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MODULE 3 - The Adjusting Process

This document provides an introduction and overview of a course on financial accounting and reporting. It outlines the following key learning outcomes: [1] Define accounting and understand its brief history; [2] Identify the elements of accounting and how transactions affect the accounting equation; [3] Understand how to prepare basic financial statements. It then provides examples and explanations of core accounting concepts like the accrual basis of accounting, accounting periods, revenues, expenses and how net income is calculated.

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MODULE 3 - The Adjusting Process

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FRANCES JEANALLEN DE JESUS

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AE 112-

MODULE 3
(THE ADJUSTING
PROCESS)

COURSE LEARNING OUTCOMES

At the end of the module, you should
be able to:
a. define accounting;
b. know the brief history of accounting;
c. identify the elements of accounting;
d. understand the effects of
transactions on accounting
equation; and
e. know how to prepare the financial
FINANCIAL ACCOUNTING statements.

AND REPORTING

“You have to understand accounting and you have to understand the nuances of accounting. It's the
language of business and it's an imperfect language, but unless you are willing to put in the effort to
learn accounting - how to read and interpret financial statements - you really shouldn't select stocks
yourself.”
Warren Buffett

Property of and for the exclusive use of SLU. Reproduction, storing in a retrieval system, distributing, uploading, or posting online, or transmitting in any form or by any
means, electronic, mechanical, photocopying, recording, or otherwise of any part of this document, without the prior written permission of SLU, is strictly prohibited.

1
COURSE INTRODUCTION
This course provides an introduction to accounting, within the context of business and
business decisions. Students explore the role of accounting information in the decision-
making process and learn how to use various types of accounting information found in
financial statements and annual reports. This course starts with a discussion of accounting
thought and the theoretical background of accounting and the accounting profession. The
next topic is the accounting cycle - recording, handling, and summarizing accounting data,
including the preparation and presentation of financial statements for merchandising and
service companies. Moreover, it continues with transactions, financial statements, and
problems peculiar to the operations of partnerships and corporations as distinguished from
sole proprietorships. Topics include accounting for partnership formation and operations;
share capital issuances, treasury shares, other related transactions affecting accumulated
profits. Emphasis is placed on understanding the reasons underlying basic accounting
concepts and providing students with an adequate background on the recording,
classification, and summarization functions of accounting to enable them to appreciate the
varied uses of accounting data.

As previously noted, net income is an increase in the owner's equity resulting from the
profitable operations of the business. Net income does not consist of any cash or any other
specific assets. Rather, net income is a computation of the overall effects of many business
transactions on owner's equity. The effects of net income on the basic accounting equation
are illustrated as follows:

ASSETS = LIABILITIES + CAPITAL

INCREASE = DECREASE + INCREASE

Either (both) of these effects …but this is what “net income”

as net income is earned really means

Our point is that net income represents an increase in owner's equity and has no direct
relationship to the types or amounts of assets on hand. Even a business operating at a profit
may run short of cash.

The net income is determined by comparing the sales price of goods or services sold during
the period with the costs incurred by the business in delivering these goods or services. The
technical accounting terms for these components of net income are revenue and expenses.
Therefore, the net income is equal to revenue minus expenses. Should expenses exceed
revenue, a net loss results.

An income statement for Guro Accounting Tutorial Services for the month ended November
30, 2020 is shown below. This will assist us in discussing some of the basic concepts involve in
measuring business income. Most important of these are the (a) accrual basis of accounting;
(b) accounting period; (c) revenue; (d) matching principle; and (e) time-period concepts.

2
Guro Accounting Tutorial Services
Statement of Comprehensive Income
For the month ended November 30, 2020

Service Income P 110,000

Less: Expenses
Supplies Expense P14,000
Salaries Expense 10,000
Rent Expense 5,000
Utilities Expense 2,500
Taxes and Licenses 1,500 33,000
Net Income P 77,000

ACCRUAL BASIS ACCOUNTING VS CASH BASIS ACCOUNTING

The policy of recognizing revenue in the accounting records when it is earned and
recognizing expenses when the related goods or services are used is called the accrual basis
accounting. The purpose of accrual accounting is to measure the profitability of the
economic activities conducted during the accounting period.

On the other hand, not-for-profit organizations and micro-businesses may use the pure-cash
basis accounting. Under this basis, activities and events are recognized and reported in the
period when cash is actually received or paid out - that is, the accounting process is based
purely on the inflows and outflows of cash. The pure-cash basis accounting measures the
amounts of cash received and paid out during the period, but it does not provide a good
measure of the profitability of activities undertaken during the period.

The primary difference between the pure-cash basis and the accrual basis is the timing of
the recognition of income and expenses.

Accrual Basis of Accounting Pure-Cash Basis of Accounting

Income is recognized when earned Income is recognized when collected
Expense is recognized when incurred Expense is recognized when paid

Financial statements prepared on the accrual basis accounting recognize and report not
only those past transactions that involved the receipts and payments of cash, but also the
resources and obligations that are expected to represent cash inflows and cash outflows in
the future. The Philippine Financial Reporting Standards (PFRS) require that a business uses
the accrual basis.

ACCOUNTING PERIOD
The period of time covered by an income statement is termed the company's accounting
period. To provide the users of financial statements with timely information, net income is
measured for relatively short accounting periods of equal length. The concept, called the
time-period principle, is one of the generally accepted accounting principles that guide the
interpretation of financial events and the preparation of financial statements.

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The length of a company's accounting period depends on how frequently managers,
investors, and other interested people require information about the company's
performance. Every business prepares annual income statements, and most businesses
prepare quarterly and monthly income statements as well. One year is the most basic
accounting period and most businesses prepare annual financial statements not only for
internal use but more so for external reporting purposes particularly to meet the reportorial
requirements of government agencies like the Bureau of Internal Revenue (BIR) and
Securities and Exchange Commission (SEC).

The 12-month accounting period used by an entity is called its fiscal year. The fiscal year
used by most companies coincides with the calendar year and ends on December 31. Some
businesses, however, elect to use a fiscal year that ends on some other date. It may be
convenient for a business to end its fiscal year during a slack season rather than a time of
peak activity

REVENUE PRINCIPLE
Revenue is the price of goods sold and services rendered during a given period of time.
Earning revenue causes the owner's equity to Increase. When should revenue be
recognized? This principle indicates that revenue should be recognized at the time goods
are sold or services are rendered. At this point, the business has essentially completed the
earning process, and the sales value of the goods or services can be measured objectively.

Revenue is recognized when the earning process is complete or almost complete. Revenue
is recognized in the period when there is a measurable increase in future economic benefits,
related to either an increase in an asset or a decrease in a liability. This means that the
recognition of revenue occurs simultaneously with that of an Increase In an asset and/or
decrease in a liability. For example, the increase in cash or accounts receivable is
recognized simultaneously with the recognition of service income arising from service
rendered to a customer.

MATCHING PRINCIPLE
A significant relationship exists between revenue and expenses. Expenses are the costs of
the goods and services used up in the process of earning revenue. Expenses are often called
the "costs of doing business", that is, the cost of the various activities necessary to carry on a
business.

In measuring net income for a period, revenue should be offset by all the expenses incurred
in producing that revenue. This concept of offsetting expenses against revenue on a basis
of cause and effect is called the matching principle.

Timing is an important factor in matching (offsetting) revenue with the related expenses. For
example, in preparing monthly income statements, it is important to offset this month's
expenses against this month's revenue. We should not offset this month's expenses against
last month's revenue because there is no cause and effect relationship between the two.

4
Proper matching is attained only if there is proper measurement, recognition, and reporting
of both the earned income (revenues and gains) and the related incurred expenses and
losses. The income statement and the balance sheet are very closely linked so that the
recognition of an item will usually affect the two statements simultaneously.

PERIODICITY CONCEPT
Periodicity concept or the time-period principle assumes that the operating life of the
business may be divided into time-periods so that timely and regular financial reports will be
available for the use of decision makers. The need for financial reports results to accounting
problems since the end of the reporting period will cut across the lives of certain elements.
For example, rent paid for 1 year beginning August 2019 to July 2020 will affect two
accounting periods if the cut-off date is December 31; that is, it will affect both years 2019
and 2020.

