College of Accountancy and Business Administration

Modular Learning
ACC13 – Financial Accounting and Reporting

ADJUSTING ENTRIES

Adjusting Entries

• Adjusting entries are entries made prior to the preparation of financial statements to update
certain accounts so that they reflect correct balances as of the designated time.

Purpose of adjusting entries

Adjusting entries are necessary for the following reasons:

A. To split mixed accounts into their real and nominal elements.

Depreciation Prepayments
Doubtful accounts Advance collections
B. To take up unrecorded income and expense of the period.
Accrual of expenses
Accrual of income

Adjustments for Depreciation

Property, plant and equipment such as buildings, equipment and machineries, furniture, etc.,
are recorded at cost as an asset (Cost principle). These assets are expected to benefit the business for a
number of years before they will be retired.
The cost of a long-lived asset (less scrap value, if any, called depreciable cost) is allocated over
its service life. This is called depreciable accounting. The portion of an assets cost allocated as expense
for the period is called depreciation.
There are several methods being used in computing depreciation of PPE. At this point we shall
discuss only one method, the Straight-line Method. In order to compute the amount of depreciation to
be charged to expense during an accounting period, there are three factors to be considered, namely:
1. Cost – the amount recorded as the value of the asset. This includes all the expenditures relating
to the acquisition and preparation for the use of the asset.
2. Residual or scrap value – the net amount which the enterprise expects to obtain from an asset
at the end of its useful life after deducting the expected cost of disposal.
3. Useful life – the period of time over which asset is expected to be used by the enterprise.
 Depreciable cost – cost of a long-lived asset less its residual value.

Straight-line Method of Depreciation

The straight-line method is the most common method being used. It is the simplest method to follow.
Under the straight-line method, the annual depreciation charge is calculated by allocating the amount to
be depreciated (depreciable cost) equally over the number of years of the estimated useful life.
The straight-line method provides equal amount of depreciation expense over the useful life of the asset
and as such is also called the uniform charge method.
Formula: Annual Depreciation = Cost – Residual value
Useful life

Illustration: On January 1 20x1, a business acquired equipment for P100,000. The business expects to
use the equipment over the next 4 years.
Journal entry:
Jan.1 Equipment 100,000
Cash 100,000
On December 31, 20x1, the equipment has already been used for 1 year out of its total useful life of 4
years. Thus one-fourth of the cost should be recognized as expense.

Cost 100,000
Divide by: Useful life 4
Annual Depreciation expense 25,000
Adjusting entry
Dec. 31 Depreciation expense 25,000
Accumulated depreciation 25,000

Illustration: Assume that an equipment was bought for P400,000 on January 1, 2020. The equipment is
estimated to be used in the business for ten years with an estimated residual value of P40,000 after.
Annual Depreciation = Cost – Residual Value
Useful life
Annual Depreciation = 400,000 – 40,000
10
Annual Depreciation = P 36,000
Journal entry:
Dec. 31 Depreciation expense 36,000
Accumulated depreciation 36,000
Suppose the equipment is acquired in October 1, 2020. How much should be the depreciation expense
for the calendar year 2020?
Depreciation expense (36k x 3/12) 9,000
Accumulated depreciation 9,000

The depreciation expense (debit) is reported in the income statement while the accumulated
depreciation (credit) is reported as contra asset account and as such is shown as a deduction from the
equipment account in the balance sheet.

The difference between the cost of the asset and its accumulated depreciation is called carrying book
value or book value.
Adjustments for Doubtful Accounts/Bad Debts
The amount of loss the business expects to suffer due to uncollectibility of accounts receivable is called
bad debts. The term “bad debts” is synonymous with the terms doubtful accounts, uncollectible
accounts, and losses on accounts receivables.

Great percentage of business activities are carried on credit. Merchandise are sold on account and
services are rendered for future collections. It is seldom, however, that all accounts due from customers
are collected. because of this, the receivable, a real account, becomes a mixed account at the end of the
accounting period.

The portion of the receivable which is expected to be collected is the real element while the portion
estimated to be uncollectible is the nominal element.

Illustration: A business has a total accounts receivable of P2,000 on December 31, 20x1 before any
adjustments. Of the total amount, it was estimated that P500 is doubtful of collection.

Journal entry:
Dec. 31 Bad debts expense 500
Allowance for doubtful accounts 500

Illustration: Assume an accounts receivable of P3,000,000 and a credit balance in the allowance account
of P20,000 before adjustment. Doubtful accounts are estimated to be 3% of accounts receivable.

