Topic 1:Midterm Adjusting the Accounts

I .Explain the Accrual Basis of Accounting

If we could wait to prepare financial statements until a company ended its operations, no adjustments would be needed. At that point, we could
easily determine its final balance sheet and the amount of lifetime income it earned .

However, most companies need immediate feedback about how well they are doing. For example, management usually wants monthly financial
statements. The Internal Revenue Service requires all businesses to file annual tax returns. Therefore, accountants divide the economic life of a
business into artificial time periods. This convenient assumption is referred to as the time period assumption.

Fiscal vs. Calendar Years

★ Both small and large companies prepare financial statements periodically in order to assess their financial condition and
results of operations. Accounting time periods are generally a month, a quarter, or a year. Monthly and quarterly time
periods are called interim periods. Most large companies must prepare both quarterly and annual financial statements.
★ An accounting time period that is one year in length is a fiscal year. A fiscal year usually begins with the first day of any
month and ends 12 months later on the last day of a month. Many businesses use the calendar year (January 1 to
December 31) as their accounting period.

Accrual- versus Cash-Basis Accounting

★ What you will learn in this chapter is accrual-basis accounting. Under the accrual basis, companies record transactions that change a
company’s financial statements in the periods in which the events occur. For example, using the accrual basis to determine net income means
companies recognize revenues when they perform services (rather than when they receive cash). It also means recognizing expenses when
incurred (rather than when paid).
★ An alternative to the accrual basis is the cash basis. Under cash-basis accounting, companies record revenue when they receive cash. They
record an expense when they pay out cash. The cash basis seems appealing due to its simplicity, but it often produces misleading financial
statements. It fails to record revenue for a company that has performed services but for which the company has not received the cash. As a
result, the cash basis does not match expenses with revenues.
★ Accrual-basis accounting is therefore in accordance with generally accepted accounting principles (GAAP). Individuals and some small
companies, however, do use cash-basis accounting. The cash basis is justified for small businesses because they often have few receivables
and payables. Medium and large companies use accrual-basis accounting.

ACCRUAL BASIS CASH BASIS

REVENUES Revenues are recognized when earned (when Revenues are recognized when cash is
the performance obligation is satisfied) received.

EXPENSES Expenses are recognized when incurred Expenses are recognized when cash is paid.
(when an item is used/expired)

Recognizing Revenues and Expenses

✻ REVENUE RECOGNITION PRINCIPLE
When a company agrees to perform a service or sell a product to a customer, it has a performance obligation. When the company meets this
performance obligation, it recognizes revenue. The revenue recognition principle therefore requires that companies recognize revenue in the
accounting period in which the performance obligation is satisfied.

To illustrate, assume that Dave’s Dry Cleaning cleans clothing on June 30 but customers do not claim and pay for their clothes until the first
week of July. Dave’s should record revenue in June when it performed the service (satisfied the performance obligation) rather than in July
when it received the cash.

✻ EXPENSE RECOGNITION PRINCIPLE

Accountants follow a simple rule in recognizing expenses: “Let the expenses follow the revenues.” Thus, expense recognition is tied to
revenue recognition. In the dry cleaning example, this means that Dave’s should report the salary expense incurred in performing the June 30
cleaning service in the same period in which it recognizes the service revenue. The critical issue in expense recognition is when the expense
makes its contribution to revenue. This may or may not be the same period in which the expense is paid. If Dave’s does not pay the salary
incurred on June 30 until July, it would report salaries payable on its June 30 balance sheet

This practice of expense recognition is referred to as the expense recognition principle (often referred to as the matching principle). It dictates
 that efforts (expenses) be matched with results (revenues). Illustration 3-1 summarizes the revenue and expense recognition principles.

The Need for Adjusting Entries

In order for revenues to be recorded in the period in which services are performed and for expenses to be recognized in the period in which they are
incurred, companies make adjusting entries. Adjusting entries ensure that the revenue recognition and expense recognition principles are
followed.