As a result of the end-of-the-period cut-offs, measurement and recognition problems may

arise. The major problems revolve around the determination of amounts that pertain to each
year of the life of the element. It can be observed that the shorter the reporting periods, the
more cut-offs there will be, and the more measurement issues are expected to arise.

THE ADJUSTING PROCESS

As introduced in the previous modules, the second phase of the accounting cycle is the
Summarizing and Reporting Process. This phase is done at the end of the accounting period
and the steps involved are:

Step 5 - Gather data for adjustment

Step 6 - Prepare a worksheet
Step 7 - Prepare the financial statements
Step 8 - Journalize and post adjusting entries

This module focuses discussions about adjustments (step 5). The preparation of the
worksheet, financial statements, and adjusting entries are covered in the next module.

THE NEED FOR ADJUSTING ENTRIES

Principally, adjusting entries are prepared so that there would be a proper matching of
earned income and incurred expenses. If these were not prepared, the reported profit is not
a fair measure of the performance of the business enterprise. Certain figures reported in the
balance sheet are either overstated or understated if adjusting entries are omitted. Failure
to prepare these entries affects not only the financial statements of the current accounting
period, but also those of the succeeding periods. It will be noted that none of the prepared
adjusting entries involve cash. There are no adjusting entries under the pure-cash basis
accounting.

ADJUSTING ENTRIES
These are general journal entries done at the end of the accounting period to split mixed
accounts and to bring the accounts up to date for the purpose of measuring the results of
operations and financial position as fair and accurate as possible.

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There are two major groups of transactions that must be adjusted before the financial
statements are prepared. They are:

1. Unrecognized/ unrecorded transactions that affect future periods

Included in this group are those transactions that already occurred but which are not yet
recognized in the records. This group includes:

⮚ Accrued Revenue - Revenue or income that is earned in the present reporting

period, but not yet recognized/recorded since it is to be collected in the future
reporting periods. This is also known as Accrued Income.
⮚ Accrued Expense - Expenses that are already incurred in the present reporting
period, but not yet recognized/recorded since they are to be paid in the
coming/future reporting periods.

2. Recognized/ recorded transactions that affect future periods

Included in this group are those transactions that are already recognized in the records,
but which require full or partial deferral/postponement for the future periods. Since these
transactions will directly or indirectly affect the future operations, the portions pertaining
to the future must be separated from the portions pertaining to the current period. The
initially recognized value is allocated over the several affected reporting periods in order
that there will be a better matching of income and expenses. This group includes:

⮚ Unearned Revenue - Revenue or income collected but will be earned over the
succeeding periods. This is also known as Pre-collected Revenue/ Income or
Deferred Revenue/Income.
⮚ Prepaid Expense - Expenses already paid for but will be incurred over the future
periods. This is also known as Unused expenses, Unexpired expenses, or Deferred
expenses.
⮚ Depreciation Expense - the cost of the property, plant and equipment is allocated
over the future periods benefited by the asset, in the form of depreciation. The
estimated allocated cost is depreciation.
⮚ Bad Debts Expense - it represents that part of the receivables, which arises when
goods have been delivered or services have been rendered to customers on
account, which is estimated to be doubtful of collection. This is also known as
Doubtful Accounts or Uncollectible Accounts.

This group of transactions gives rise to mixed accounts. In the previous modules, we have
noted that there are two kinds of accounts - Balance Sheet Accounts and Income
Statement Accounts. However, another way of classifying these accounts is as follows:

a. Real Accounts - these include all balance sheet accounts except Owner's
Drawing. These are also known as Permanent Accounts because their ending
balances are not brought down to zero at the end of the accounting period.

b. Nominal Accounts - these include all income statement accounts and the owner's
drawing account. These are also known as Temporary Accounts because they

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relate only to the current accounting period and their balances are eventually
transferred to the capital account; thus, bringing their balances to zero at the end
of the accounting period.

c. Mixed Accounts - the nature of these accounts is partly real and partly nominal. It
may either be composed of:
i. Asset and expense elements
ii. Liability and income elements

MIXED ACCOUNT

Real/ Permanent part Nominal/ Temporary part

(reported in the balance sheet) (reported in the income statement)

GATHERING DATA FOR ADJUSTMENTS

One of the duties of the accountant is to gather data that are needed in preparing the
adjustments at the end of the accounting period. These entries are not caused by external
events; the accountant must be resourceful in order to gather the necessary adjustment
data. Without them, the financial statements cannot be properly prepared.

Data that will be used in the preparation of the adjusting entries may come from any of the
following steps:

1. Review of the Trial Balance and Analysis of the Ledger Accounts

A careful analysis of the accounts is one way of determining some of the items that should
be adjusted. The existence of certain unearned income or prepaid expenses may be
initially gathered from a thorough review of the unadjusted trial balance. The accountant
must gather data for him to know how much of the expenditures benefited the current
period, and how much would benefit the future periods. A careful review and analysis of
the accounts will reveal whether certain collections were earned or not, and whether
certain payments were used or not. There should be an objective basis for allocating the
income collections and expense payments between the present and the future reporting
periods.

2. Review of the Source Documents

The review and analysis of accounts are accompanied by a careful study of the source
documents that support the recorded income collections or expense payments.
Information about accrued income and accrued expenses is usually gathered by
analyzing the collections and payments within the last week of the current reporting
period and the first weeks of the next reporting period. For example, if the BENECO bill
paid on January 10, 2020 represented the electric consumptions from November 24, 2019

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to December 23, 2019; it means that there is unbilled electricity consumed from
December 24 to 31, 2019. This unbilled expense must also be estimated and adjusted as
accrued expense as of December 31, 2019.

3. Undertaking Ocular Inspections and Counts

Sometimes, there is a need to make ocular inspections and actual counts of the unused
items in order to determine certain prepayments. For example, the values assigned to
the unused supplies and unsold goods are based on a count of the items inside the
storeroom.

4. Consultation with Experts

Researches or consultations with experts are helpful in estimating the useful lives of long-
lived property, plant, and equipment. Dialogues with the external auditor will give the
accountant some insight about the practices of other businesses in the same industry.

ACCRUED REVENUE/INCOME
Generally, income is recorded at the time when cash is received for services rendered by
the business. However, income is also considered earned or realized in the period when the
service is rendered whether or not cash has been received in payment for such service.
Therefore, to prevent the understatement of income and assets for the current period,
adjusting entries are needed to record accrued revenue. This refers to income that has been
earned but is not yet due for collection or has not yet been received. In other words, the
business has an amount receivable (asset) for the services already considered.

The adjusting entry for accrued revenue is to debit the accrued receivable asset account
which represents the amount of cash receivable in the future and credit the
revenue/income account. The accrued asset account is debited to record the increase in
the asset receivables and the income account is credited to record the increase in capital
due to income already earned.

The adjusting entry to record accrual of an income is:

Accrued revenue/income receivable xxx
Income account xxx

Case 1:
A dentist renders professional services valued at P4,500 to his patients from December 26 to
29 of the current year. As of December 31, he has not billed the patients for the services
rendered.

Since the dentist already rendered services, the earning process is almost complete, and
income ls earned even though cash has not been collected. The right to collect from
patients for the unbilled income must be recognized in the records before the preparation
of the financial statements. The adjusting entry for this is as follows:

8
Dec. 31 Professional Fees Receivable 4,500
Professional Fees 4,500
To record unbilled services Dec 26-29.

CASE 2:
The business subleases a portion of the store to a sweepstakes ticket vendor at P500 a month.
At the end of the quarterly accounting period, December 31, the rentals for the month of
November and December have not been received, and accordingly no entries have been
made for this income. The adjusting entry for this is as follows:

Dec. 31 Accrued Rent Receivable 1, 000

Rent Income 1, 000
To record uncollected rent for Nov & Dec.

Accrued Rent Receivable is an asset account representing the amount of cash collectible
in the future. It is debited to show the increase in assets. Rent Income is credited because of
the increase in owner's equity due to income earned within the year.

The ledger accounts before and after the adjusting entry are as follows:

Before Adjustments After Adjustments

Rent Income Rent Income
Oct 31 500 Oct 31 500
Dec31 AJE 1,000

Accrued Rent Receivable

Dec 31 AJE 1,000

The adjusted balance of the Rent income account of P1,500 is the correct amount for three
months. This is shown in the income statement. The balance of the Rent receivable account
of P1, 000 refers to the right of the business to collect the amount in the future. It is shown
among the current assets in the balance sheet.

