MODULE8–ADJUSTI
NG ENTRI
ES 1
MODULE 8 – ADJUSTING ENTRIES
INTRODUCTION
Preparation of adjusting entries is the 5 th step in the accounting cycle. The balances of
the accounts in the unadjusted trial balance prepared after posting are not up to date.
Some of these accounts do not reflect economic activities that have taken place and
these activities are to be recorded at the end of the period.
LEARNING OUTCOMES:
After reading this module, the learner should be able to:
1. Enumerate the common end-of-period adjustments.
2. Prepare adjusting entries.
TIME:
The time allotted for this module is 6 hours.
LEARNER DESCRIPTION
The participants in this module are 1 st year college students taking up BS in
Accountancy.
MODULE CONTENTS:
LESSON 1: Definition and Purpose of Adjusting Entries
Definition: Adjusting entries are entries made prior to the preparation of financial
statements to update certain accounts so that they reflect correct balances as of the
designated time.
ACC1 – FINANCIAL ACCOUNTING AND REPORTING
MODULE8–ADJUSTI
NG ENTRI
ES 2
Purpose of Adjusting Entries
1. To take up unrecorded income and expense of the period
2. To split mixed accounts into their real and nominal elements
Accounts are classified into one of the following:
1. Real Accounts (Permanent Accounts) - are accounts that are not closed at the
end of the accounting period. These are extended to the next accounting period.
Real accounts include all Balance Sheet accounts, except the “Owner’s drawing”
account.
2. Nominal Accounts (Temporary Accounts) – are accounts that are closed at the
end of the accounting period. Nominal accounts include all income statement
accounts, drawing account, clearing accounts and suspense accounts.
- Clearing account is an account used temporarily to store amounts that will
eventually be transferred be transferred to another account. An example is
the “Income summary” account which stores amounts of income and
expenses during the period. The balance of income summary represents the
profit or loss during the period and this will be closed to the “owner’s capital”
account before the preparation of financial statements.
- Suspense account is an account used temporarily to store discrepancies in
the accounts pending their analysis and permanent classification. An
example is the “Cash shortages or overages” pending their investigation.
3. Mixed accounts – accounts that have both real and nominal account
components. These accounts are subject to adjustment to separate the nominal
component which is to be presented to income statement and real component
which is to be presented in balance sheet.
Adjusting Entries are subdivided into the following:
1. Accruals of income and expenses
2. Recognition of depreciation expense and bad debts expense
3. Deferrals of income and expenses (splitting of mixed accounts)
Activity 1:
TRUE OR FALSE
1. Adjusting entries are usually recorded at the beginning of each reporting period.
2. Adjusting entries are optional. An entity can prepare financial statements without
preparing first the adjusting entries.
References:
Chapter 8 of Financial Accounting and Reporting by Prof. Zeus Millan.
ACC1 – FINANCIAL ACCOUNTING AND REPORTING
MODULE8–ADJUSTI
NG ENTRI
ES 3
LESSON 2: Accruals of Income and Expenses
In accounting, the term ‘accrual” (or to accrue) means to recognize an:
a. income that is already earned but not yet collected or
b. expense that is already incurred but not yet paid
Accruals give rise to both income and receivables (or both expense and payable).
Observe the following concepts in accruals of income and expenses:
1. All adjusting entries involve at least one balance sheet account and one income
statement account.
2. All adjusting entries affect the profit and loss for the period.
Illustration: Adjusting entries – Accruals of income and expenses
ABC Company is preparing its financial statements for the period ended December 31,
20x1. Adjustments are needed for the following:
Case #1: Accrual of Income – Interest income
ABC Company received a 12%, PHP 100,000.00, one-year, note receivable on April 1,
20x1. ABC uses a calendar year period. The principal and interest on the note are
due on April 1, 20x2.
Step 1 - Analysis:
As of December 31, 20x1, (end of accounting period), interest income would have been
earned because there is already a passage of time (from April 1, 20x1 to December
31, 20x1), although interest will only be collected in the next accounting period (i.e.
April 1, 20x2)
Interest income shall be accrued for the 9 months covering April 1 to December 31,
20x1.