Adjusting entries are necessary because the trial balance—the first pulling together of the transaction data—may not contain up-to-date and
complete data. This is true for several reasons:

1. Some events are not recorded daily because it is not efficient to do so. Examples are the use of supplies and the earning of wages by
employees.
2. Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result
of recurring daily transactions. Examples are charges related to the use of buildings and equipment, rent, and insurance.
3. Some items may be unrecorded. An example is a utility service bill that will not be received until the next accounting period.
Adjusting entries are required every time a company prepares financial statements. The company analyzes each account in the trial balance
to determine whether it is complete and up-to-date for financial statement purposes. Every adjusting entry will include one income statement
account and one balance sheet account.

✻ TYPES OF ADJUSTING ENTRIES

Adjusting entries are classified as either deferrals or accruals.

DEFERRALS ACCRUALS

Prepaid expenses: Expenses paid in cash before they are used or Accrued revenues: Revenues for services performed but not yet
consumed. received in cash or recorded.

Unearned revenues: Cash received before services are performed. Accrued expenses: Expenses incurred but not yet paid in cash or
recorded.

II. Prepare adjusting entries for deferrals

To defer means to postpone or delay. Deferrals are expenses or revenues that are recognized at a date later than the point when cash was
originally exchanged. The two types of deferrals are prepaid expenses and unearned revenues.

✻ Prepaid Expenses
When companies record payments of expenses that will benefit more than one accounting period, they record an asset called prepaid
expenses or prepayments. When expenses are prepaid, an asset account is increased (debited) to show the service or benefit that the
company will receive in the future. Examples of common prepayments are insurance, supplies, advertising, and rent. In addition, companies
make prepayments when they purchase buildings and equipment.

Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or through use (e.g., supplies). The expiration
of these costs does not require daily entries, which would be impractical and unnecessary. Accordingly, companies postpone the recognition of
such cost expirations until they prepare financial statements. At each statement date, they make adjusting entries to record the expenses
applicable to the current accounting period and to show the remaining amounts in the asset accounts.

Prior to adjustment, assets are overstated and expenses are understated. Therefore, as shown in Illustration 3-4, an adjusting entry for prepaid
expenses results in an increase (a debit) to an expense account and a decrease (a credit) to an asset account.
BASIC ENTRIES:

Adjusting entry for prepaid expense when used or

expired:
Expense account xxx
Asset or Contra-asset account xxx

“Let’s look in more detail at some specific types of prepaid expenses: supplies, insurance, long
lived assets.”
Payment for prepaid expense:
Asset account xxx
Cash xxx
a. Supplies
The purchase of supplies, such as paper and envelopes, results in an increase (a debit) to an asset account. During the accounting period, the
company uses supplies. Rather than record supplies expense as the supplies are used, companies recognize supplies expense at the end of the
accounting period.

Illustration a.1: On October 1, Eini Wan purchased supplies for P1,000 cash. At the end of the month, it was determined that P800 of the supplies
was used.
ENTRIES:
Purchase of Supplies: Adjusting Entry:
Supplies 1,000 Supplies Expense 800
Cash 1,000 Supplies 800

The cost of supplies used is P1,600 (P2,500 – P900). Remember in the previous illustration that only the amount of supplies used is used in the
adjusting entry.

“If Piña Asha does not make the adjusting entry, October expenses are understated and net income is overstated by P1,600. Moreover,
both assets and owner’s equity will be overstated by P1,600 on the October 31 balance sheet.”

b. INSURANCE
Companies purchase insurance to protect themselves from losses due to fire, theft, and unforeseen events. Insurance must be paid in advance,
often for more than one year. The cost of insurance (premiums) paid in advance is recorded as an increase (debit) in the asset account Prepaid
Insurance. At the financial statement date, companies increase (debit) Insurance Expense and decrease (credit) Prepaid Insurance for the cost of
insurance that has expired during the period.

