overstate the Net Income, the Asset as well as the Owner’s
Equity.

Example: Acquired Office Equipment costing P 350,000 on June1, 2013 which is expected to last
5 years with
P 50,000 salvage value.

The annual depreciation is P 60,000 computed as follows:

Annual Depreciation = P 350,000 – P 50,000 = P 60,000

 5 years

However, the adjusting entry on December 31, 2013 should be as follow:

Depreciation Expense- Office Equipment P 35,000

Accumulated Depreciation- Office Equipment P 35,000
To record depreciation covering 7 months
period, from June 1 to Dec. 31.

PROVISION FOR DOUBTFUL ACCOUNTS

Offering credit terms to customers is normal to any business entity. Some of these account may
not be collected thus, there is a need to reflect these as charges against revenue. Doubtful Accounts or
Bad Debts is the anticipated loss recognized for the estimated uncollectible accounts in the current period.
Estimates of uncollectible accounts may be based on the ff:
a. credit sales for the period (gross sales or net sales)
b. Aging of Account Receivable
c. The balance of the valuation account is “increased to “ a desired new balance.
d. The balance of the valuation account is “ increases by” a desired amount.

Below is the adjusting entry to record for the provision for Doubtful Accounts:

Doubtful Account P xx
Allowance for Doubtful Account P xx

Allowance for Doubtful Account is a contra asset account . This is to be deducted from Accounts
Receivable Account , to obtain the Net Realizable Accounts Receivable.

If the accounts proves to be definitely uncollectible, the appropriate amount is written off against
the contra account with the following entry :

Allowance for Doubtful Account P xx

Accounts Receivable P xx

No entry is made to Uncollectible Accounts Expense, since the adjusting entry has already
provided for an estimated expense based on previous experience for all receivable.

Failure to record the doubtful accounts adjusting entry will overstate the Net Income, the Assets
as well as the Owner’s Equity.

Example: The company has a total credit sales of P1,000,000 with Accounts Receivable Balance
of P
300,000 and Allowance for Doubtful Account Balance of P 20,000. Assume that
Doubtful Accounts
is estimated to be 1% of credit sales.

The adjusting entry by December 31, 2013 should be as follow:

Doubtful Accounts P 10,000

Allowance for Doubtful Accounts P 10,000
To record provision for doubtful Account.
(P1,000,000x .01)

After the above adjusting entry, Allowance for Doubtful Account will have a balance of P30,000
while Net
 Realizable Accounts Receivable will have a balance of P 270,000 ( P 300,000 – P 30,000 ).

Case II. The same data above except that the management has decided to increase the balance
of the valuation account to P 25,000.

The provision for doubtful account for the period should be equal to P 5,000 computed as
follows:

Desired new balance of Allowance for Doubtful Account P 25,000

Less: Balance of Allow. for Doubtful Acct before Adjustment 20,000
Estimated Doubtful Account for the period P 5,000
=====
The adjusting entry should be:

Doubtful Account P 5,000

Allowance for Doubtful Account P 5,000

After the adjusting entry, the Allowance for Doubtful Account will have a balance P
25,000 while Net
Realizable Value of P 275,000 (300,000- 25,000).

Case III. The same data above, except that the management has decided to increase the valuation
account by
P 6,000.

The adjusting entry should be:

Doubtful Account P 6,000

Allowance for Doubtful Account P 6,000

After the adjusting entry, the Allowance for Doubtful Account will have a balance P 26,000, while
the net realizable value of 274,000 (300,000-26,000)

Case IV. The same data above, except that the management has decided to increase the
valuation account
by 5% of the outstanding Accounts Receivable.

The adjusting entry should be:

Doubtful Account P 15,000

Allowance for Doubtful Account P 15,000

After the adjusting entry, the Allowance for Doubtful Account will have a balance P 35,000, while
net realizable value of 265,000.