CASE 3:
Interest is earned on notes receivable from day to day. Therefore, at the end of the
accounting period an adjusting entry is needed for the total uncollected interest on notes
receivable earned during the current period.

Assume that June 30 is end of the accounting period and that no interest has been collected
on a 60-day, 6% note for P12, 000 received from Joe Mina on June 20. In this case, the interest
which has accrued from June 20 to June 30 is an income of the month of June. The interest
from July 1 to August 19, the date of maturity, is income of future accounting periods and
should not be taken up in June.

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The computation of interest earned in each month is as follows:

Interest on P12, 000 at 6% for 60 days (P12, 000 x 6% x 60/360*) = P120.00

Interest on P12, 000 at 6% for 10 days in June (P120 x 10/60) = 20.00
Interest on P12, 000 at 6% for 31 days in July (P120 x 31/60) = 62.00
Interest on P12, 000 at 6% for 19 days in August (P120 x 19/60) = 38.00

* Denominator varies depending on the term of the note. If the term of the note is in months,
the denominator is 12 since there are 12 months in a year. If it is in weeks, then the
denominator is 52 weeks. The term is converted into a year since the interest rate is also for
a year.

The adjusting entry for this is as follows:

Jun. 30 Accrued Interest Receivable 20

Interest Income 20
To record uncollected interest on note.

Accrued Interest Receivable is debited to record the increase in assets, representing the
amount of cash collectible in the future and Interest income is credited to record the
increase in owner's equity due to income earned during the month of June.

Assuming that interest on other notes receivable for the month of June totaling P150 had
been collected previously, the ledger accounts before and after posting the adjusting entry
would appear as follows:

Before Adjustments After Adjustments

Interest Income Interest Income
Jun 15 150 Jun 15 150
30 AJE 20

Accrued Rent Receivable

Jun 30 AJE 20

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The adjusted balance of interest income account is P170. This is the correct amount of
income earned during the month of June which would be shown in the income statement.
The balance of P20 of the Accrued Interest Receivable account refers to the right of the
business to collect the accrued interest in the future. This would be shown among the current
assets in the balance sheet.

If two or more notes receivable are uncollected at the end of the accounting period, the
accrued interest on each note is computed separately. The separate amounts of accrued
interest are then added and only one adjusting entry is made for the resulting total.

ACCRUED EXPENSE
At the end of the accounting period there are some expenses from which the benefits have
already been received but for which payments have not been made. These unpaid
expenses are called accrued expenses. The expense should be charged to the accounting
period when the benefit is received and not when the payment is made. Hence, for each
unrecorded and unpaid expense an adjusting entry debiting the expense account and
crediting the accrued liability account 1s made at the end of the accounting period. The
expenses and liabilities will thus be correctly stated on the books and financial statements.

The expense account is debited to record the increase in expense, thus decreasing owner’s
equity, and the accrued liability account is credited to record the increase in liabilities.

The adjusting entry to record accrual of an expense is:

Expense account xxx
Accrued expense payable xxx

Case 1:
Interest on notes payable is recorded when it is paid in cash. But interest accrues from day
to day. Therefore, at the end of the accounting period the total unpaid interest on notes
payable for the current period is recorded by means of the adjusting entry.

Assume that January 31 is the end of the ·accounting period and that no interest has been
paid on a 60-day, 6% note for P30, 000 issued on January 11. The interest which was accrued
from January 11 to January 31, or a period of 20 days, is an expense of January. The interest
from February 1 to March 12, the date of maturity, is an expense of future accounting periods
and should not be taken up in January. The following diagram shows the distribution of the
interest for 60 days:

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The computation of interest incurred in each month is as follows:
Interest on P30,000 at 6% for 60 days (P30,000 x 6% x 60/360) = P300.00
Interest on P30,000 at 6% for 20 days in Jan. (P300 x 20/60) = 100.00
Interest on P30,000 at 6% for 28 days in Feb. (P300 x 28/60) = 140.00
Interest on P30,000 at 6% for 12 days in March (P300 x 12/60) = 60.00

The adjusting entry for this is as follows:

Jan. 31 Interest Expense 100
Accrued Interest Payable 100
To record unpaid interest on note.

Assuming that interest on other notes payable for the month of January totaling P120 had
been paid previously, the ledger accounts before and after posting the adjusting entry
would appear as follows:

Before Adjustments After Adjustments

Interest Expense Interest Expense
Jan 11 120 Jan 11 120
31 AJE 100

Accrued Interest Payable

Jan 31 AJE 100

The adjusted balance of Interest Expense account is P220. This is the correct total interest
expense for the month of January which would be shown in the income statement. The
balance of P100 of the Accrued Interest Payable account represents the liability for the
accrued Interest. This would be shown among the current liabilities in the balance sheet.

If two or more notes are unpaid at the end of the accounting period, the accrued interest
on each note is computed separately. The separate amounts of accrued Interest are then
added and only one adjusting entry is made for the resulting total.

CASE 2:
Businesses have different policies in paying the wages of their employees. Some pay their
employees monthly, twice every month, every Saturday, or every Monday. Amounts already
earned by the employees but not paid as of the end of the reporting period must be
adjusted.

Assuming that the policy of a business is to pay salaries of employees every Saturday and
their rest day is Sunday. There are 10 employees who receive a daily rate of P200, and 4
employees receive a rate of P500 per day. At the end of its accounting period, December
31 which falls on a Thursday, the unpaid salaries of employees from December 28 to 31 or a
period of 4 days, is an expense of the month of December. The amount of salaries from
January 1 to 2, the date of payment, is an expense of future accounting periods and should
not be taken up in December.
Property of and for the exclusive use of SLU. Reproduction, storing in a retrieval system, distributing, uploading, or posting online, or transmitting in any form or by any
means, electronic, mechanical, photocopying, recording, or otherwise of any part of this document, without the prior written permission of SLU, is strictly prohibited.

12
The computation of salaries for the week is as follows:
10 employees earning P200/day (10 x P200 x 6 days) P 12,000
4 employees earning P500 / day (4 x P500 x 6 days) 12,000
Total salaries for 6 days P 24,000

Salaries for 4 days in December (P24, 000 x 4/6) P 16,000

Salaries for 2 days in January (P24, 000 x 2/6) 8,000
The adjusting entry for this is as follows:

Dec. 31 Salaries Expense 16, 000

Accrued Salaries Payable 16, 000
To record unpaid salaries from Dec. 28 – 31

Assuming that salaries expense for the month of December totaling P92, 000 had been paid
previously, the ledger accounts before and after posting the adjusting entry would appear
as follows:

Before Adjustments After Adjustments

Salaries Expense Salaries Expense
Dec 5 20,000 Dec 5 20,000
12 24,000 12 24,000
19 24,000 19 24,000
26 24,000 31AJE 16,000
92,000 108,000

Accrued Salaries Payable

Dec 31 AJE 16,000

The adjusted balance of Salaries Expense account is P108, 000. This is the correct total salaries
expense for the month of December which would be shown in the income statement. The
balance of P16, 000 of the Accrued Salaries Payable account represents the liability for the
accrued salaries. This would be shown among the current liabilities in the balance sheet.

Case 3:
Billings of electricity, water and other form of utility expenses are usually based on actual
consumption of, or services received by the consumer. These are usually paid and taken up
in the records after a statement of account has been received from the service provider. If
Property of and for the exclusive use of SLU. Reproduction, storing in a retrieval system, distributing, uploading, or posting online, or transmitting in any form or by any
means, electronic, mechanical, photocopying, recording, or otherwise of any part of this document, without the prior written permission of SLU, is strictly prohibited.

13
at the end of the accounting period, there are benefits already received but not yet paid
to the service provider, adjustments must be prepared to take up the expense and the
corresponding liability.

Assume that electricity and water already consumed in December of the current year, but
not yet billed by the utility company as of the end of the year, is estimated at P3, 500. The
adjusting entry for this is as follows:

Dec. 31 Utilities Expense 3,500

Accrued Salaries Payable 3,500
To record unpaid salaries from Dec 28 to 31.