ENTRIES:
Payment for Prepaid Insurance: Adjusting entry:
Prepaid Insurance 6,000 Insurance expense 500
Cash 6,000 Prepaid Insurance 500

Insurance of P500 (P6000/12) expires each month. The expiration of prepaid insurance decreases an asset, Prepaid Insurance. It also decreases
owner’s equity by increasing an expense account, Insurance Expense.

After the adjustment, the PREPAID INSURANCE account show a balance of P5,500 (6,000 - 500), which is represents the unexpired portion of the
insurance (remaining 11-months of the coverage). At the same time, the balance in Insurance Expense equals the insurance cost that expired in
October. If Pioneer does not make this adjustment, October expenses are understated by $50 and net income is overstated by $50.
Moreover, both assets and owner’s equity will be overstated by $50 on the October 31 balance sheet.

c. DEPRECIATION
A company typically owns a variety of assets that have long lives, such as buildings, equipment, and motor vehicles. The period of service is
referred to as the useful life of the asset. Because a building is expected to be of service for many years, it is recorded as an asset, rather than an
expense, on the date it is acquired. Companies record such assets at cost, as required by the historical cost principle.

To follow the expense recognition principle, companies allocate a portion of this cost as an expense during each period of the asset’s useful life.
Depreciation is the process of allocating the cost of an asset to expense over its useful life.

NEED FOR ADJUSTMENT. The acquisition of long-lived assets is essentially a long-term prepayment for the use of an asset. An adjusting entry
for depreciation is needed to recognize the cost that has been used (an expense) during the period and to report the unused cost (an asset) at the
end of the period. One very important point to understand: Depreciation is an allocation concept, not a valuation concept. That is, depreciation
allocates an asset’s cost to the periods in which it is used. Depreciation does not attempt to report the actual change in the value of the asset.

Illustration c.1: Anju Wable purchased an equipment costing P24,000 on October 1. This equipment has a useful life of 2-years. Prepare the
adjusting entry on October 31.

Purchase of equipment: Adjusting entry:

Equipment 24,000 Depreciation expense 1,000
Cash 24,000 Accumulated Depreciation – Equipment 1,000

Depreciation for Anju Wable is P1,000 per month (P24,000 / 24 months). Instead of recording the adjustment by decreasing the asset account
directly (The equipment account), Anju Wable credits Accumulated Depreciation— Equipment.
Accumulated Depreciation is called a contra asset account. Such an account is offset against an asset account on the balance sheet. Thus, the
Accumulated Depreciation—Equipment account offsets the asset Equipment. This account keeps track of the total amount of depreciation
expense taken over the life of the asset. To keep the accounting equation in balance, Anju Wable decreases owner’s equity by increasing an
expense account, Depreciation Expense.

The balance in the Accumulated Depreciation—Equipment account will increase P1,000 each month, and the balance in Equipment remains
P24,000.

STATEMENT PRESENTATION As indicated, Accumulated Depreciation—Equipment is a contra asset account. It is offset against Equipment on
the balance sheet. The normal balance of a contra asset account is a credit. A theoretical alternative to using a contra asset account would be to
decrease (credit) the asset account by the amount of depreciation each period. But using the contra account is preferable for a simple reason: It
discloses both the original cost of the equipment and the total cost that has been expensed to date. Thus, in the balance sheet, Pioneer deducts
Accumulated Depreciation—Equipment from the related asset account.

Equipment P 24,000
(Accumulated Depreciation) (1,000)
Book Value or Carrying Value P 23,000

Book value is the difference between the cost of any depreciable asset and its related accumulated depreciation. In Illustration 3-8, the book value
of the equipment at the balance sheet date is $4,960. The book value and the fair value of the asset are generally two different values. As noted
earlier, the purpose of depreciation is not valuation but a means of cost allocation.

