COLLEGE OF ACCOUNTANCY

C-AE13: Financial Accounting and Reporting

First Semester | AY 2020-2021

Module 8

A. Course Code – Title : C-AE13: Financial Accounting and Reporting

B. Module No – Title : M08 – The Need for Adjusting Journal Entries, Part 2
C. Time Frame : 1 week (Week 8) – 6 hrs
D. Materials : Course Syllabus

1. Overview
This learning material is the second part of Module 7. It provides a discussion of
accruals and bad debts, and the related adjusting entries that are usually prepared at the
end of the accounting period for accruals and bad debts or uncollectible accounts.
You should read clearly and understand well the topics explained herein. It is also
expected that you answer the assigned problems and exercises. Please finish reading
Chapter 4 of your textbook.

2. Desired Learning Outcomes

At the end of the learning session, you should be able to:
a) Analyze and discuss accruals and bad debts;
b) Formulate the correct adjusting journal entries for accruals and bad debts; and,
c) Explain the purpose of each adjusting entry made.

3. Content/Discussion

Lesson 1 – Accruals and Bad Debts and their Adjusting Journal Entries

An accrual is income which has already been earned but not yet received and
recognized (called accrued income), or an expense which has already been incurred but
not yet paid and recorded (called accrued expense).
Why is there a need to make adjusting entries for these items? As you will learn
later, there are items that span more than one accounting period. Therefore, you have to
separate, for example, the income earned in one year from the income earned in another
year, or the expense incurred in one year from the expense incurred in another year. This
conforms to the matching principle, in which only the expenses incurred in a year should
be matched against or deducted from the income earned during the same year. It would
be illogical or a mismatch to deduct salaries incurred in 2019 from the income earned in
2020.

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 COLLEGE OF ACCOUNTANCY
C-AE13: Financial Accounting and Reporting
First Semester | AY 2020-2021

How can you formulate the correct adjusting entry? Of course, you have to analyze
closely the item that needs to be adjusted or updated. Remember, the purpose of an
adjusting entry is to bring certain account balances up to date or to their correct balances.
An adjusting entry always has one balance sheet account and one income statement
account. The balance sheet accounts (assets, liabilities and capital) are real or permanent
accounts, because these accounts are not closed or brought to a zero balance at the end
of the accounting period. On the contrary, the balances of these accounts are carried
forward to the next accounting period, since they do not relate to only one accounting
period. The income statement accounts (income, expenses, gains, losses) as well as the
income summary and drawing accounts are nominal or temporary accounts. These
accounts relate only to the specific accounting period during which the income was
earned or the expense was incurred, and not to any other accounting period; hence, these
accounts are closed or brought to a zero balance at the end of the accounting period. At
the start of the next accounting period, these accounts start with a clean slate or a zero
balance.
Note: Cash is not debited or credited when you make the adjusting entries, so don’t even
consider it.
Let us now analyze closely the following transactions on accruals. Again, bear in mind
that adjusting entries are prepared to bring certain account balances up to date at the end
of the accounting period, not during the accounting period.

a) Accrued Income – income which has already been earned but not yet received and recorded

Assume that on May 1, 2020, San Fernando Bank extended to Hot Air Co. a loan of
P200,000 at 12% interest per year to be paid on April 30, 2021.

The entry to record this transaction on May 1, 2020, in the books of San Fernando
Bank, the lender or creditor, is:

Debit: Loans Receivable P200,000

Credit: Cash P200,000

At the end of the accounting period on Dec 31, again assuming that San Fernando
Bank follows the calendar year, the bank has already earned the interest, Interest
Income, which has accumulated for the past 8 months, from May 1 until Dec 31.
However, the bank will receive the payment for this interest from Hot Air Co. only
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C-AE13: Financial Accounting and Reporting
First Semester | AY 2020-2021

on April 30, 2021, the following accounting period, as agreed upon, so the bank has
a claim or receivable, Interest Receivable, from the borrower, Hot Air. But since this
8 months’ interest was earned during 2020, then, following accrual basis accounting,
it is only proper to include it in the financial statements of 2020. This can be done by
making the appropriate adjusting entry on Dec 31, as follows:

Debit: Interest Receivable P 16,000

Credit: Interest Income P 16,000
To record the accrued interest for 8 months
P200,000 x 12% x 8/12 mos=P16,000

Other account titles which can be used aside from Interest Receivable are Accrued
Interest Income or Accrued Interest Receivable, all of which are asset accounts.
For the income accounts, Interest Earned may also be used in lieu of Interest Income.
Note: The entry to record accrued income is always a debit to an asset account,
Receivable, and a credit to an Income account. Why debit a Receivable? Because the
business has a claim against a third party which the business has yet to receive or
collect, but it is not yet recorded in the books of the lender or creditor-business. Why
a credit to Income? Because income has been earned during the period, but it has not
yet been recognized; therefore, it must be recorded.

b) Accrued Expense – an expense that has already been incurred but not yet paid and recorded
Let us use the same example for Accrued Income, but this time, let us focus on the
borrower, Hot Air Co. As of Dec 31, the end of the accounting period, Hot Air Co.
has used the money it borrowed for 8 months at the agreed interest rate of 12% per
year or 1% per month. So, the business has incurred Interest Expense, since the loan
now has accumulated interest for 8 months, but because this interest will be paid by
Hot Air Co. only on April 30, 2021, as agreed upon in the loan agreement with San
Fernando Bank, then, Hot Air also has incurred a liability, Interest Payable. But
because the 8 months’ interest was incurred during 2020, then, it must be reflected in
the financial statements for 2020, following accrual basis accounting. How can we do
this? Again, by making the appropriate adjusting entry on Dec 31, 2020 as follows:

Debit: Interest Expense P 16,000

Credit: Interest Payable P 16,000
To record accrued interest for 8 months

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 COLLEGE OF ACCOUNTANCY
C-AE13: Financial Accounting and Reporting
First Semester | AY 2020-2021

Other account titles which can be used aside from Interest Payable are Accrued
Interest Expense and Accrued Interest Payable, all of which are liability accounts.
Note: The entry to record an accrued expense is always a debit to an Expense, and a
credit to a liability, Payable. Expense is debited because an expense was incurred, but
it has not yet been recorded. A liability, Payable, is credited because the expense has
not been paid, since the payment is not yet due and the liability has not been
recorded.

c) Bad Debts or Uncollectible Accounts or Doubtful Accounts

Business today is done largely on credit, and so, business firms exercise caution in
extending credit to customers and clients by screening them. However, no matter
how efficient the screening process is, the business firms still are unable to collect all
of their receivables because some of their customers or clients may still be unable to
pay. This is a risk that the entity assumes when it extends credit to its customers.
Uncollectible accounts or bad debts is a common and recurring experience of
business firms. As such, therefore, it is considered as an operating expense of the
entity. How does the business determine its uncollectible accounts or bad debs?
There are two methods of determining bad debts: the direct write-off method and
the allowance method.

1) Direct write-off method – In this method, the business recognizes bad debts
expense only when the uncollectibility of an account is certain or when the
business, in spite of repeated collection efforts, cannot collect the account from
its customer anymore. The entry to record bad debts expense under this method
is:

Debit: Bad Debts Expense Pxxx

Credit: Accounts Receivable Pxxx

This method does not conform to the expense recognition principle under the
accrual basis of accounting.