UNEARNED INCOME
Cash is sometimes received in advance for services to be rendered in the future. In other
words, income is received in the present period but is earned in the future. This is known as
unearned income or deferred income of the present period. It is considered a liability
because it represents the obligation of the business to render the corresponding services for
the amount collected. As the services are rendered, the liability is cancelled, and income is
earned.

The adjusting entry for unearned income depends on the entry originally made at the time
cash is collected. At the time of collection either the income account or the unearned
income account may be credited. These methods of handling unearned income are known
as the income method and liability method.

A. Income Method. Under this method, the balance of the income account at the end of
the accounting period may not represent the correct amount of the income earned
during the current period. The business may still have the liability to render services in the
future in exchange for the cash received in advance, thus giving rise to unearned
income. In this case, the income account is the mixed account. The income would be
overstated and there would be an unrecorded liability. Therefore, to adjust the books,
the income account should be debited to correct the overstatement and the unearned
income account should be credited for the amount of the unrecorded liability.

14
B. Liability Method. The unearned income becomes earned or realized as the business
renders the corresponding services. Therefore, under the liability method, the original
amount of the unearned income may be overstated as of the end of the current
accounting period and they may be unrecorded income. In this case, the unearned
income account is the mixed account. Hence, to adjust the books, the overstatement of
the unearned income should be debited to the unearned income account and the
unrecorded income should be credited to the income account.

From the foregoing discussions, it will be noted that the adjusting entry for unearned
income depends on the entry at the time it was received. As will be proven in subsequent
illustrations, the use of either of the two methods will lead ultimately to the same results;
that is, after adjustment the ledger account balances under one method are the same
as those under the other method. When the adjusting entries are to be prepared with the
aid of the unadjusted trial balance, the adjustment for unearned income depends on
the related account which appears in the trial balance. If only the income account, like
Rent Income, appears on the trial balance, the income account must have been
credited at the time of collection and accordingly, the adjustment under the income
method should be made. On the other hand, if the unearned income account like
Unearned Rent is shown on the trial balance, the collection must have been credited to
the liability account so that the adjustment under the liability method should be used.

CASE 1:
On December 11, a 60-day 6% note for P30, 000 was received from a customer together with
the total interest for sixty days of P300. December 31 was the end of the accounting
period. Therefore, as of that date, the interest for twenty days (December 11 to 31) represents
the currently earned income while the interest for the remaining forty days (Term of note at
60 days less 20 days for the earned income period) is unearned income. The amounts for
these are as follows:

15
In either of the two methods, the results after adjustment are the same, as follows:

1. The interest income for the current period is P100, representing the interest on the
customer's note which was earned in December.
2. The unearned interest or liability as of December 31 is P200 representing the interest
on the customer's note for the remaining forty days covered by a future period.

It can be seen from the foregoing illustration that because of the adjusting entry the ledger
accounts for the interest income and unearned interest accounts show the correct
balances. Thus, the income statement and balance sheet also show the correct amount of
these items.

16
CASE 2:
Problem: The following item appears on the unadjusted trial balance on Dec. 31:

Debit Credit
Rent income 9,000

Prepare the adjusting entry if the rentals were received on December 1 for three months in
advance.

Analysis:
1. The income account appears on the trial balance; therefore, the income method must
have been used for the original entry. The income account is the mixed account and to
adjust it, debit the income account and credit the liability account for the amount of
unearned income as of December 31.
2. On December 31, the composition of the total amount received of P9, 000 is as follows:

Income portion: Rental for month of December (1/3 x P9, 000) = P 3,000
Liability portion: Rentals for January and February (2/3 x P9, 000) = 6,000
Total amount received P 9,000

The liability portion of P6, 000 should be transferred from the Rent Income account to the
Unearned Rent Income account. The adjusting entry is as follows:

Dec. 31 Rent Income 6,000

Unearned Rent Income 6,000
To record rent earned in December.

The ledger accounts before and after posting the adjusting entry would appear as follows:

Before Adjustments After Adjustments

Rent Income Rent Income
Dec 1 9,000 Dec31-AJE 6,000 Dec 1 9,000
Balance 3,000

Unearned Rent Income

Dec31-AJE 6,000

PREPAID EXPENSES
Prepaid expenses at the end of an accounting period include unused supplies and services
which have already been paid for but the benefits from which apply to future period or
periods. They are assets of the current period but become expense of the future.

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The adjusting entry for a prepaid expense depends on the entry originally made at the time
it was paid. At the time of payment either the expense account or the prepaid expense
(asset) account may be debited. These two possible methods of handling prepaid expenses
are referred to as the expense method and the asset method.

A. Expense method. Under this method, the balance of the expense account at the end of
the accounting period may not represent the correct account of the expense incurred
during the period. There may be future period(s) which may benefit from the amount
paid in advance, thus giving rise to prepaid expense (asset). In this case, the expense
account is the mixed account. The expense would be overstated and there would be
an unrecorded asset. Therefore, to adjust the books, the prepaid expense account
should be debited for the amount of the unrecorded asset and the expense account
should be credited to correct the overstatement of such account.

B. Asset method. The prepaid expense (asset) becomes an expense as benefits are
received by the business. Therefore, under the asset method the original amount of the
prepaid expense may be overstated as of the end of the current period and they may
be an unrecorded expense. The mixed account in this case is the asset account. To
adjust the books, the unrecorded expense should be debited to an expense account
and the overstatement of the prepaid expense should be credited to the prepaid
expense account

From the foregoing discussions it will be noted that the adjusting entry for a prepaid
expense depends on the entry at the time it was paid. As will be proven in subsequent
illustrations, one method produces the same results as the other provided that the

18
adjusting entry is correctly made. In other words, after adjustment, the ledger account
balances under one method are the same as those under the other method.

When adjusting entries are to be prepared with the aid of the unadjusted trial balance,
the adjustment for prepaid expense depends on the related account which appears in
the trial balance. If only the expense account, like Insurance Expense, appears on the
trial balance, the expense account must have been debited at the time of payment and
accordingly, the adjustment under the expense method should be made. in like manner,
if the prepaid expense account like Prepaid Insurance is shown on the trial balance, the
asset account must have debited at the time of payment so that the adjustment under
the asset method should be used.

Case 1:
In December 1the business paid rent for three months in advance amounting to P6,000. This
means that the monthly rent is P2,000 so that the composition of the total amount paid is as
follows:

The entry in December 1for the payment of rent, the related adjusting entry on December
31, and the ledger accounts under the expense method and the asset method are as
follows:

19
In either of the methods the results after adjustment are the same. They are as follows:
1. The rent expense for the current period is P2,000, representing the rent for the
month of December. This is shown in the income statement.
2. The prepaid rent or asset portion as of December 31 is P4,000 representing the rent
for the remaining two months covered by future periods. This is shown as a current
asset in the balance sheet.

The foregoing case proves that the adjusting entry changes the balances of the expense
and prepaid expense accounts to the correct amounts. Thus, the income statement and
balance would also show the correct amounts of these items.

Case 2:
Problem: The following item appears on the unadjusted trial balance on Dec. 31:

Debit Credit
Supplies expense 500

Prepare the adjusting entry if the unused supplies on December 31 per physical count total
P200.

Analysis:
1. The expense account appears on the trial balance; therefore, the expense method
must have been used for the original entry. To adjust, debit the asset account and
credit the expense account for the unused supplies on December 31.
2. The value of the unused supplies on December 31 as given in the problem is P200.

The adjusting entry is as follows:

Dec. 31 Unused Supplies 200

Supplies Expense 200
To set-up ending supplies inventory.

The ledger accounts before and after posting the adjusting entry would appear as follows:

Before Adjustment After Adjustment

Supplies Expense Supplies Expense
Dec 31-Unadj 500 Dec 31-Unadj 500 Dec 31- AJE 200
Bal. 300

Unused Supplies
Dec 31-AJE 200

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Case 3:
Problem: The following item appears on the unadjusted trial balance on Dec. 31:

Debit Credit
Unused Supplies 500

Prepare the adjusting entry if the unused supplies on December 31 per physical count total
P200.

It should be noted that except for the account title shown on the trial balance the data in
the problem are the same as in the preceding illustration.

