BUSINESS TRANSACTIONS AND

THEIRANALYSIS AS APPLIED TO
THE ACCOUNTINGCYCLE OF A
SERVICE FIRM (PART II)
CHAPTER 9
 LEARNING OBJECTIVES

AT THE END OF THIS CHAPTER, THE STUDENTS SHOULD BE ABLE TO:

1. PREPARE ADJUSTING AND CLOSING ENTRIES; AND
2. COMPLETE THE ACCOUNTING CYCLE.
 INTRODUCTION
IN CHAPTER 8, 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 SUMMARIZED IN A TABULAR
PRESENTATION, TOGETHER WITH THE PROPER DEBIT AND CREDIT BALANCES. THIS
CHAPTER WILL UTILIZE THE EXAMPLE USED IN CHAPTER 8, MATALINO
DORMITORY. THE RESULT OF THE PROCESSES DISCUSSED IN THE SAID CHAPTER IS
THE UNADJUSTED TRIAL BALANCE, WHICH IS AS FOLLOWS:
Adjusting Entries
The trial balance, which was prepared from the information found in the
ledgers, reflects the effect of the various transactions entered into by the entity
throughout the accounting period. However, some of the amounts are not the
final amounts that would be seen in the financial statements. This is due to the
presence of accounts in which there are expired and unexpired portions.
Expired amounts are those in which no economic benefits are expected.

To illustrate it better, imagine the sight when you open your refrigerator. As
much as you are hungry and want to consume all the foods that you see, most
probably, you cannot. This is because there might be some items that are
already past their expiry date, hence not edible anymore. Since these are
deemed to provide no further nutrition to us, these are thrown away. This is
the same to the economic benefit concept used in accounting
In the accounting process of a service firm, there are six classifications of
adjusting entries: depreciation, bad debts, prepaid expenses, accrued
expenses, deferred revenues, accrued revenues.

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 (e.g. Asset or liability) and at least one income
statement account (e.g., revenue or expense); and(3) each entry has no
cash account in either the debit or the credit side.
Depreciation
Depreciation is applied to components of property, plant and equipment, or PPE.
These are assets held by an entity and expected to benefit more than one accounting
period. In other words, these are assets held for long-term purposes. Depreciation is
done to allocate the cost, less residual value of the PPE over its useful life. In theory,
an entity is benefitted through increased revenues when it uses its PPE. Although there
is no real outflow of resources by the entity, an expense is still recorded in order to
match depreciation expense in the same period that the revenue is generated. In
business, “when there is gain, there is also pain.” In this case, gain is represented by
revenue and pain is represented by depreciation expense. The entry to record
depreciation is:
Dr. Depreciation Expense
Cr. Accumulated Depreciation XX
Depreciation Expense is an income statement account while Accumulated
Depreciation is a balance sheet account. Accumulated Depreciation is a deduction
from a PPE account. The difference between a PPE account and its related
Accumulated Depreciation Account is called book value. For example, if the building
account has a balance of P250 000 and its related Accumulated Depreciation Account
The basic formula in computing depreciation is as follows:

Depreciation Expense = Cost of the PPE – Estimated Residual Value

Estimated Useful life

In the Matalino Dormitory example, there are several depreciable assets, namely, building, furniture
and fixtures, and computer. Although land is an asset that benefits an entity for the long-term, it is
not a depreciable asset because its estimated useful life cannot be determined. For instance, the
building is expected to be used for a period of 20 years, and the residual value is expected to be
P500 000. The residual value is the amount that is expected to be recovered from the asset at the
end of its useful life through sale, rather than through continuing use. To determine the amount of
depreciation to be recorded, the residual value is deducted from the cost of the building, which is
P12 500 000, and the resulting figure, P12 000 000, is simply divided by the useful life in years,
which is 20, we get ₱600 000.Hence, the entry for depreciation should be:
Dr. Depreciation Expense 600 000
Cr. Accumulated Depreciation-Building 600 000

This method of depreciation is called the straight-line method.