Interest = Principal x Rate x Time
= PHP 100,000.00 x 12% x 9/12
= PHP 9,000.00
==========
Accounts Affected Effects on Account Debit/Credit
Interest Receivable (asset) Increased Debit
Interest Income (income) Increased Credit
ACC1 – FINANCIAL ACCOUNTING AND REPORTING
MODULE8–ADJUSTI
NG ENTRI
ES 4
Step 2 – Adjusting Entry
20x1
Dec 31 Interest Receivable PHP 9,000.00
Interest Income PHP 9,000.00
To accrue interest income
In the next accounting period, the collection of the interest will be recorded as follows:
20x2
Apr 1 Cash PHP 12,000.00
Interest Receivable PHP 9,000.00
Interest Income PHP 3,000.00
To record collection of interest
Interest = Principal x Rate x Time
= PHP 100,000.00 x 12% x 12/12
= PHP 12,000.00
==========
1-yr interest income of PHP 12,000.00 should be broken down as follows:
9-mo interest (Apr 1 – Dec. 31, 20x1) PHP 9,000.00
(recognized in 20x1)
3-mo interest (Jan 1 – Mar 31, 20x2) 3,000.00
(recognized in 20x2)
Case #2: Accrual of Income – Rent income
ABC Company rents out its building to a tenant for a monthly rent of PHP 50,000.00. As
of December 31, 20x1, the tenant has not yet paid the rent for the month of
December.
Step 1 – Analysis
The tenant has already used the building in December; hence, rent income should be
recognized by ABC Company.
ACC1 – FINANCIAL ACCOUNTING AND REPORTING
MODULE8–ADJUSTI
NG ENTRI
ES 5
Accounts Affected Effects on Account Debit/Credit
Rent Receivable (asset) Increased Debit
Rent Income (income) Increased Credit
Step 2 – Adjusting Entry
20x1
Dec 31 Rent Receivable PHP 50,000.00
Rent Income PHP 50,000.00
To accrue rent income
When the rent will be collected in the next accounting period, it will be recorded as
follows;
20x2
Jan Cash PHP 50,000.00
Rent Income PHP 3,000.00
To record collection of Dec. rent
Case #3: Accrual of Expense – Interest expense
ABC Company issued a 12% PHP 100,000.00, one-year, note payable on October 1,
20x1. The principal and interest are due on October 1, 20x2
Step 1 - Analysis:
As of December 31, 20x1, (end of accounting period), interest expense is incurred
because there is already a passage of time (from October 1, 20x1 to December 31,
20x1), although interest will only be paid in the next accounting period (i.e. October
1, 20x2)
Interest expense shall be accrued for the 3 months covering October 1 to December 31,
20x1.
Interest = Principal x Rate x Time
= PHP 100,000.00 x 12% x 3/12
= PHP 3,000.00
ACC1 – FINANCIAL ACCOUNTING AND REPORTING
MODULE8–ADJUSTI
NG ENTRI
ES 6
Accounts Affected Effects on Account Debit/Credit
Interest expense (expense) Increased Debit
Interest payable (liability) Increased Credit
Step 2 – Adjusting Entry
20x1
Dec 31 Interest Expense PHP 3,000.00
Interest Payable PHP 3,000.00
To accrue interest expense
In the next accounting period, the payment of the interest will be recorded as follows:
20x1
Oct 1 Interest Payable PHP 3,000.00
Interest Expense PHP 9,000.00
Cash PHP 12,000.00
To record the payment of interest
Interest = Principal x Rate x Time
= PHP 100,000.00 x 12% x 12/12
= PHP 12,000.00
==========
1-yr interest income of PHP 12,000.00 should be broken down as follows:
3-mo interest (Oct 1 – Dec. 31, 20x1) PHP 3,000.00
(recognized in 20x1)
9-mo interest (Jan 1 – Oct 1, 20x2) 9,000.00
(recognized in 20x2)
ACC1 – FINANCIAL ACCOUNTING AND REPORTING
MODULE8–ADJUSTI
NG ENTRI
ES 7
Case #4: Accrual of Expense – Utilities expense
The cost of electricity used for the month of December 20x1 is PHP 4,000.00. The
electricity bill was received and paid in January of 20x2.
Step 1 – Analysis
The electricity bill, although paid in January 20x2, pertains to the cost of electricity used
in December 20x1. Hence, Utilities expense shall be accrued in December 31,
20x1.
Accounts Affected Effects on Account Debit/Credit
Utilities expense(expense) Increased Debit
Utilities Payable (liability) Increased Credit
Step 2 – Adjusting Entry
20x1
Dec 31 Utilities Expense PHP 4,000.00
Utilities Payable PHP 4,000.00
To accrue unpaid utilities
In the next accounting period, the payment of the electricity bill is recorded as follows:
20x2
Jan Utilities Payable PHP 4,000.00
Cash PHP 4,000.00
To record the payment of the Dec 20x1 electricity bill
Activity 2:
1. Entity A obtained a 12%, PHP 100,000.00, one-year loan on October 1, 20x1.
On Oct 1, 20x2, Entity A paid the lender PHP 112,000.00, representing
settlement of both the principal and interest on the loan. The PHP 12,000.00
total interest should be recognized as interest expense
a. In 20x1
b. In 20x2
c. partly in 20x1 and partly in 20x2
d. not recognized as expense
2. The instance described in #1 above is an application of which of the following
accounting concepts?