Depreciation expense identifies the portion of an asset’s cost that expired during the period (in this case, in October). The accounting equation
shows that without this adjusting entry, total assets, total owner’s equity, and net income are overstated by P1,000 and depreciation
expense is understated by P1,000.

UNEARNED REVENUES
When companies receive cash before services are performed, they record a liability by increasing (crediting) a liability account called unearned
revenues. In other words, a company now has a performance obligation (liability) to transfer a service to one of its customers.
Unearned revenues are the opposite of prepaid expenses. Indeed, unearned revenue on the books of one company is likely to be a prepaid
expense on the books of the company that has made the advance payment. For example, if identical accounting periods are assumed, a landlord
will have unearned rent revenue when a tenant has prepaid rent.

When a company receives payment for services to be performed in a future accounting period, it increases (credits) an unearned revenue (a
liability) account to recognize the liability that exists. The company subsequently recognizes revenues when it performs the service. During the
accounting period, it is not practical to make daily entries as the company performs services. Instead, the company delays recognition of revenue
until the adjustment process. Then, the company makes an adjusting entry to record the revenue for services performed during the period and to
show the liability that remains at the end of the accounting period. Typically, prior to adjustment, liabilities are overstated and revenues are
understated. Therefore, the adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a
credit) to a revenue account.

Receipt of cash for services to be performed: Adjusting entry when the performance obligation is satisfied:
Cash xxx Liability account xxx
Liability account xxx Revenue account xxx

BASIC ENTRIES:
Illustration: Pioneer Advertising received P1,200 on October 2 from R. Knox for advertising services expected to be completed by December 31.
On October 31, determine the amount of income to be recognized and prepare the adjusting entry.

Receipt of Cash on October 1: Adjusting entry on October 31:

Cash 1,200 Unearned service revenue 400

Unearned service revenue 1,200 Service revenue 400

No revenue is recognized because the performance obligation is not yet The amount of income is P400 per month (P1,200 / 3 months). The
satisfied amount of income recognized in October is P400.

After the adjustment, the liability Unearned Service Revenue now shows a balance of P800. That amount represents the remaining advertising
services expected to be performed in the future (November and December). Without this adjustment, revenues and net income are
understated by $400 in the income statement. Moreover, liabilities will be overstated and owner’s equity will be understated by $400 on
the October 31 balance sheet.

III. Prepare adjusting entries for accruals

The second category of adjusting entries is accruals. Prior to an accrual adjustment, the revenue account (and the related asset account) or the
expense account (and the related liability account) are understated. Thus, the adjusting entry for accruals will increase both a balance sheet
and an income statement account.

ACCRUED REVENUES
Revenues for services performed but not yet recorded at the statement date are accrued revenues. Accrued revenues may accumulate (accrue)
with the passing of time, as in the case of interest revenue, or may result from services that have been performed but not yet billed nor
collected, as in the case of commissions and fees.
An adjusting entry records the receivable that exists at the balance sheet date and the revenue for the services performed during the period. Prior to
adjustment, both assets and revenues are understated. An adjusting entry for accrued revenues results in an increase (a debit) to an asset
account and an increase (a credit) to a revenue account.

Adjusting entry for accrued revenues not yet paid:

Receivable Account xxx
Revenue account xxx

ILLUSTRATION: In October, Pioneer Advertising performed services worth P200 that were not billed to clients on or before October 31. Because
these services are not billed, they are not recorded.

Adjusting entry to record the accrual of unrecorded service revenue:

Accounts Receivable 200
Service Revenue 200

Service Revenue is recorded because the services were already performed. The accrual of unrecorded service revenue increases an asset
account, Accounts Receivable. It also increases owner’s equity by increasing a revenue account, Service Revenue

The asset Accounts Receivable shows that clients owe Pioneer P200 at the balance sheet date. Without the adjusting entry, assets and
owner’s equity on the balance sheet and revenues and net income on the income statement are understated.