Analysis:
1. The asset account appears on the trial balance; therefore, the asset method must
have been used for the original entry. To adjust, debit the expense account and
credit the asset account for the value of the supplies used during the present period.
2. The supplies expense for the period is computed as follows:

Supplies in the unadjusted trial balance P 500

Less: Unused supplies on December 31 200
Supplies used up to December 31 300

The adjusting entry is as follows:

Dec. 31 Supplies Expense 300

Unused Supplies 300
To set-up ending supplies inventory.

The ledger accounts before and after posting the adjusting entry would appear as follows:

Before Adjustments After Adjustments

Unused Supplies Unused Supplies
Dec 31-Unadj 500 Dec 31-Unadj 500 Dec 31-Unadj 300
200
Supplies Expense
Dec 31-AJE 300

It will be noted that although the analysis and adjusting entry in this illustration differ from
those in the preceding illustration, the account balances after adjustment are the same.

Case 4:
On December 16, a 60-day, 6% note for P50, 000 was issued to a supplier and the total interest
for 60 days of P500 was paid in advance. December 31 is the end of the period. Therefore,
as of this rate the interest for 15 days (from December 16 to 31) represents the current
expense and interest for the remaining 45 days is the prepaid interest. The respective
amounts for these are as follows:

21
The entry on December 16 for the payment of the interest, the related adjusting entry on
December 31, and the ledger accounts under the expense method and the asset method
are as follows:

In either of the two methods, the adjusted ledger balances which are the correct amounts
as of December 31 as follows: Interest Expense = P125 and Prepaid Interest = P375

DEPRECIATION EXPENSE
Property, plant, and equipment are those of a relatively permanent nature which are used
in the operations of the business and are not intended to be sold, such as land, buildings,
office equipment, deliver equipment, furniture, and fixtures. Although these assets are
durable in nature, with the exception of land used for business purposes, they decrease in
value as time passes due to wear and tear from operations. They also decrease in value due

22
to inadequacy and obsolescence. These factors that decrease the fixed asset's values can
be classified as follows:

1. Physical Deterioration. This results from the frequent use (wear and tear) and/or exposure
to the elements like the wind, rain, and sun. Nonuse of such assets for a prolonged period
and· accidents such as fire, flood, and earthquake may also cause the physical
deterioration of plant assets.

Regular repairs and maintenance may keep property, plant, and equipment in good
operating condition for a longer time but there would always be a point when they have
to be discarded because of their decreased effectiveness and efficiency.

2. Inadequacy and Obsolescence. Though a fixed asset is still operating effectively, it may
be becoming inadequate, i.e. its capacity is sufficient to fulfill the demands of the
business. In addition, because of fast-changing technology and rapidly changing tastes
and demands, property, plant and equipment become obsolete before they even wear
out. It can happen that there is no future demand for the goods that the fixed asset
produces. It is also possible that a new asset, which can do the same or even more
functions than the other asset at a substantially lesser cost, becomes available,

Depreciation related to physical deterioration is known as Physical Depreciation. On the

other hand, if it is attributed to obsolescence or inadequacy of the asset to perform
efficiently, it is known as Functional or Economic Depreciation.

Because of the limited life of these tangible assets, their costs should be distributed as
expenses over the years they benefit. This system of accounting that aims to distribute
the cost or other basic value of tangible capital assets, less the remaining value when it
is retired or worn out, if any, over the estimated useful life of the unit which maybe a group
of assets, in a systematic and rational manner is called Depreciation Accounting.

It must be noted that depreciation as understood by layman is differently viewed by

accountants. If the former considers it as a decrease in value of an asset, the latter treats
it as a portion of an asset's cost allocated or changed to expense during an accounting
period. In short depreciation accounting is a process of allocation, not of valuation.

The gradual decrease in value of property, plant, and equipment due to use,
inadequacy, and obsolescence is called depreciation. It is an operating expense of a
trading business and must be shown in the books and financial statements.

There are several methods of determining the amount of depreciation to be charged as

an expense of each accounting period. The simplest one is called the straight-line
method. This is used in this module. The other methods will be explained in higher
accounting courses.

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COMPUTATION OF DEPRECIATION
In order to properly compute the amount of depreciation to be charged as expense during
an accounting period, three fundamental factors must be considered:

1. Cost. As mentioned earlier in the module, the cost does not only include the purchase
price as lifted from the seller's invoice, but also other expenses needed in acquiring and
preparing the asset for its intended use. In the case of land, included as part of its cost is
the purchase price plus incidental costs such as commissions, legal fees, escrow fees,
surveying fees, mortgage assumed and water line assessments.

The cost of a building includes the purchase price and incidental costs like commissions,
related unpaid taxes assumed, legal and other professional fees, and reconditioning
costs. An equipment's cost normally includes the purchase price, taxes, freight, insurance,
installation costs and any other expenditure incurred in preparing the asset for its
Intended use, e.g. reconditioning and testing costs. It is important that the total cost of a
depreciable fixed asset is properly accounted from because it would be one of the bases
in computing the depreciation charges.

2. Scrap Value. This is the estimated amount that will be received at the time the asset sold
or removed from service. It is also known as Salvage value and Residual value.

When the scrap value is significant and can be reasonably estimated, it should be
considered in determining depreciation. It should be reviewed periodically and revised
if necessary to recognize changing conditions. But such adjustment should be downward
only. From the practical standpoint, the scrap value is often equal to zero because the
value is very usually very small or not capable of estimation.

3. Estimated Useful Life. When an asset is acquired, it is not possible to know exactly how
long it will be useful to the business. Therefore, the number of years the asset would be
beneficial to the firm must be estimated. The approximation may be based on past
experience of the company or of other entities, or upon studies or professional judgment.
The service life of an asset may be expressed any of the following ways: (a) time periods
as in years or months; (b) working hours or service hours; and (c) units of output or
production.

Under the straight-line method, the following formula is used in computing the amount of
depreciation of a fixed asset:

Depreciation Expense per Year = Cost Scrap Value

Estimated Useful Life (in years)

24
The numerator "Cost less Scrap value", also known as depreciable cost, is the maximum
amount of depreciation which can be charged to expense over the depreciable asset's
useful life. If the scrap value is zero, the depreciable cost is equal to the asset's cost.

Another formula used in computing depreciation in this method is the use of an annual
straight-line rate. This rate is computed by dividing 100% with the fixed asset's estimated
useful life. For example, a fixed asset with an estimated useful life of five (5) years will have
an annual straight-line rate of 20% (100% / 5 yrs). The formula to compute the
depreciation is as follows:

Depreciation Expense per Year = Straight line Rate X (Cost – Scrap Value)

The straight-line method is based on the theory that periods benefited by the use of the
asset should bear an equal or equitable share of the asset's cost. Clearly, this method
considers depreciation as a function of time rather than a function of usage.

This method therefore is adopted when the principal cause of depreciation is passage
of time. Examples of assets which employ the straight-line method are buildings, other
structures like radio and TV towers, dams, bridges, and equipment like typewriters, cash
registers and computers. Although use and obsolesce contribute to the depreciation
of such assets, these causes are insignificant compared to the effects of time.

RECORDING DEPRECIATION
Depreciation usually is recorded at the end of the accounting period, along with other
necessary adjusting entries. The entry to record depreciation is:

Depreciation Expense XXX

Accumulated Depreciation - (Specific Fixed Asset) XXX

The debit to Depreciation Expense account is made to recognize the expense incurred in
relation to using the asset for the period. This account is a nominal account; hence it is
presented in the income statement as part of the business's operating expense. Qualifying
these accounts to identify them with the specific property, plant, and equipment they are
related to may also be done. For instance, a company may have as account titles
Depreciation Expense - Building, Depreciation Expense - Equipment, Accumulated
Depreciation Expense - Building and Accumulated Depreciation - Equipment.

25
The credit to Accumulated Depreciation account, a contra asset account, is made to
recognize the reduction in the value of the depreciable asset. This is a valuation account
and should therefore be presented in the asset section of the balance sheet as deduction
to the primary account to which it relates. Allowance for Depreciation is sometimes used
instead of Accumulated Depreciation. But the latter is preferred because it avoids the
erroneous connotations that may be associated with the word "Allowance".