ACC1 – FINANCIAL ACCOUNTING AND REPORTING
MODULE8–ADJUSTI
NG ENTRI
ES 8
a. Accrual
b. Time period
c. a and b
d. matching
References:
Chapter 8 of Financial Accounting and Reporting by Prof. Zeus Millan.
LESSON 3: Recognition of depreciation expense and bad debts expense
Recognition of Depreciation Expense
Under the concept of systematic and rational allocation, costs that provide economic
benefits over several accounting periods but cannot be directly associated with the
earning of revenues are recognized as expense over the periods where the
economic benefits are consumed.
This concept is applied in recognition of depreciation expense. The expenditure to
acquire equipment is initially recorded as asset, and the expenditure is recognized
as expense over the period the equipment is used. A portion of the cost is
recognized as expense on a piecemeal basis (little by little). This portion is called
depreciation. In Accounting, depreciation means the allocation of the cost of a
depreciable asset over the periods the asset is used.
Case #1 – Adjusting entries – Depreciation
On January 1, 20x1, a business acquired equipment for PHP 20,000.00. The business
expects to use the equipment over the next 4 years.
The entry on January 1, 20x1 to record the acquisition is as follows:
20x1
Jan 1 Equipment PHP 20,000.00
Cash PHP 20,000.00
To record the acquisition of equipment
ACC1 – FINANCIAL ACCOUNTING AND REPORTING
MODULE8–ADJUSTI
NG ENTRI
ES 9
Step 1 – Analysis
On December 31, 20x1, the equipment has already been used for 1 year out of its total
useful life of 4 years. Thus, one fourth of the cost should be recognized as expense.
The annual depreciation is computed as follows
Acqusition cost – salvage value
Annual Depreciation = Useful Life
= 20,000.00 – 0
4 years
= PHP 5,000.00
A PHP 5,000.00 depreciation expense will be recorded at the end of each of the next
four years.
Accounts Affected Effects on Account Debit/Credit
Depreciation expense(expense) Increased Debit
Accumulated depreciation Increased Credit
(contra asset)
Step 2 – Adjusting Entry
20x1
Dec 31 Depreciation Expense PHP 5,000.00
Accumulated Depreciation PHP 5,000.00
To record depreciation expense for the period
The carrying amount of the equipment as of Dec 31, 20x1 is:
Equipment PHP 20,000.00
Accumulated Depreciation 5,000.00
Equipment – net PHP 15,000.00
===========
ACC1 – FINANCIAL ACCOUNTING AND REPORTING
MODULE8–ADJUSTI
NG ENTRI
ES 10
Recognition of Bad debts Expense
Under the concept of immediate recognition, a cost that produces no future economic
benefits or an asset that ceases to provide future economic benefits is recognized
immediately as an expense.
This concept is applied in recognition of bad debts expense. Portion of accounts
receivable will be charged to bad debts expense if it ceased to provide future
economic benefits, i.e., it became uncollectible.
Case #2 – Adjusting entries – Bad debts expense
A business has total accounts receivable of PHP 2,000.00 on Dec 31, 20x1 before any
adjustments. Of the total amount, it was estimated that PHP 500.00 is doubtful of
collection.
Step 1 – Analysis
On December 31, 20x1, the amount of PHP 500.00 produces no future benefit or
ceases to provide future economic benefit, hence, it shoulbe be recognized as
expense.
Accounts Affected Effects on Account Debit/Credit
Bad debts expense(expense) Increased Debit
Allowance for bad debts Increased Credit
(contra asset)
Step 2 – Adjusting Entry
20x1
Dec 31 Bad debts Expense PHP 500.00
Allowance for bad debts PHP 500.00
To record bad debts expense for the period
The carrying amount of the accounts receivable as of Dec 31, 20x1 is:
Accounts Receivable PHP 2,000.00
Allowance for bad debts 500.00
Accounts Receivable – net PHP 1,500.00
===========
ACC1 – FINANCIAL ACCOUNTING AND REPORTING
MODULE8–ADJUSTI
NG ENTRI
ES 11
Activity 3:
Use the following information for the next two questions:
The unadjusted trial balance of Entity A shows the following:
Accounts Receivable PHP 280,000.00
Allowance for bad debts -
Equipment 360,000.00
Accumulated Depreciation 144,000.00
Additional Information:
- 3% of total accounts receivable are doubtful of collection
- The equipment was acquired 2 years ago and estimated to have a 5-year
useful life
1. What is the adjusted (net) carrying amount of accounts receivable to be
presented in the year-end statement of financial position?
a. 271,600.00
b. 288,400.00
c. 280,000.00
d. 276,100.00
2. What is the adjusted (net) carrying amount of equipment to be presented in the
year-end statement of financial position?
a. 360,000.00
b. 216,000.00
c. 144,000.00
d. 72,000.00
References:
Chapter 8 of Financial Accounting and Reporting by Prof. Zeus Millan.