This adjusting entry affects the accounting equation in the
following manner: Assets will go down because the credit to
accumulated depreciation will bring down the book value of the
building. Equity will go down because an expense is recorded-
Depreciation Expense.
Bad Debts
The concept of bad debts is an application of the conservatism principle of accounting,
which when applied to assets will imply that overstatement of assets is undesirable. Bad
debts concept is applied to the accounts receivable of a firm. In the ordinary course of a
business, itis just but normal to encounter customers who later on, would not be able to pay
their dues to the business entity. The most common method of estimating bad debts is by
multiplying the amount of accounts receivable by a certain percentage, which is determined
through years of experience of the entity in business. The resulting figure is the required
balance of the allowance for doubtful accounts. The pro-forma entry for a bad debts
adjusting entry is:

Dr. Bad Debts Expense XXX

Cr. Allowance for Doubtful Accounts XXX
Bad Debts Expense is an income statement account while Allowance for Doubtful
Accounts is a balance sheet account. Allowance for Doubtful Accounts is a
deduction from Accounts Receivable. The difference between Accounts Receivable
and the Allowance for Doubtful Accounts is called the Net Realizable Value of the
Accounts Receivable. For example, if the Accounts Receivable Account has a
balance of P450 000 and the Allowance for Doubtful Accounts has a balance of P45
000, the Net Realizable Value of the Accounts Receivable is P405 000.

For instance, there is a P1 000 000 accounts receivable at the end of the year, and it
is determined that 5% of these receivables could be uncollectible. P1,000,000 times
5% is equal to P50 000.Hence, the adjusting entry is:

Dr. Bad Debts Expense 50000

Cr. Allowance for Doubtful Accounts 50000
This adjusting entry affects the accounting equation in the following manner:
Assets will go down because the credit to Allowance for Doubtful Accounts will
bring down the Net Realizable Value of Accounts Receivable. Equity will go
down because an expense is recorded-Depreciation Expense.
When later on, a receivable is proved to be uncollectible, it is simply written off.
For example, P20 000 is deemed uncollectible, the entry is simply:

Dr. Allowance for Doubtful Accounts 20000

Cr. Accounts Receivable 20000
Take note that the amount written off is just the amount that has been established as uncollectible. This
journal entry does not affect the amount of total assets because it reduces the amount of an asset account and
its contra-asset account. After making the entry, the balance of the Allowance for Doubtful Accounts is P30
000. This amount is compared to the estimated Bad Debts Amount from the accounts receivable in the
subsequent period to determine the Bad Debts Expense to be recorded.
In the next accounting, for instance, the ending balance of accounts receivable is P1,500,000. If the estimated
doubtful accounts of 5% is still valid, these figures are just multiplied to get P75 000. Again, take note that
this is the required balance of the allowance account, not necessarily the amount to be recorded as bad debts
expense. Since there is already an existing P30 000 balance, only the deficiency of P45 000 is recorded as
Bad Debts Expense. The entry should be:

Dr. Bad Debts Expense 45 000

Cr. Allowance for Doubtful Accounts 45 000

Notice that by making this adjusting entry, the new balance of the allowance account is now P75,000.
Prepaid Expenses
As the name suggests, these expenses are paid even before they are incurred. The outlay of
cash precedes the actual consumption of the economic benefits. Prepaid expenses are
usually periodic expenses which are paid at the beginning of a certain period of time for
convenience of both the payor and the payee. Most prepaid expenses are expenses incurred
every month, and instead of being bothered to go to the payee every month to tender
payment, the payor just pays the whole amount at the start of a period.
When cash is paid, the cash account is credited to indicate the outflow of cash, while a
prepaid account is debited for the same amount. The pro-forma entry is as follows:

Dr. Prepaid Expense XXX

Cr. Cash XXX
When the prepaid expense has already expired, the following is the pro-forma adjusting
entry:

Dr. Expense XXX

Cr. Prepaid Expense XXX
In the Matalino Dormitory example, there is a P6 000 balance in the prepaid insurance account. This
amount is insurance premium paid July 1, for the next six months, or until December 31. Since period
covered by such prepaid expense has already lapsed, the balance should already be zero. Hence, we
make the following adjusting entry:

Dr. Insurance Expense 6 000

Cr. Prepaid Insurance 6 000

This adjusting entry affects the accounting equation in the following manner: Assets will go down
because the credit to Prepaid Insurance will bring down the value of the Prepaid Insurance Account.
Equity will go down because an expense is recorded-Insurance Expense.

Accrued Expense
In prepaid expense, cash is disbursed before the incurrence of the actual expense. In accrued expense,
incurrence comes before the actual disbursement of cash. A perfect example of accrued expense is
utilities, like electricity and water. The actual bill for utilities comes after the month end, or any other
period for that matter. An expense should be recorded, although there is no actual outlay of cash. The
pro-forma entry to record an accrued expense is simply as follows:
Dr. Expense XXX
Cr. Accrued Expenses Payable XXX
Again, following the Matalino Dormitory example, the total electricity, water, and telephone bills total
P32 983.20. In that case, the adjusting entry should be:

Dr. Utilities Expense 32 983.20

Cr. Utilities Payable 32 983.20

This adjusting entry affects the accounting equation in the following manner: Liability will go up
because of the credit to Utilities Payable. Equity will go down because an expense is recorded-
Utilities Expense.