Computation:
Required allow. for doubtful accounts (3M x 3%) P 90,000
Less: Credit balance of allowance before adjustment 20,000
Doubtful accounts expense P 70,000

Journal entry:
Bad debts expense 70,000
Allowance for doubtful accounts 70,000

Illustration: Assume an accounts receivable of P3,000,000 and a debit balance in the allowance account
of P20,000 before adjustment. Doubtful accounts are estimated to be 3% of accounts receivable.

Computation:
Required allow. for doubtful accounts (3M x 3%) P 90,000
Add: debit balance of allowance before adjustment 20,000
Doubtful accounts expense P 110,000

Journal entry:
Bad debts expense 110,000
Allowance for doubtful accounts 110,000
Adjustment for Prepayments
Prepayment or prepaid expenses are prepaid rent, prepaid interest, prepaid insurance, prepaid
advertising and prepaid unused supplies.

The adjusting entry for prepaid expenses lies on the entry made at the time of its payment. There are
two methods of recording prepayments of expenses namely:

ASSET METHOD
Under the asset method, a prepaid expense is recorded as an asset. At the end of the accounting period,
the asset account, which is classified as real account, now becomes a mixed account. That is real and
partly nominal. The used, expired or consumed portion is the expense element while the unused,
unexpired or unconsumed portion remains as an asset.

Thus, the asset is overstated and the expense is understated. The two elements can be corrected by
preparing an adjusting entry debiting the understated expense account and crediting the overstated
asset account. The adjusting amount should be properly determined.

EXPENSE METHOD
Under the expense method, a prepayment of expense is recorded as an expense by debiting an expense
account. At the end of the accounting period, the expense account which is classified as nominal
account, now becomes a mixed account. That is partly nominal and partly real. The unused, unexpired,
or unconsumed portion is the asset element while the used, expired, or consumed part is the expense
element.

Because of this, the expense is overstated and the asset is understated. The two elements can be
corrected by preparing an adjusting entry debiting the understated asset account and crediting the
overstated expense account. The adjusting amount should be properly determined.

Illustration: On October 1, 2020, ABC Company paid one year rental of the office building for the
P120,000. The period covered is from October 1, 2020 to September 30, 2021.

Asset Method Expense Method

Oct. 1 Prepaid rent 120,000 Oct. 1 Rent Expense 120,000
Cash 120,000 Cash 120,000

On Dec. 31, 2020, the end of the accounting period, the adjusting entry should be:
Asset Method Expense Method
Dec. 31 Rent expense 30,000 Dec. 31 Prepaid rent 90,000
Prepaid rent 30,000 Rent expense 90,000

Computation: expense portion (expired potion) = 120,000 x 3/12 = 30,000

Asset portion (unexpired portion) = 120,000 x 9/12 = 90,000
Adjustment for income collected in advance
An income collected in advance is actually at the date of collection. This is technically called unearned
income. However, the transaction can be recorded in two different methods, namely:

LIABILITY METHOD
Under the liability method, the total amount of cash received in advance is credited to a liability
account. This method is theoretically the sound method considering that at the point of collection no
portion of the amount had yet been earned. However, as day pass, the unearned income will gradually
be earned.

The unearned income account is a real account being a liability. This account, however becomes mixed
account at the end of the accounting period. The earned portion is the income element and the
unearned portion remains a liability. Thus, the liability account is overstated while the income account is
understated.

The adjusting entry to correct the accounts would be to debit the liability account and credit income
account.

INCOME METHOD
Under the income method, the total amount of cash received in advance is credited to an income
account. While the amount collected is not yet earned at the date of collection, eventually this will be
earned. The credit to an income account is actually in anticipation that this will be earned later.

The income account is classified as nominal account. However, this account becomes a mixed account at
the end of the accounting period if the real element while the earned portion is the nominal portion.

Since income was credited at the date when the cash was received, the income account is overstated
and the unearned income account is understated

The adjusting entry to correct the accounts would be to debit income account and credit unearned
income account.

Illustration: On August 1, 2020 AB Realty collected 1 year rental from a tenant, P180,000. The rental
covers the period August 1,2020 to July 31,2021.

Liability Method Income Method

Aug. 1 Cash 180,000 Aug. 1 Cash 180,000
Unearned rent 180,000 Rent income 180,000

Adjusting entry
Dec. 31 Unearned rent 75,000 Dec. 31 Rent income 105,000
Rent income 75,000 Unearned rent 105,000

Computation: income portion (earned potion) = 180,000 x 5/12 = 75,000

 Asset portion (unearned portion) = 180,000 x 7/12 = 105,000
Adjustment for Accrual of Expenses
Expenses are normally recorded when paid. However, under the accrual basis of accounting, expenses
should be recognized when incurred regardless of when payment was made.

Expenses already incurred but not yet paid as of the end of the accounting period are called accrued
expenses. Examples of accrued expenses are accrued salaries, accrued interest and accrued utilities
expense.