LESSON 4: Deferrals of income and expenses (splitting of mixed accounts)
ACC1 – FINANCIAL ACCOUNTING AND REPORTING
MODULE8–ADJUSTI
NG ENTRI
ES 12
In accounting, deferral means:
- To postpone the income recognition of an advance collection. The advance
collection is treated as liability until earned.
- To postpone the expense recognition of a prepayment. The prepayment is
treated as asset until incurred.
Deferral of Income
To understand how adjusting entries for mixed accounts are made, let us first take up
the methods of initial recording of income.
Advanced collections of income are initially recorded using either the (1) liability method
or (2) income method.
1. Liability method – under this method, advanced collections of income are initially
credited to a liability account. At the end of the period, the earned portion is
recognized as income, while the unearned portion remains as liability.
2. Income Method – under this method, advanced collections of income are initially
credited to income account. At the end of the period, the unearned portion is
recognized as liability, while the earned portion remains as income.
Case # 1 – Adjusting entry deferral of income
A business rents out its building to various tenants. On April 1, 20x1, the business
receives one-year rent in advance of PHP 120,000.00 from one of its tenants. Rent per
month is PHP 10,000.00.
The receipt of advance rent may be recorded either under liability method or income
method:
Liability Method:
20x1
April1 Cash PHP 120,000.00
Unearned rent PHP 120,000.00
To record the receipt of one year advance rent
Income Method:
20x1
April1 Cash PHP 120,000.00
Rent Income PHP 120,000.00
To record the receipt of one year advance rent
ACC1 – FINANCIAL ACCOUNTING AND REPORTING
MODULE8–ADJUSTI
NG ENTRI
ES 13
Observe that under the liability method, the rent received in advance is credited to a
liability account, while under the income method, the rent received in advance is
credited to an income.
Step 1 – Analysis
As of December 31, 20x1, we need to get the earned and unearned portion of advance
rent:
Earned Portion – April 1, 20x1 to Dec 31, 20x1 - 9 months
To compute the amount of earned portion:
PHP 10,000.00 rent per month x 9 months = PHP 90,000.00 or
PHP 120,000.00 x 9/12 = PHP 90,000.00
Earned portion is recognized as income for the period
Unearned portion – Jan 1 20x2 to Mar 31, 20x2 – 3 months
To compute the amount of unearned portion:
PHP 10,000.00 rent per month x 3 months = PHP 30,000.00
PHP 120,000.00 x 3/12 = PHP 30,000.00
Unearned portion is recognized as liability as of Dec 31, 20x1.
Under liability method:
Accounts Affected Effects on Account Debit/Credit
Unearned rent (liability) Decreased Debit
Rent Income (income) Increased Credit
Under Income Method
Accounts Affected Effects on Account Debit/Credit
Rent Income (income) Decreased Debit
Unearned rent (liability) Increased Credit
Step 2 – Adjusting Entry
ACC1 – FINANCIAL ACCOUNTING AND REPORTING
MODULE8–ADJUSTI
NG ENTRI
ES 14
Under liability Method:
20x1
Dec 31 Unearned rent PHP 90,000.00
Rent Income PHP 90,000.00
To recognize the earned portion of advance 1 year rent
Under Income Method:
20x1
Dec 31 Rent Income PHP 30,000.00
Unearned rent PHP 30,000.00
To recognize the unearned portion of advance 1 year rent
Notes:
- Under the liability method, adjusting entry is needed to recognize the earned portion
(income) of mixed account.
- Under the income method, adjusting entry is needed to recognize the unearned
portion (liability) of mixed account.
Both the liability and income methods are acceptable. Regardless of the method
used, the adjusted amounts of rent income and unearned rent to be presented in the
financial statements are the same. These are analyzed in the T-accounts below.
LIABILITY METHOD
Unearned rent Rent Income
: 120,000.00 Apr 1, 20x1 :
A/E 90,000.00 : : 90,000.00 A/E
: 30,000.00 End Bal : 90,000.00 End Bal
: :
INCOME METHOD
Unearned rent Rent Income
: : 120,000.00 Apr 1, x1
: 30,000.00 A/E A/E 30,000.00 :
: 30,000.00 End Bal : 90,000.00 End Bal
Deferral of Expenses
ACC1 – FINANCIAL ACCOUNTING AND REPORTING