It is to be noted that the reduction in the value of the asset due to depreciation is not
credited directly to the fixed asset account because that would indicate that some of the
fixed asset had been sold or discarded. Furthermore, the use of the accumulated
depreciation account would give the reader of the financial statements information about
the original cost and the approximate age of the asset. As the title implies, accumulated
depreciation is the total depreciation charges that increases or accumulates every year or
as time passed by.

Some of ways of presenting property, plant, and equipment and accumulated depreciation
in the balance sheet is as follows:

Presentation 1:
Property, Plant and Equipment
Land P XXX
Building P XXX
Less: Accumulated Depreciation - Building XXX XXX
Equipment P XXX
Less Accumulated Depreciation – Equipment XXX XXX
Total Property, Plant and Equipment P XXX

Presentation 2:
Property, Plant and Equipment
Land P XXX
Building P XXX
Equipment XXX
Total ` P XXX
Less Accumulated Depreciation XXX XXX
Net Book Value/ Carrying Value P XXX

Presentation 3:
Property, Plant and Equipment
Cost Accumulated Depreciation Book Value
Land P XXX P XXX
Building XXX P XXX XXX
Equipment XXX XXX XXX
Total P XXX P XXX
Carrying Value P XXX

26
The net book value or carrying value is the excess of the depreciable asset's cost after
deducting the accumulated depreciation. The fixed asset's carrying value is gradually
decreased every year. At the end of the asset's useful life, the carrying value is equal to the
scrap value.

Carrying value is of significance primarily for accounting purposes. It represents cost that will
be offset against the revenue of future periods. It also gives users of financial statements an
indication of the age of a company's depreciable assets. It is however important to realize
that the carrying value does not necessarily represent an asset's current fair market value.

To illustrate, an equipment costing P198,500, have an estimated useful life of 5 years and that
at the end of 5 years the equipment will have a scrap value of P25,000. Freight cost of P1,500
was paid on the purchase. The annual depreciation of the equipment can be computed as
follows:

Depreciation Expense = Cost – Salvage Value

Estimated Useful Life

= (P 198,500 + 1,500) - 25,000

5 years

= P 175 000
5 years

= P35,000

Another way of solving the annual depreciation expense is the use of a straight-line rate.
Annual Straight-line rate = 100% / Estimated Useful Rate
Annual Straight-line rate = 100% / 5 years
= 20%

Annual Depreciation Expense = Depreciable Cost x Annual Straight-line rate

= (Cost - Salvage Value) x Annual Straight-line Rate
= [(Pl98,500 + 1,500) - 25,000] x 20%
= [P200,000 - 25,000] x 20%
= P175,000 x 20%
= P35, 000

The adjusting entry to record one-year depreciation is as follows:

Dec. 31 Depreciation Expense 35,000

Accumulated Depreciation- Equipment 35,000
To record depreciation for the year.

27
The computation of equipment's carrying value for the five-year period is presented below:

Depreciation Accumulated Carrying

Value Depreciation Value
Cost (198, 500 + 1500) P 200 000.00
Jan. 1 to Dec. 31, 2005 P 35 000.00 P 35,000.00 165 000.00
Jan. 1 to Dec. 31, 2006 35 000.00 70 000.00 130 000.00
Jan. 1 to Dec. 31, 2009 35 000.00 105 000.00 95 000.00
Jan. 1 to Dec. 31, 2010 35 000.00 140,000.00 60 000.00
Jan. 1 to Dec. 31, 2011 35 000.00 175 000.00 25 000.00
Total P 175 000.00

The Accumulated Depreciation account is increased every year by the amount of

Depreciation Expense.

Accumulated Depreciation this year = Depreciation Expense this year + Accumulated Depreciation,

balance last year

Using the formula above, the Accumulated Depreciation of 2010 of P140,000 is computed
by adding the Depreciation expense for 2010 of P35,000 and Accumulated Depreciation
balance last 2009 of P105,000.

The Carrying Value is computed as follows:

Carrying Value this year = Cost - Accumulated Depreciation this year

Using the formula above, the Carrying Value of 2010 of P60,000 is computed by deducting
the Accumulated Depreciation balance for 2010 of P140,000 from the cost of P200,000.

It can also be computed using the following:

Carrying Value this year = Carrying Value last year – Depreciation Expense this year

Using the formula above, the Carrying Value of 2010 of P60,000 is computed by- deducting
the Depreciation Expense for 2010 of P35,000 from the carrying value balance of 2009 of
P95,000.

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DEPRECIATION FOR FRACTIONAL PERIOD
The depreciation for the accounting period during which the asset was purchased should
be calculated from the date of purchase to the end of that period. When the date of
purchase falls on the first day of the accounting period, like a year, this depreciation will be
for one whole year. However, when the date does not coincide with the first day of the
accounting period, this depreciation will be for only a fraction of the accounting period. If
the above equipment is acquired on April 1 of the calendar year, the depreciation expense
for the first year should be P26, 250, in the sense that the equipment is in use for only nine
months. The depreciation for nine months is computed as follows:

Depreciation Expense for 1yr X 9/12 = P35, 000 x 9/12 = P26,250

If the fixed asset was acquired during the month, it is not necessary to compute the
depreciation per day. Treatment to this would be a matter of company policy. For example,
for purposes of computing depreciation, fixed asset acquired during the first half-month may
be treated as it was purchased at the beginning of the month; while those acquired during
the second half of the month may be treated as if it was acquired at the beginning of the
following month. Note that depreciation is just an estimated amount; hence the above
policy is considered sufficiently accurate.

If a schedule of depreciation for the entire estimated useful life is to be prepared, it can be
presented as foIIows:

Depreciation Accumulated Carrying

Expense Depreciation Value
Cost P200,000.00
Apr. 1 to Dec. 31, 2005 P 26,250.00 P 26, 250.00 173,750.00
Jan. 1 to Dec. 31, 2006 35 000.00 61, 250.00 138,750.00
Jan. 1 to Dec. 31, 2009 35,000.00 96, 250.00 103,750.00
Jan. 1 to Dec. 31, 2010 35,000.00 131,250.00 68,750.00
Jan. 1 to Dec. 31, 2011 35,000.00 166,250.00 33,750.00
Jan. 1 to Mar. 31, 2012 8,750.00 175 000.00 25,000.00
P 175,000.00

At the end of the asset's useful life, the net book value is equal to the scrap value.

BAD DEBTS EXPENSE

Usually most business firms extend credits to attract more customers and to sell more goods.
However, an element of risk is involved in rendering services or selling goods on credit.
Regardless of the care taken in investigating the credit worthiness of each customer, there
are times where a business may find it difficult to collect on some of its credit accounts. A

29
certain percentage of these collectibles are not collected. For this reason, the business
should provide for such losses for non-collection of credits. This loss from uncollectible
accounts is called bad debts, an operating expense which must appear on the books and
financial statements.

Bad debts arise from sales made on account. Under the matching principle, they should be
taken up as an expense of the period in which the related sale took place. The amount of
bad debts for each period is generally a mere estimate because the uncollectibility of
customers' accounts related the current sales is usually proved in a later period. The records
of the business regarding uncollectible accounts in the past periods would be useful in
making this estimate.

ACCOUNTING FOR BAD DEBTS

There are two methods being followed in accounting for bad debts, namely:
1. Allowance method
2. Direct charge-off method/Direct write-off method

A. Allowance method. The allowance method of accounting for uncollectible accounts

argues that in accordance with the matching rule, a business should assume that losses
from an uncollectible account at the moment the sale is made to the customer. The
Allowance for Bad debts is used because the company does not know until after the sale
that the customer will not pay. Since the amount of loss must be estimated if it is to be
matched against the sales or revenue for the period, it is not possible to credit the amount
of any particular customer. Also it is not possible to credit the Accounts Receivable
controlling account in the general ledger because doing so would cause the controlling
account to be out of balance with the total customers' accounts in the subsidiary ledger.

B. Direct Charge-off method. In contrast with the allowance method, the direct charge-off
method record doubtful accounts by debiting expense directly when bad debts are
discovered. This method 1s not in accordance with generally accepted accounting
principles because it makes no attempt to match revenues and expenses. Uncollectible
accounts are charged to expenses in the accounting period in which they are
discovered rather than in the period of sale. On the balance sheet the accounts
receivable are shown at gross value, because there is no Allowance for Bad Debts
account. Only the direct charge-off method, however, is allowable in computing taxable
income. The allowance method is still used for financial reporting because it is better from
the standpoint of accounting theory.

RECORDING BAD DEBTS

Bad debts are usually recorded at the end of the accounting period, along with other
necessary adjusting entries. The entry to record bad debts is:

Bad Debts Expense XXX

Allowance for Bad Debts XXX

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The Bad Debts Expense, which may also be termed as Uncollectible Accounts or Doubtful
Accounts, account is debited to record the decrease in capital due to the estimated toss.
Allowance for bad debts, also known as Estimated Uncollectible Accounts for Estimated
Doubtful Accounts, which like Accumulated Depreciation, is a valuation or a contra-asset
account that is credited to record the corresponding decrease in the value of the related
asset account, Accounts Receivable. The Accounts Receivable account is not credited
directly because it is not known immediately which customers' accounts are definitely
uncollectible. To determine the carrying value or the net amortized cost of accounts
receivable, the credit balance of the Allowance for Bad Debts is deducted from the debit
balance of Accounts Receivable. Below is the balance sheet presentation of the Allowance
account:

Current Assets:
Cash P XXX
Accounts Receivable P XXX
Less: Allowance for Bad Debts Net Amortized Cost XXX
Net amortized Cost XXX

COMPUTATION OF BAD DEBTS

Because it is impossible to know which accounts will be uncollectible at the time financial
statements are prepared, it is necessary to estimate the expense to cover the expected
losses for the year. Of course, estimates can vary widely.
There are two methods of estimating doubtful accounts, namely:
1. Percentage of Accounts Receivable, ending balance
2. Aging of the Accounts Receivable

Percentage of Accounts Receivable or Balance Sheet Approach

A certain rate is multiplied by the open accounts at the end of the period In order to get the
required allowance balance. The rate used is usually determined from the past experience
of the company. This procedure has the advantage of presenting the accounts at net
amortizable value. It is also simple to apply.

For example, the following unadjusted December 31 account balances are available:
Accounts receivable of P720,000 and a credit balance in the allowance account of P5, 000.
Bad debts accounts are estimated to be 2% of accounts receivable at the end.

Computation:
Required allowance (2% x 720,000) P 14,400
Less: Allowance balance (credit) 5,000
Increase in allowance – Expense P 9,400

When the accounts receivable is multiplied by the rate of percent, the resulting amount is
the required balance of the Allowance for Bad Debt account. Thus to determine the amount
of the adjustment, the balance before adjustment should be considered, If the balance
before adjustment is a credit. It Is deducted from the required balance; if the balance before
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31
adjustment is a debit, it is added to the required balance to arrive at the amount of the
adjustment.

The adjusting entry to record bad debts is as follows:

Dec. 31 Bad Debts Expense 9,400

Allowance for Bad Debts 9,400
To record bad debts for the year.

The Allowance for Bad Debts account before and after posting the adjusting entry would
appear as follows:

Before Adjustment After Adjustment

Allowance for Bad Debts Allowance for Bad Debts
Dec 31-Unadj 5,000 Dec 31-Unadj 5,000
31-AJE 9,400
14, 400

If the allowance account has a debit balance, then the following computation and entry is
made:

Computation:
Required allowance (2% x 720,000) P 14, 400
Add: Allowance balance (debit) 5, 000
Increase in allowance – Expense P 19, 400

The adjusting entry to record bad debts is as follows:

Dec. 31 Bad Debts Expense 19,400

Allowance for Bad Debts 19,400
To record bad debts for the year .

Before Adjustment After Adjustment

Allowance for Bad Debts Allowance for Bad Debts
Dec 31-Unadj 5,000 Dec 31-Unadj 5,000 Dec 31-Unadj 19, 400
14, 400

If in the above example, the allowance account has a zero balance, the amount computed
is the amount of bad debts expense.

Computation: Bad debts expense (2% x 720,000) P 14, 400

The adjusting entry to record bad debts is as follows:

Dec. 31 Bad Debts Expense 14,400

Allowance for Bad Debts 14,400
To record bad debts for the year .
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means, electronic, mechanical, photocopying, recording, or otherwise of any part of this document, without the prior written permission of SLU, is strictly prohibited.

32
Aging of the Accounts Receivable or Balance Sheet Approach
The aging of accounts receivable involves an analysis of the accounts where they are
classified to not due or past due. Past due accounts are further classified in terms of length
of the period they are past due. The most common classifications are:
1. Not due
2. 1to 30 days past due
3. 31 to 60 days past due
4. 61to 90 days past due
5. 91 to 120 days past due
6. 121 to 180 days past due
7. 181 to 365 days past due
8. more than 1year past due
9. bankrupt or under litigation

The required allowance is then determined by multiplying the total of each classification by
the rate of percent of loss experienced by the company for each category. In practice, the
classifications may vary depending on the experience of the company.

For example, the following data are gathered in aging the accounts at the end of the year.

Required
(a) Balance (b) rate Allowance(a*b)
Not due P 500,000 1% P 5, 000
1- 30 days past due 50,000 2% 1,000
31 - 60 days past due 30 000 4% 1,200
61 - 90 days past due 70,000 8% 5,600
91 - 180 days past due 40 000 10% 4,000
181 - 365 days past due 20 000 20% 4,000
More than 1 year past due 10 000 30% 3 000
Total P 720, 000 P 23, 800

Computation:
Required allowance (see schedule) P 23,800
Less: Allowance balance, credit 5,000
Increase in allowance – Expense P 18,800

The adjusting entry to record bad debts is as follows:

Dec. 31 Bad Debts Expense 18,800

Allowance for Bad Debts 18,800
To record bad debts for the year.

33
When is an account past due?
The credit terms will determine whether the account is past due. For instance, if the credit
terms were 2/10, n/30, and the account is 45 days old, it is considered to be 15 days past
due.

Therefore, the phrase "past due" refers to the period beyond the maximum credit term. In
the example, the credit term or credit period is 30 days.

The balance sheet will reflect the following:

Accounts Receivable P 720, 000

Less: Allowance for Bad Debts 18, 800
Net Amortized Cost P 701, 200

Estimation of bad debts based on an analysis of receivables is preferred because it provides

a more accurate estimate of the amortized cost of receivables.

WRITING OFF WORTHLESS ACCOUNTS

When it becomes clear that a specific account will not be collected, the amount is
considered worthless and should be written off to the Allowance for Bad Debts account.
Accounts become worthless if any or a combination of the following condition exists:
▪ The customer cannot be located,
▪ The customer is declared dead, very ill or bankrupt, or
▪ Legal efforts have been exerted, yet the customer refuses to pay his balance

After approval of the responsible officer or officers, the worthless accounts are written off by
reducing their balance in the records to zero. The entry to record the write-off of bad debts
is:

Allowance for Bad Debts XXX

Accounts Receivable XXX

Remember that it was already accounted for as an expense when the allowance was
established before. The write off does not affect the estimated net realizable amount of
accounts receivable because there is no expense involved and because the related
allowance for bad debt account has already been deducted from the receivables. The
write off simply reduces the allowance for bad debts account and the gross accounts
receivable by a similar amount.

For example, on January 15 of the current year, J. Flores, who owes the business P5,000, is
declared bankrupt by the court. The entry to write-off this account is as follows:

Jan. 15 Allowance for Bad Debts 5,000

Accounts Receivable 5,000
To record write off of receivable.

34
RECOVERY OF ACCOUNTS RECEIVABLE WRITTEN OFF
Sometimes a customer whose account has been written off as uncollectible will later be able
to pay the amount in full or in part. When this happens, it is necessary to make two journal
entries; one to reverse the earlier write-off, which is now incorrect; and another to show the
collection of the account.

For example, assume that in September 1of the current year, J. Flores, after his bankruptcy
on January 15, notified the company that he would be able to pay P1, 000 of his account
and send a check for P500. The entries to record this transaction are as follows:

Sept. 1 Accounts Receivable 1,000

Allowance for Bad Debts 1,000
To reverse write off of receivable.
1
Cash 500
Accounts Receivable 500
To record partial collection.