Unearned Revenue In this particular type of adjusting entry, the first of two adjusting entries related to
revenue, cash is received first before services are rendered. This arrangement could be stipulated by
certain companies, more especially when enforcing cash collection is quite hard. When cash is
received, the following entry is made:

Dr. Cash XXX

Cr. Unearned Revenue XXX
As the period covered by the cash received expires, or the required services have already been
rendered, such revenue is deemed earned, rather than unearned. This is because the company has
already provided the economic benefits that are expected from it by the payor. When such
revenue is earned, an adjustment of this form should be made:
Dr. Unearned Revenue XXX
Cr. Revenue XXX
Notice that in the trial balance of Matalino Dormitory, there is a 30 000 credit balance in the
Unearned Rent Revenue account. Such amount is an advance payment made at the beginning of
the year, to be applied to the December. Although this rent payment is for the last month of the
year, it has been agreed upon by the tenant and the Matalino Dormitory that such payment be paid
at the beginning of the year. In order to properly reflect the amount of revenue earned during the
year, the following adjusting entry should be made:
Dr .Unearned Rent Revenue 30 000
Cr. Rent Revenue 30 000
This adjusting entry affects the accounting equation in the following manner: Liability will go
down because of the debit to Unearned Rent Revenue. Equity will go up because a revenue is
recorded-Rent Revenue.
Accrued Revenue
Just like in the case of expenses, there is also an opposite of unearned revenue, and that is accrued
revenue. Instead of receiving rent in advance, rent is received after services are completely rendered.
This is usually the case when rendering of services is subject to certain conditions that would make
it necessary to finish rendering the services before payment is payment. Simply, the adjusting entry
should be:
Dr. Receivable XXX
Cr. Revenue XXX
For instance, if a certain dormer in Matalino Dormitory failed to pay rent during a certain month, an
adjusting entry should still be made even though cash is yet to be received. The entry should be as
follows:
Dr. Rent Receivable 30 000
Cr. Rent Revenue 30 000

This adjusting entry affects the accounting equation in the following manner: Assets will go up
because of the debit to Rent Receivable. Equity will go up because a revenue is recorded-Rent
Revenue.
Adjusted Trial Balance
After all the adjusting entries are made, the adjusted trial balance can now be prepared. This is done
by updating the balances of the items from the unadjusted trial balance, and if applicable, add items
that came only after the preparation of the adjusting entries. The adjusted trial balance is simply the
unadjusted trial balance plus the effects of the adjusting entries.
Financial Statements
In financial reporting, there are several financial statements which serve different purposes.
Some of which are: income statement, balance sheet, statement of cash flows, statement of
changes in equity, among others. For the purposes of this chapter, the income statement and the
balance sheet would be illustrated using the Matalino Dormitory example.
Income Statement
The first financial statement to be prepared is the income statement. The simplified presentation
of the income statement should follow the following format:
Name of Company
Income Statement
Period Ended December 31,20XX
Revenue XXX
Expenses XXX
Other Gains and Losses XXX
Net Income XXX

The income statement basically contains all the nominal accounts, except the drawing accounts
and the income summary account. Matalino Dormitory's income statement is as follows
Balance Sheet
Also known as the statement of financial position, the balance sheet provides the amounts for the various assets,
liabilities, and owner's capital accounts.
The assets are presented first, followed by the liabilities and equity. To show that the accounting equation is
satisfied, the total assets and the total liabilities and owner's capital should be highlighted to be of equal amount.
Owner's Capital
Notice that in the last line of the heading of the balance sheet, the phrase "for the period
ended" is used. This is because the income statement is the result of operations on an
entity for a particular period. Meanwhile, in the heading of the balance sheet, the phrase
"as of" is used because what is shown are the amounts of assets, liabilities, and owner's
capital at a certain point in time.

Usually, the assets and liabilities are presented according to their liquidity. Cash, being the
most liquid asset, is presented first, followed by receivables, inventories, and PPE
accounts. Basically, the shorter the time an asset is expected to be converted into cash, the
more liquid it is, and this is the reason why cash is presented first. The same is followed in
the presentation of liabilities. Those liabilities expected to be paid first are presented
before those that will be paid later.
The following is the balance sheet of Matalino Dormitory:
The owner's capital is determined as follows:
Owner's Capital Balance from the Adjusted Trial Balance 8,994,270.00
Net Loss from the Income Statement (939,661.89)
Owner's Drawings from the Adjusted Trial Balance (10,000.00)
Owner's Capital, December 31,2015 8,044,608.11

