PAMANTASAN NG LUNGSOD NG VALENZUELA
College of Accountancy
FINANCIAL ACCOUNTING AND REPORTING (FAR1)
Lecture 04: Adjusting Entries (Step 5)
ACCRUAL BASIS ACCOUNTING
One of the basic assumptions in accounting is that the financial statements are prepared
under the accrual basis accounting. Under this, the effects of the activities and events are
measured, recognized, and reported in the period when they occur-not necessarily when cash
or its equivalent is received or paid out. Using this basis, a business enterprise determines its
profit for a certain period of time by deducting the total expenses incurred during a reporting
period from the total income earned during that same period. On the other hand non-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 primary difference between the pure-cash basis and the accrual basis
accounting is the timing of the recognition of income and expenses.
MATCHING CONCEPT
The profit of an enterprise could be properly measured if there is a proper matching of
earned income and incurred expenses within the reporting period. This procedure is
commonly referred to as the matching concept, the concept of matching of costs with
revenues, or the matching of income and expenses. It is the accrual basis accounting that
results in a better matching of income and expenses.
At the end of a reporting period, it is common that there are certain transactions that
already occurred but are not yet recognized in the records. For example, electricity and other
utilities are already consumed but are not taken since these are not yet paid for by the end of
that particular reporting period.
It is equally common that there are certain transactions that already occurred and are
recognized in the records in the current period, but the life of these items will have direct or
indirect effects on the succeeding reporting periods. For example, machinery was acquired
and paid for in the current period but it is expected to be useful over the next 5 or 8 years.
Another example, the insurance premium paid for will give protection to the insured over the
following two or more years.
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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 or non-recognition of an item will usually affect the two statements
simultaneously.
INCOME REGOGNITION
The general rule is that the income is recognized when the earning process is complete or
almost complete. Income is recognized in the period when there is measurable increase in
future economic benefits related to either an increase of asset or a decrease in a liability. This
means, in effect, that the recognition of income occurs simultaneously with that of an increase
in an asset and/or decrease in a liability.
Point of Income Recognition
For service enterprises, income is usually recognized after rendering significant
portion of the service to the customer. For merchandising and most of the manufacturing
enterprises, income is frequently recognized upon delivery of the goods to the customer –
that is when ownership over the goods passes from the seller to the customer.
EXPENSE RECOGNITION
Expenses are usually recognized in the period when there is a measurable decrease in
future economic benefits, related to either a decrease in an asset or an increase in a liability.
Expense Recognition Criteria
1. Some expenses are recognized on the basis of a direct association between an
expense and a specific item of income. This involves the simultaneous recognition of
income and expenses that resulted directly from the same transaction.
2. When an item of expenditure has no direct association with a specific income, the
item of expense is recognized in the time-period to which it relates. When economic
benefits are expected to extend over a certain length of time, expenses are recognized
in the basis of systematic and rational allocation procedure. This procedure
recognizes expenses during the periods when the economic benefits are used,
expired, or are derived.
3. From the moment an item is found to have no future economic usefulness, pr when
an item ceases to produce future economic benefits, prudence calls for immediate
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 measurement and recognition of a loss in the income statement of that accounting
period.
PURPOSE OF ADJUSTMENTS
Principally, adjusting entries are prepared so that there would be a proper matching of
earned income and incurred expenses. If there 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 reporting period
but also those of the succeeding periods.
GATHERING DATA NEEDED TO ADJUST THE RECORDS
One of the duties of the accountant is to gather data that are needed in preparing the
adjustments at the end of the reporting period. These entries are not triggered 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 or all
of the following steps:
Review the Trial Balance and Analyze 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.
Review the Source Documents. The review and analysis of the accounts are accompanied
by a careful study of the source business documents that support the recorded income
collections or expense payments. Information about accrued payments within the last
weeks of the current reporting period and the first weeks of the next reporting period.
Undertake Ocular Inspection and Counts. Sometimes there is a need to make ocular
inspections and actual counts of the unused items in order to determine certain
prepayments.
Consult with Experts. Researches or consultations with experts are helpful in estimating
the useful lives of long-lived fixed assets. Dialogue with the external auditor will give the
accountant some insight about the practices of other business in the same industry.
USE OF ESTIMATES
Under the accrual basis accounting, the use of estimates is unavoidable. Many of the
adjusting entries are based on carefully computed estimates. Proper matching of income and
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expenses makes use of financial information that is not precise but which is objectively
determined. The estimates are based on information gathered within the enterprise or from
others in the same line of business.
An estimate used in one reporting period may be revised as new information is gathered
or if there are changes in the circumstances on which the previous estimate was based on.
Revising an estimate is normal and is not considered as a correction of an error from the
accounting viewpoint.
PERIODICITY CONCEPT
Periodicity concept 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 the
decision makers. Because of this concept, some accounting elements are interrupted at the
end of each reporting period and as a result, measurement and recognition problems may
arise. The major problems revolve around the determination of the amounts that pertain to
each year of the life of the element. It can observed that the shorter the reporting periods, the
more cut-offs there will be, and the more measurement issues are expected to arise.
ITEMS TO BE ADJUSTED
1. Unrecognized Transactions that Affect the Future Periods
- Included under this group are those transactions that already occurred but which
are not yet recognized in the records. Also known as unrecognized transactions,
the first group includes:
o Income that is earned in the present reporting period, but not yet recognized
since it is to be collected in the future reporting periods. This is also known
as accrued income or accrued revenues.
o Expenses that are already incurred in the present reporting period, but not yet
recognized since they are to be paid in the coming reporting periods. These
are known as accrued expenses.
2. Recognized Transactions that affect the Future Periods
- Included under the second group are those transactions that are already
recognized in the records but which require full or partial deferral since they
affect the future periods.
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ACCRUED INCOME
ACCRUED EXPENSE
Proforma Adjusting Entries:
Accrued Income or Income Receivable xxx Proforma Adjusting Entries:
Income xxx Expense xxx
Accrued expense or Expense Payable xxx
Illustration:
1. A dentist renders professional service valued at P4,500 to his patients from December 26 Illustration:
to 29, 2017. As of December 31, 2017, he has not billed the patients for the service 1. Unpaid wages for factory workers for services they rendered from Monday to Wednesday
rendered. (December 29-31, 2017) amounted to P7,500.00. Company policy is to pay wages every
Saturday.