Failure to record an expense because it is not yet paid results in an understatement of expense and also
an understatement of liability. The expense and the liability can be recognized by preparing an adjusting
journal entry debiting the expense account and crediting the liability account.

Illustration: (Accrued interest expense)

Normally, interest on notes payable is paid together with the principal at the date of maturity. When the
term of the note payable covers two or more accounting periods, the interest on such note must be
allocated among the period covered. At the end of the accounting period, the total interest already
incurred because of the note during the current period is considered an interest expense for the period.
Such interest expense can be recognized by preparing an adjusting entry which is a debit to interest
expense and a credit to accrued interest payable.

Example: At the end of the accounting period, December 31, 2020, ABC Company has a note payable for
P100,000 issued and dated November 1, 2020. The note bears an interest rate of 12% and will mature
on October 31, 2021.

Adjusting entry:
Dec. 31 Interest expense P2,000
Accrued interest payable P2,000
Computation: interest = face value x interest rate x time
= 100,000 x 12% x 2/12
= P2,000

Illustration 2 (Accrued Salaries)

Normally, salaries are paid weekly, biweekly or on a monthly basis. When salaries are paid, these are
recorded by a debit to salaries expense and credit to cash. If the last payment of salaries coincides with
the end of the accounting period, no accrued salaries exist.

Unpaid and unrecorded salaries as of the end of the accounting period are called accrued salaries. To
record this, an adjusting entry should be made – debit salaries expense and credit accrued salaries
payable.

Example: ABC Company pays salaries of employees on a weekly basis. The salaries for a five working-day
week is P35,000 paid every Friday. On May 31, 2020, the end of the accounting period, fall on a
Wednesday.
Adjusting entry:
Salaries expense P21,000
Accrued salaries payable 21,000
To record the salaries for Monday to Wednesday still unpaid as of June 30.
Computation:
Accrued salaries = 3/5 x 35,000 = P21,000

Adjustment for Accrual of Income

Normally income is recorded upon collection. However, under the accrual basis of accounting, income
should be recognized when earned regardless of when it is collected. Accrued income is an income
already earned but not yet collected. this is not yet recorded in the books.

Accrued income can be recorded in the books by preparing an adjusted entry – debit to accrued income
receivable account and credit to income account. The accrued income receivable account should b
recorded as an asset in the balance sheet, while the income should be reported in the income
statement.

Illustration: On December 31,2020, ABC Company has a note receivable from BA Enterprises. The note
has a face value of P120,000 dated September 1,2020. The note bears an interest rate of 10% and will
mature on August 31,2021.

Adjusting entry
Accrued interest receivable P4,000
Interest income P4,000
Computation: 120,000 x 10% x4/12 = 4,000

COMPREHENSIVE ILLUSTRATION (ADJUSTING ENTRIES)

The following transaction were made for the month of June

JUNE
5 Mr. Ocampo acquired office equipment on account from Dagupan Enterprise, P52,500.
6 Mr. Ocampo acquired office supplies from LimPan Commercial worth P7,000, issuing a
promissory note due in 15 days.
7 Paid business taxes to the City treasurer for cash, P5,400.
8 Bought a second-hand automobile for business use from Dagupan Auto Center issuing a two-
year promissory note for P250,000 bearing a 12% interest rate and dted June 9,2020
9 Paid office rent for one year to Abarabar Buildings issuing check for the total amount of
P48,000. The rent covers the period June 1, 2020 to May 31,2021.
9 Billed the following clients audit work performed:
Alpha Company P22,000
Beta Trading 30,000
 Cat Gaz Company 15,000
9 Paid P3,000 cash for one month insurance premium covering June 11 to July 10,2020
Collected a one-month retainers fee for P3,000 from client covering the period of June 21 to
July 20,2020

Journal Entries

Additional Information:
1. As of June 30, 2020, P4,000 of the office supplies remain unused.
2. The office equipment is estimated to have a useful life of 5 years and P1,500 residual value at
the end of its useful life.
3. The automobile can be used by the enterprise for 10 years after which, this can be sold at its
scrap value of P10,000.
4. One-third of the retainer’s fee collected in June 30 is considered earned as of the date.
5. Two-thirds of the insurance premium has expired as of June 30.
6. Four hundred fifty pesos (P450) is considered prepaid taxes as of June 30, 2020
7. The rent paid is for one year.
8. Accrued salaries as of June 30 amounts to P2,700. Ignore withholding tax, SSS, and Philhealth in
the adjustment
9. Interest on the note payable to Dagupan Auto Center should be accrued.
10. Two percent of the total receivables is considered uncollectible.