ADJUSTING FOR ENDINGINVENTORY AND THE COST OF MERCHANDISE SOLD

There are two methods by which inventory can be accounted for - Periodic Inventory
Method and Perpetual Inventory Method. The main difference lies on the determination of
the quantity of the inventory on hand and the inventory sold to customers.

Periodic Inventory Method

A physical inventory is taken at the end of the accounting period to determine the cost of
the merchandise sold. A physical inventory is an item-by- item count of the inventory on
hand at the end of each year. It is obtained by (a) counting the number of each item in
stock, (b) pricing, or identifying the cost, of each item, (c) extending each item, that is
multiplying the cost per unit by the quantity on hand, and (d) totaling the cost of all items in
the inventory list.

The merchandise on hand at the beginning of the period plus the net merchandise
purchased during the period gives the total merchandise that is available for sale during the
period. But much of this merchandise would have been sold during the period. And if it was
not sold, then it will still be on hand (ending inventory). The merchandise available for sale
reduced by the ending inventory is equivalent to the cost of the merchandise sold.

During the accounting period, no entries are made to the Merchandise Inventory account.
Its balance at the end of the period, before adjusting and closing entries, is the same as it
was at the beginning of the period. Thus its balance at this point represents beginning
merchandise inventory. The objectives of handling merchandise inventory at the end of the
period are to (1) remove the beginning balance from the Merchandise Inventory account,
(2) enter the ending balance into the Merchandise Inventory account, and (3) enter the
beginning inventory as a debit and the ending inventory as a credit to the Income Summary
account to properly calculate net income. The following entries are prepared:

35
Date Particulars Debit Credit
Dec 31 Income Summary xx.xx
Merchandise Inventory (beg) xx.xx
To close beginning inventory.

31 Merchandise Inventory (end) xx.xx

Income Summary xx.xx
To set-up ending inventory.

The first entry transfers the beginning inventory to Income Summary. Since this beginning
inventory is part of the total cost of goods available for sale, it is debited to Income Summary.
It is also a subtraction from the asset account, merchandise Inventory, and hence is credited
to that account.

The second entry debits the cost of merchandise inventory at the end of the period to the
asset account, Merchandise Inventory. The credit portion of the entry effects a deduction of
the unsold merchandise from the total cost of merchandise available for sale during the
period.

Such details may be presented on the income statement in the following manner:

Merchandise Inventory, beg P 59,700

Add: Purchases P 530,280
Less: Purchase Discount 2,525
Net Purchases 527,755
Total Goods Available for Sale P 587,455
Less: Merchandise Inventory, end 62,150
Cost of goods sold P 525, 305

Date Particulars Debit Credit

Dec 31 Income Summary 59,700
Merchandise Inventory (beg) 59,700
To close beginning inventory.

31 Merchandise Inventory (end) 62, 150

Income Summary 62, 150
To set up ending inventory .

The effect of the two inventory adjustments is indicated in the following T-accounts,
Merchandise Inventory, and Income Summary:

36
In the accounts, the inventory of P59,700 at the end of the preceding year (beginning of
current year) has been transferred to Income Summary as a part of the cost of merchandise
available for sale. It is replaced by a debit of P62,150, the merchandise inventory at the end
of the current year; the credit of the same amount to Income Summary is a deduction from
the cost of merchandise available for sale.

Perpetual Inventory Method

In contrast with the periodic method, the perpetual inventory method employs accounting
records to continuously disclose the amount of the inventory. A separate account for each
type of merchandise is maintained in a subsidiary Ledger. Increases in inventory items are
recorded as debits to the appropriate accounts, and decreases are recorded as credits;
the balances of the accounts are called the book inventories of the items on hand.
Regardless of the care with which the perpetual inventory records are maintained, itis
necessary to test their accuracy by taking a physical inventory of each type of commodity
at least once a year. The records are then compared with the actual quantities on hand
and any discrepancies are corrected.

During the accounting period, the Merchandise Inventory account would be debited for all
purchases made and credited for any sales made to customers as well as any adjustments
to be made on purchases like purchase returns and allowances, and purchase discounts. In
recording the sale to a customer, a debit is made to Cost of Goods Sold. The balance of the
Merchandise Inventory account is at the end of the accounting period. Thus, it is no longer
necessary to set-up ending inventory and close beginning inventory.

37
Practice Exercise 3-1. BAD DEBTS EXPENSE
Samantha Merchandising has the following balances as of December 31, 2020:
Accounts Receivable P 375,000
Sales 1,400,000
Allowance for Bad Debts 12,500

REQUIRED:
Prepare the adjusting entry to take up bad debts under each method. Show supporting
computations in good format in a separate sheet of paper.
a. 10 % of Accounts Receivable is uncollectible.
b. Allowance for Bad Debts is to be increased by P15,000.
c. Allowance for Bad Debts is to be increased to P15,000.
d. The net realizable value of Receivable should be P345,000.
e.
Date Particulars PR Debit Credit

(a)

(b)

(c)

(d)

Practice Exercise 4-2. VARIOUS ACCOUNTS

The accounts listed below appear in the ledger of Angel Cleaning Services on December
31, 2020. None of the year-end adjustments had been recorded.

Unused cleaning supplies 9,900 Advertising expense 156,000

Prepaid insurance 31,700 Interest expense 0
Rent income 995,000 Salaries expense 461,000

The following Information relates to adjustments on December 31:

a. The company counted the unused cleaning supplies on hand on December 31 and
ascertained the same amounted to P4, 200.
b. The prepaid insurance comprise of (a) P18,000, 1-year property insurance covering
the period April 1, 2020 to May 31, 2021; and (b) P13,700, fire insurance from which
insurance record indicated that P9,750 has expired during the year.

38
c. The advertising expense was for advertising space in a local newspaper paid at the
beginning of the year, 80% has been used and the remainder will be used in the
following year.
d. A short-term 12% interest bearing note payable amounting to P120, 000 was dated
October 31. It was due on March 31, 2021.
e. Salaries unpaid on December 31, P15,500
f. P84, 000 of the rent income has been collected in advance and will not be earned
until the following year.

REQUIRED: Journalize the adjusting entries

Date Particulars PR Debit Credit

(a)

(b)

(c)

(d)

(e)

(f)

Practice Exercise 4-3. DEPRECIATION EXPENSE

Charlie Freight Co. purchased a second-hand delivery van on July 1, 2020 for P572,000. The
machine has an expected useful life of only three years, primarily because the past owner
was not careful in using the van. The company further estimated that after three years the
van can still be sold for P36,000.

REQUIRED:
1. Compute for the depreciation expense for the years 2020 to 2022 using the straight-
line method. (Complete the depreciation table below)

39
2. Prepare the entry to take up the depreciation on December 31, 2020 and December
31, 2021.

Annual Straight-line depreciation computation:

Depreciation Schedule
Depreciation Accumulated Net
Year Computation Expense Depreciation Book Value

Adjusting Entries:
Date Particulars PR Debit Credit

2020
Dec 31

2021
Dec 31

Practice Exercise 4-4. VARIOUS ACCOUNTS

On the basis of the following data journalize the adjusting entries on December 31 the
close of the current year:
a. Office supplies account balance before adjusting, P21,750; office supplies
physical inventory, December 31, P6,850.
b. Merchandise inventory: January 1, P 885,100; December 31, P615,300.
c. The prepaid insurance account before adjustment on December 31 has a balance
of P44,200. An analysis of the policies indicates that the unexpired balance should
have been P16,420.
d. Salaries are uniformly P127,610 for a five-day workweek, ending on Friday. The last
payday of the year was Friday, December 27.

40
e. The Prepaid Advertising accounts shows a total of P72,000 representing the cost of
52-weeks contract dated October 1.
f. On November 1, Unearned Rent was credited for P270,000 representing rental for
nine months beginning on that date.
g. Store supplies of P12,000 were purchased during the year and were debited to
Store supplies expense account. On December 31, supplies of P3,000 are on hand.
h. The company acquired equipment on March 31, costing P460,000 with an estimated
resale value of P10,000 after an estimated useful life of 10 years.
i. Accounts receivable balance on December 31 amounted to P1,200,000. Of this
amount, P4,500 are estimated to be uncollectible.
j. The Notes receivable account has a balance of P150,000 representing a 90-day, 12%
note received on December 1. The interest on the note is collectible upon maturity.

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