Subsequent transaction: On November

10, Pioneer receives Nov. 10 Cash 200 cash of P200 for the services
performed in October Accounts Receivable 200 and makes the following
entry. (To record cash collected on account)

The company records the collection of the receivables by a debit (increase) to Cash and a credit (decrease) to Accounts Receivable. No service
revenue account is recorded on this date because it was already recorded on October 31.

ACCRUED EXPENSES

Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses. Interest, taxes, and salaries are common
examples of accrued expenses.

Companies make adjustments for accrued expenses to record the obligations that exist at the balance sheet date and to recognize the expenses
that apply to the current accounting period. Prior to adjustment, both liabilities and expenses are understated. Therefore, an adjusting entry for
accrued expenses results in an increase (a debit) to an expense account and an increase (a credit) to a liability account.

Adjusting entry for accrued expenses not yet paid:

Expense Account xxx
Liability account xxx

“Let’s look in more detail at some specific types of accrued expenses: accrued interest, accrued salaries and wages, and accrued taxes.”

ACCRUED INTEREST

ILLUSTRATION: Pioneer Advertising signed a three-month note payable in the amount of P5,000 on October 1. The note requires Pioneer to pay
interest at an annual rate of 12%. Determine the amount of interest expense at the end of October 31 and prepare the necessary adjusting entry.

Answer: The amount of the interest recorded is determined by three factors: (1) the face value of the note; (2) the interest rate, which is always
expressed as an annual rate; and (3) the length of time the note is outstanding.

For Pioneer, the total interest due on the P5,000 note at its maturity date three months in the future is P150 (P5,000 x 12% x 3/12) or P50 per
month.
Adjusting entry for accrued interest expenses at October 31:

Interest expense 50 The same adjusting entry is

used at the end of November
Interest payable 50 and December.
The accrual of interest at October 31 increases a liability account, Interest Payable. It also decreases owner’s equity by increasing an expense
account, Interest Expense.

Interest Expense shows the interest charges for the month of October. Interest Payable shows the amount of interest the company owes at the
statement date. Pioneer will not pay the interest until the note comes due at the end of three months. “Companies use the Interest Payable account,
instead of crediting Notes Payable, to disclose the two different types of obligations—interest and principal—in the accounts and statements”.
Without this adjusting entry, liabilities and interest expense are understated, and net income and owner’s equity are overstated.

Subsequent transaction: On December 31, Pioneer paid cash of

P150 for the amount of interest incurred as of December 31.
Interest payable 50 To record the subsequent
payment of accrued interest.
Cash 50

ACCRUED SALARIES AND WAGES

Companies pay for some types of expenses, such as employee salaries and wages, after the services have been performed.

Adjusting entry for accrued interest expenses at October 31:

Salaries expense 1,200 To record the amount of
accrued salaries expenses for
Accrued Salaries payable 1,200 the 3-day period October 29, 30,
and 31.

At October 31, the salaries and wages for these three days represent an accrued expense and a related liability to Pioneer. The employees receive
total salaries and wages of P2,000 for a five-day work week, or P400 per day. Thus, accrued salaries and wages at October 31 are P1,200 (P400 x
3). This accrual increases a liability, Salaries and Wages Payable. It also decreases owner’s equity by increasing an expense account, Salaries and
Wages Expense

After this adjustment, the balance in Salaries and Wages Expense of P5,200 (13 days x P400) is the actual salary and wages expense for October.
The balance in Salaries and Wages Payable of P1,200 is the amount of the liability for salaries and wages Pioneer owes as of October 31. Without
the P1,200 adjustment for salaries and wages, Pioneer’s expenses are understated P1,200 and its liabilities are understated $1,200.

Pioneer pays salaries and wages every two weeks. Consequently, the next payday is November 9, when the company will again pay total salaries
and wages of P4,000. The payment consists of P1,200 of salaries and wages payable at October 31 plus P2,800 of salaries and wages expense for
November (7 working days, as shown in the November calendar x P400). Therefore, Pioneer makes the following entry on November 9.