Closing Entries From the adjusted trial balance, closing entries are to be made. By making
closing entries, all nominal or temporary accounts are closed out to the owner's capital
account, through the income summary account. Closing entries reduce the balances of the
temporary accounts to zero to prepare them for accumulating amounts for another accounting
period. The following pro-forma journal entries should be made:
Dr. Revenues
Cr. Income Summary
To close revenue accounts

Dr. Income Summary

Cr. Expenses
To close expense accounts
Dr. Income Summary
Cr. Owner's Capital
To close income summary account if there is a net income

Or
Dr. Owner's Capital
Cr. Income Summary
To close income summary account if there is a net loss

Dr. Owner's Capital

Cr .Owner's Drawings
To close the drawings account
The first two entries effectively close out all income statements accounts to the income summary account.
After making the first two entries, the balance of the income summary account is either a credit or a debit,
and should be equal to the amount of net income or loss, respectively. The third entry closes out the
income summary account to the owner's capital if there is a net income. The fourth entry closes out the
income summary account to the owner's capital if there is a net loss. The fifth entry closes the owner's
drawings to the owner's capital. It should be noted that although there is an outflow of resources in
owner's drawings, it is not included in the income statement since it is purely a transaction with the
owner.
The post-closing trial balance proves the equality of debits and credits after the preparation of
closing entries
Adjusting Entries
1.Interest Expense. An interest charge of 7.25% is to be accrued for the two months starting
from the date of acquisition up to year-end, on the 680 000 loans payable from the purchase of
company car on credit. Interest expense is computed, and the corresponding adjusting entry,
as follows:
680 000x7.25%x2/12=8 216.67
Dr. Interest Expense 8216.67
Cr. Interest Payable 8216.67
2.Supplies. Inventory count at year-end reveals the following supplies left: 1 320 worth of
office supplies; 2 140 worth of repair supplies; 120 worth of air fresheners. The following
adjusting entries should be made for the aforementioned supplies:

Dr. Office Supplies Expense 8 996.50

Dr. Maintenance and Repairs Expense 11.060
Cr. Office Supplies Inventory 8996.50
Cr. Repair Supplies Inventory 5360
Cr. Car Supplies Inventory 5700
3.Service Revenue. Gross receipts amounting to 89 310.75 were collected by the drivers
during the last day of the year. Since celebrations are expected to start early evening, they
are told to remit their receipts, net of commissions of 4 465.54, during the next working day
of the following year. Hence, the following entry is made:

Dr. Receivable from Employees 84 845.21

Dr. Salaries, Wages, and Bonuses Expense 4465.54
Cr. Service Revenue 89 310.75

4.Depreciation. Expense for the depreciation of various components of PPE should be

booked. Although one depreciation expense account may be used for the combined
amounts, separate accumulated depreciation accounts should be charged for each class of
PPE. The following is the computation of the depreciation expense for each class, and
thereafter, the adjusting entry.
Taxicab-[(4 320 000 less 1 000 000)/5 years]x3/12=166 000
Each taxicab has a residual value of 200 000 at the end of five years, hence the 1 000 000
deduction to get the depreciation.
Company Car-[(680 000 less 250 000)/5 years]x2/12=14 333.33
Same as the taxicabs, the company car has a five-year useful life, except that the
residual value is 250 000.Notice that 2/12 is multiplied to get the depreciation expense
because for the current year, it has only been two months from the time the company
car was purchased and put into use. For the other cases, the multiplier depends on the
number of months of usage.

Office Equipment-(32 000/5 years)x3/12=1600

Radio Communication System-(12 500/5 years) x3/12 =625
For both the office equipment and the radio communication system, the useful life is
five years, but no residual value.
Adjusting Entry:

Dr. Depreciation Expense 182,558.33

Cr. Accumulated Depreciation-Taxicab 166 000
Cr. Accumulated Depreciation-Company Car 14333.33
Cr. Accumulated Depreciation-Office Equipment 1600
Cr. Accumulated Depreciation-Radio Communication System 625
5.Prepaid Rent. The 40 000 amount of prepaid rent on the unadjusted trial balance
pertains to rent paid for December of the current year and January of next year. Since
the amount pertaining to the last month of the current year is deemed expired, the
following adjusting entry is necessary:

Dr. Rent Expense 20 000

Cr. Prepaid Rent 20 000

6. Utilities. Since the bills for utilities are only received at the sixth day of the
succeeding month, no utilities expense for the month of December has been recorded.
It has-been determined that the total utilities for December amount to 8
355.90,thereforenecessitating the following adjusting entry:

Dr. Utilities Expense 8355.90

Cr. Utilities Payable 8 355.90
After all the necessary adjusting entries, the resulting adjusted trial balance is as
follows: