Adjusting Entries

The Need for Adjusting Entries

After the trial balance is completed, normally the financial statements cannot be prepared yet. The reason
is there are still some transactions of the business that are not yet recorded. These transactions have to be recorded
first in order to bring all the accounts up to date at the end of the accounting period. The entries to record these
transactions are called adjusting entries.
All adjusting entries affect at least one income statement account and one balance sheet account. Thus, an adjusting
entry will always involve a revenue or an expense and an asset or a liability account.

The entity’s life can be meaningfully subdivided into equal time periods for reporting purposes. An
accounting period can be monthly, quarterly, semi-annually or annually. This is called the periodicity principle.
Applying this concept, a business adjusts and closes its books at the end of an accounting period and then prepares
the various financial statements at the end of each period. The most basic accounting period is one year.

Cash and Accrual Basis of Accounting

As mentioned earlier, the cash basis recognizes revenues and expenses only when they are received and
paid, respectively whereas the accrual basis recognizes revenues when earned and expenses when incurred,
regardless of when collected or paid.

Generally accepted accounting principles require that a business use the accrual basis of accounting.

Types of Adjusting Entries

 Accrued Expenses – These are expenses incurred in one period but remain unrecorded and unpaid as of the end
of the period. They are also called accrued liabilities or unrecorded expenses.

The pro-forma adjustment is:

Expense account xxxx

Liability account xxxx

For example: A company’s accounting period is monthly, January 1-31, 2019. All expenses incurred
during the month of January must be recorded in January. Let us say, taxes for the month of January amounting to
P 5,000 will be paid on February 5, 2019, the adjusting entry will be:

2019
Jan 31 Taxes Expense 5,000

Taxes Payable 5,000

So, since we are using the accrual basis of accounting, the question is when did the company incur the
expense? The answer of course is for the month of January, therefore we will record the expense in January. And
since this will still be paid in February, we will record a liability in January.
 Another example is, assume a small business is paying a total of P 10,000 for the salaries of its employees
for a 5-day work week. Payday is every Friday. Accounting period is monthly. The Salaries Expense during the
month of March is shown below:
Salaries Expense
Mar. 5 10,000
12 10,000
19 10,000
26 10,000
40,000

If March 26 is a Friday, then the last day of the month (March 31) falls on a Wednesday. Therefore the
adjusting entry to be made will be:

Mar. 31 Salaries Expense 6,000

Salaries Payable 6,000

If financial statements are prepared on March 31, the Salaries Expense to be shown in the statement of
comprehensive income totaled P 46,000 and the statement of financial position will show Salaries Payable
amounting to P 6,000.

 Accrued Revenues – These are revenues earned in one period but remain unrecorded and not received as of the
end of the period. They are also called accrued assets or unrecorded revenues.

The pro-forma adjustment is:

Asset account xxxx

Revenue account xxxx

For example: ABC Company’s accounting period is monthly, August 1-31, 2019. All revenues earned
during the month of August must be recorded in August. If the company is in the business of renting apartments and
one of its tenants has not paid the August rent for P 8,000, then the adjusting entry of ABC Company will be:

2019
Aug. 31 Rent Receivable 8,000

Rent Revenue 8,000

 Prepaid Expenses – These are expenses paid by the business in advance; or these are expenses already paid in
cash by the business but the expenses are not yet incurred or only a portion of the amount paid was used up as
expense. Prepaid expenses are also termed as deferred expenses.

There are two methods of accounting for prepaid expenses:

1. Asset method – if at the date of payment, the business debited an asset account, say Prepaid Rent
and credited Cash.

The pro-forma adjustment is:

Expense Account used or expense

Asset Account portion
 2. Expense method – if at the date of payment, the business debited an expense account, say Rent
Expense and credited Cash.