2. A 60-day , 12% loan for P50,000 was granted by the proprietor to a business associate on
December 31, 2017. The associate promised to pay the lender the amount of P51,000 on 2. Electricity and water already consumed in 2017, but not yet billed by the utility company
January 30, 2018. as of the end of the year, is estimated at P3,452.

3. The December rent for a store space has not been collected as of December 31, 2017.
Monthly rental is P12,000. 3. Taxes on the sales of December 2017, payable in January 2018, is computed at P23,576.

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Precollected or Unearned Income
Prepaid or Unexpired Expenses
The manner of adjusting for unearned income depends on how the advance collection was
The manner of adjusting for prepaid expense depends on how the pre-payment was initially
initially recorded in the books of accounts. There are two options in recording the advance
recorded in the books of accounts. There are two options in recording the pre-payment –
collection – credit either income account title or a liability account title for the collection.
credit either anexpense account title or an asset account title for the collection.
Illustration:
Illustration:
1. On December 1, 2017, Fame Realty collected P75,000 representing the rent for 5 months,
1. Paid insurance premium of P3,600 on May 1, 2017. The premium paid is good for a
until April 30, 2018.
period of one year, Until April 30, 208.

2. On November 1, 2017, Atty. Anita Mijares received P30,000 as her retainer fees for
2. Bought office supplies on August 18, 2017, As of December 31, 2017, approximately ¾
professional services to be rendered until January 31, 2018.
of the supplies have been used up.

3. Mina Creative Arts received P150,000 from a customer representing advertising service
3. Borrowed P80,000 from the bank on September 15, 2017. The 6-month loan carries an
fees for a period of 12 months beginning October 1, 2017.
interest rate of 12%. The bank deducted the P4,800 interest from the face value of the
loan. Cash proceeds were P75,200.

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 = Estimate, out of the credit sales (or Gross sales or Net sales) of the current period,
that is doubtful of collection.

Percentage of Receivable Method:

Percentage of loss x Receivable balance at the end of the current period
= Estimate, out of the Receivable balances, that is doubtful of collection.

Depreciation of Fixed Assets

Depreciation – pertains to the portion of the cost of fixed assets that is considered as an
expense of the reporting period. For each of the independent illustration
a. Compute for the estimated doubtful accounts that must be recognized by Bethel
Computation of depreciation Company on December 31, 2017.
Depreciation=Cost of the ¿ asset−Expected residual vlue ¿ Asset ¿ b. Compute for the balance of allowance for doubtful accounts and the net realizable
Estimated Ueful Life of the¿ value of accounts receivable as of December 31, 2017.
c. Prepare the adjusting entry for each case.
Illustration:
The enterprise purchased a machine for use in its shop for P43,000 on December 15, 2016. Illustration:
Before the machine is ready for normal use on July 2, 2017, the business incurred additional 1. Bethel Company estimated that ½ of 1% of all services rendered on credit term would
costs of P50,000. It is estimated that the machine will be useful for 4 years, after which it s turn out to be bad debts. During the year, the total value of the services rendered on
expected to be sold for P8,000. credit term is P425,750. The accounts receivable and allowance for doubtful accounts has
balances of P65,720 and P850, respectively, before the adjustments.

2. Upon analyzing the balance of accounts receivable as of December 31, 2017, the credit
Doubtful Accounts and collection manager estimated that about 2% of its debit balance of P65,720 may not
At the end of the reporting period, the accountant needs to make a reasonable estimate of be collectible. This is the first time that the accountant will recognize doubtful accounts
the accounts that are doubtful of collection. expense.

The two methods for estimating the expense resulting from uncollectible accounts,
are used in the following manner:

Percentage of Sales Method 3. Upon analyzing the balance of accounts receivable as of December 31, 2017, the credit
Percentage of loss x Credit sales (or Gross sales or Net sales) of the current period and collection manager estimated that about 2% of its debit balance of P65,720 may not
be collectible. Last reporting period, the accountant recognized doubtful accounts

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 expense, As of December 31, 2017, before making the adjusting entry for the current
period, the allowance for doubtful accounts has a remaining balance of P850.

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