The pro-forma adjustment is:

Asset Account unused or asset

Expense Account portion

To illustrate, assume that XYZ Company is using a monthly accounting period. On January 1, 2019, the
company paid P 45,000 representing 3-month rent beginning January 1, 2019. The company adjusts and closes its
books every month. The entry to record the prepayment and the adjusting entry at the end of the month will be:

Asset Method Expense Method

2019
Jan 1 Prepaid Rent 45,000 Rent Expense 45,000
Cash 45,000 Cash 45,000

2019
Jan 31 Rent Expense 15,000 Prepaid Rent 30,000
Prepaid Rent 15,000 Rent Expense 30,000

Since P 45,000 is for 3 months, the monthly rent is P 15,000. For January, the used or expense portion is
one month or P 15,000; therefore the unused or asset portion will be two months or P 30,000 as of January 31.

The effects of these entries are shown in the following T-accounts:

Asset Method

Prepaid Rent Rent Expense

2019 2019 2019
Jan. 1 45,000 Jan. 31 15,000 Jan. 31 15,000

30,000

Expense Method

Rent Expense Prepaid Rent

2019 2019 2019
Jan. 1 45,000 Jan. 31 30,000 Jan. 31 30,000

15,000

Regardless of which method a business used in any particular case, the amount reported as expense in the
statement of comprehensive income and the amount reported as asset in the statement of financial position will be
the same.

Both methods of accounting for prepayment are acceptable although most companies employ the expense
method due to its simplicity. A business must also use a method consistently for a particular type of prepayment,
say asset method for rent while expense method for supplies.
 Unearned Revenues – These are revenues collected or received by the business in advance; or these are
revenues already collected in cash by the business but the revenues are not yet earned or only a portion of the
amount received was earned or became revenue. Unearned revenues are also termed as deferred revenues.

There are two methods of accounting for unearned revenues:

1. Liability method – if at the date of collection, the business credited a liability account, say
Unearned Rent and debited Cash.

The pro-forma adjustment is:

Liability Account earned or income

Revenue Account portion

2. Revenue method – if at the date of collection, the business credited a revenue account, say Rent
Revenue and debited Cash.

The pro-forma adjustment is:

Revenue Account unearned or liability

Liability Account portion

To illustrate, assume that ABC Company is using a monthly accounting period. On October 1, 2019, the
company collected or received P 30,000 representing 3-month rent beginning October 1, 2016. The company
adjusts and closes its books every month. The entry to record the advance collection and the adjusting entry at the
end of the month will be:

Liability Method Revenue Method

2019
Oct 1 Cash 30,000 Cash 30,000
Unearned Rent 30,000 Rent Income 30,000

2019
Oct 31 Unearned Rent 10,000 Rent Income 20,000
Rent Income 10,000 Unearned Rent 20,000

Since P 30,000 is for 3 months, the monthly rent is P 10,000. For October, the earned or income portion is
one month or P 10,000; therefore the unearned or liability portion will be two months or P 20,000 as of October 31.

The effects of these entries are shown in the following T-accounts:

Liability Method

Unearned Rent Rent Income

2019 2019 2019
Oct 31 10,000 Oct. 1 30,000 Oct. 31 10,000

20,000
 Revenue Method

Rent Income Unearned Rent

2019 2019 2019
Oct. 31 20,000 Oct. 1 30,000 Oct. 31 20,000

10,000

Regardless of which method a business used in any particular case, the amount reported as income in the
statement of comprehensive income and the amount reported as liability in the statement of financial position will be
the same.

Both methods of accounting for unearned or deferred revenues are acceptable although most companies
employ the revenue or income method due to its simplicity. A business must also use a method consistently for a
particular type of unearned or deferred revenue, say liability method for rent while income or revenue method for
subscription.

 Depreciation of Property, Plant and Equipment

Physical resources that are owned and used by a business which are permanent in nature or have a long
useful life are called property plant and equipment. They are also called fixed assets or plant assets. Examples are
land, building, equipment, trucks, automobiles, a computer, store fixtures, or office furniture. These assets help
generate income for the business. It is important and proper that a portion of the asset be recorded as expense in
each accounting period.

Property, plant and equipment are recorded at their acquisition cost, which comprises:

a. The purchase price;

b. Freight, insurance, installation and other related expenses in bringing the assets for use; and

c. The initial estimate of the costs of dismantling and removing the item at the end of its useful
life.

Fixed assets, with the exception of land have limited useful lives and as such are subject to depreciation.

Depreciation is the systematic allocation of the cost of the fixed asset over its useful life. Depreciation is
not a process of asset valuation.

There are three factors to be considered in computing depreciation:

 Cost of the asset.

 Residual value, or the estimated amount that the fixed asset can be sold at the end of its useful
life. Other terms used are salvage value, scrap value or trade-in value.

 Useful life or the estimated number of years or number of units or hours that the asset can be
used during its life.
 The pro-forma adjustment for depreciation is:

Depreciation Expense – Name of asset xxx

Accumulated Depreciation – Name of asset xxx

There are different methods of computing depreciation. We will discuss here only the simplest and the
most commonly used method which is the straight-line method. This method will result into equal periodic charges
for depreciation. Also take note that in the adjusting entry for depreciation the account credited is the account
Accumulated Depreciation. This is a contra-asset account which will be deducted from the related fixed asset
account in the balance sheet. The credit is not made directly to the fixed asset account in order to preserve the
original cost of the fixed asset in the balance sheet.

To illustrate, assume that on January 1, 2019, Jug Company bought a delivery truck for a total cost of
P 500,000. Its estimated life is 10 years and the estimated residual value is P 50,000. The company is using the
straight-line method of computing depreciation and it is using an annual accounting period. The entries of Jug
Company for the above transactions are:

2019
Jan 1 Delivery Truck 500,000
Cash 500,000
To record the purchase of delivery truck.

The adjusting entry on December 31, 2019:

2019
Dec 31 Depreciation Expense-Delivery Truck 45,000
Accumulated Depreciation-Delivery Truck 45,000

Computations will be:

Annual depreciation = Cost – Residual Value

Estimated Life

= P 500,000 – 50,000
10

= P 45,000
=======

Other computation for straight-line method is:

Annual depreciation = (Cost – Residual Value) x

Depreciation rate

= (P 500,000 – 50,000) x 10%

= P 45,000
=======
 The depreciation rate can be computed by getting the reciprocal of the life. Example: 10 years is equal to
1/10 or 10%.

The balance of the Depreciation Expense account is shown in the statement of comprehensive income. In
the statement of financial position as of December 31, 2019, the carrying amount or the book value of the asset is
P 455,000, as shown below:

Delivery Truck P 500,000

Less Accumulated Depreciation 45,000

Carrying amount or Book value P 455,000

The depreciation of the fixed asset will be recorded at the end of each year (for ten years). The same
adjusting entry will be recorded for 10 years. Assuming a statement will be made on December 31, 2025:

Delivery Truck P 500,000

Less Accumulated Depreciation 270,000

Carrying amount or Book value P 230,000

At the end of ten years, the Accumulated Depreciation account will have a balance of P 450,000. At this
point, the book value of the asset will be equal to the residual value of P 50,000.

The other types of adjustments, bad debts and merchandise inventory, will be taken up in the discussion of
merchandising business.
 DISCUSSION QUESTIONS

1. What are adjusting entries?

2. Give the importance of adjusting entries.

3. After the trial balance is completed, why are financial statements not prepared yet?

4. Why is it important to prepare the financial statements at the end of an accounting period?

5. What is the periodicity concept?

6. Distinguish between the cash basis and the accrual basis of accounting. Give examples.

7. Which of the two methods is generally accepted, the cash basis or the accrual basis of accounting?

8. What are the basic types of adjusting entries? Explain each.

9. What are the two methods of accounting for prepayments?

10. What adjusting entries are made assuming the business records prepayment under the asset
method? Under the expense method?

11. What are the two methods of accounting for unearned revenue?

12. What adjusting entries are made assuming the business records unearned revenue under the liability
method? Under the income method?

13. What are fixed assets? Give examples.

14. What is depreciation? Why do we have to record depreciation?

15. What are the factors to be considered in computing depreciation?

16. If the accountant failed to record accrued income, what are the effects of this omission on the
financial statements?

17. What is the pro-forma adjustment for accrued expense? Accrued revenue?

18. What is the pro-forma adjustment for depreciation?

19. If the accountant failed to record depreciation, what are the effects of this omission on the financial
statements?

20. What is the difference between an adjusting entry and a correcting entry?
 EXERCISES

Exercise 1

Quick Company paid P 25,920 premium on a three-year insurance policy on September 1, 2019. The effectivity of
the policy begins on September 1, 2019.

1. Assuming the accrual basis of accounting, how much of the premium will appear as an expense
on the annual statement of comprehensive income for the year 2019? For 2020? For 2021? For
2022?

2. Assuming the accrual basis, how much of the premium will appear as an asset on each December
31 statement of financial position for the year 2016? For 2017? For 2018? For 2019?

Use the following table. Use the space provided for the supporting computations in good form.

2019 2020 2021 2022

1.

2.

Exercise 2

Classify the following items as (a) deferred expense (prepaid expense), (b) deferred revenue (unearned revenue),
(c) accrued expense ( accrued liability), or (d) accrued revenue (accrued asset). Use CAPITAL LETTERS.

____________ 1. A two-year premium paid on a fire insurance policy

____________ 2. Electric bill owed but not yet paid

____________ 3. Office Supplies on hand

____________ 4. Wages owed but not yet paid

____________ 5. Telephone bill owed but payable in the following period

____________ 6. Subscriptions collected in advance by a newspaper publisher

____________ 7. Service Revenue collected but not yet earned

____________ 8. Service Revenue already earned but not yet received

____________ 9. Interest paid in advance from a bank loan

____________ 10. Rent received in advance

____________ 11. Services rendered but not yet collected

____________ 12. Advertising contract paid in advance for one year

____________ 13. Income collected but not yet earned

____________ 14. Rent paid in advance

____________ 15. Interest collected in advance by the creditor

Exercise 3

At the end of the current year, P 21,780 of fees had been earned but had not been billed to clients.

a. Journalize the adjusting entry to record the accrued fees.

Post
Date Description Ref. Debit Credit

b. If the cash basis rather than the accrual basis had been used, would an adjusting entry have been
necessary? Explain.

Exercise 4

Prepare the adjusting entries on December 31, 2019, the end of the annual accounting period, on the following
independent data. Show your computations after each entry.

1. The Insurance Expense account had a debit balance on December 31, 2019 of P 36,000
representing premium for a 2-year fire insurance policy effective October 1, 2019.

2. Rent Income was credited for P 18,000 on November 1, 2019 representing nine months rent
collected in advance.

3. Equipment per general ledger on December 31, 2019 shows a balance of P 372,000. Equipment
acquired during the year was P 52,000 on April 1, 2019. All equipment is to be depreciated at
the rate of 25% per annum.

4. As of December 31, 2019, commissions already earned but not yet collected amounted to
P 48,000.

5. Office Supplies costing P 9,000 bought during the period was debited to the Office Supplies
account. Of the amount, P 5,000 were consumed during the year.

6. Unearned Service Fees account showed a credit balance of P 80,000 per general ledger on
December 31. Of this, 40% had been actually earned during the period.

7. On December 31, 2019 a 90-day, 9% Notes Payable has a balance of P 120,000 per general
ledger. The note was issued on December 5, 2019. No interest has been taken on this note.

8. Unearned service revenue has a balance of P 400,000 of which 60% has been earned.

9. Notes Receivable has a balance of P 100,000 received from a client in settlement of an open
account on November 16, 2019. The note is a 90-day, 12% note. No interest has been taken on
this note.

10. The Prepaid Insurance account has balance of P 210,000 on December 31, 2019. The balance
represented two fire insurance policies acquired during 2019. The first policy, Policy I for
P 120,000 was acquired on March 1, 2019 and the second policy, Policy II was acquired on
August 1, 2019 for P 90,000. Policy I is payment for a 2-year plan while Policy II is for a one-
year plan.