2) Allowance method – This method recognizes bad debts expense during the
period that the service or sales is recorded. How can the business do this? Does
the business know who among its customers to whom it extended credit will
pay in full, who will pay only a portion of their account, or who will not pay at
all? Most likely, the business does not know. The bad debts are estimated based
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 COLLEGE OF ACCOUNTANCY
C-AE13: Financial Accounting and Reporting
First Semester | AY 2020-2021

on the past years’ experiences of the entity or the experience of other business
firms in the same industry as the entity. To determine the estimated bad debts
expense, one of the following methods may be used by the business:

2.1) A certain percentage is applied to outstanding accounts receivable at the

end of the accounting period
Assume that based on the industry’s experience on bad debts, it is
estimated that 8% of the outstanding accounts receivable of P200,000 at
the end of the accounting period, Dec 31, 2019, is doubtful of collection.
Assume further that the entity has had no provision for bad debts in the
past. The adjusting entry to recognize the bad debts expense is:

Debit: Bad Debts Expense P16,000

Credit: Allowance for Bad Debts P16,000
To record bad debts expense for the year
8% x P200,000 = P16,000

To continue, assume that at the end of the following accounting period,

Dec 31, 2020, the outstanding accounts receivable is P250,000. How will
you determine the bad debts expense? The bad debts expense is
computed as follows:

Required allowance balance

(8% x P250,000) P 20,000
Less: Credit balance of Allowance for
Bad Debts before adjustment (16,000)
Bad Debts Expense P 4,000

The adjusting entry on Dec 31, 2020 would be:

Debit: Bad Debts Expense P 4,000

Credit: Allowance for Bad Debts P 4,000

2.2) Aging of receivables – Under this method, the receivables are classified
into those accounts which are not yet due and those which are already
past due. The accounts which are past due are further classified based on
the length of time that each account is past due. The rate of
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 COLLEGE OF ACCOUNTANCY
C-AE13: Financial Accounting and Reporting
First Semester | AY 2020-2021

uncollectibility is then applied to each account classification to

determine the total doubtful accounts, which is the required balance of
the Allowance for Bad Debts account. This method will be discussed
thoroughly in a higher accounting course.

2.3) A certain percentage of sales for the period is recognized as bad debts
expense for the same period.
Assume that during the year 2019, the entity earned total service fees of
P1,500,000, and based on past years’ experience, 2% of total income is the
provision for bad debts. The adjusting entry to record the bad debts on
Dec 31, 2019 would be:

Debit: Bad Debts Expense P30,000

Credit: Allowance for Bad Debts P30,000
To record bad debts for the year
2% x P1,500,000 = P30,000

Note: Just like Accumulated Depreciation, Allowance for Bad Debts is also a contra-asset
account. It is also deducted from Accounts Receivable when presented in the Balance
Sheet or Statement of Financial Position. The excess of Accounts Receivable over the
Allowance for Bad Debts is the estimated net realizable value of the accounts receivable.
The first two methods (percent of accounts receivable and aging of accounts receivable)
are both based on accounts receivable. Observe that in these two methods, the amount
arrived at is the required allowance balance, which may not be the bad debts expense for
the period. To get the bad debts expense, which is the amount of the adjusting entry,
you have to go back to the allowance account to check if it has a beginning balance. This
balance has to be considered in determining the bad debts expense. Please go back to the
first method and analyze the example. In the second year, 2020, the required allowance
balance is P20,000 on Dec 31, 2020. To get the amount of bad debts expense for the same
period, the beginning credit balance of P16,000 (assuming there was no change in the
account during 2020) was deducted from the P20,000 required allowance balance to
arrive at the bad debts expense of P4,000 for the year 2020.
The third method (percent of sales) is a very simple one. The amount arrived at if you
multiply the rate by the total income or fees earned (in a service business) or by sales (in
a merchandising or manufacturing entity) is already the amount of bad debts expense,
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 COLLEGE OF ACCOUNTANCY
C-AE13: Financial Accounting and Reporting
First Semester | AY 2020-2021

regardless of the balance of the allowance account. In other words, the entire amount
you get in this method is credited or added to the allowance account. This method, aside
from its simplicity, also conforms to the matching principle of accounting, because the
expense is matched against the income or revenue of the same period.

Important: In deferrals, cash is paid or received in advance; whereas in accruals, cash

will be paid or received later or at a future time.

Balance Sheet presentation:

Accounts Receivable P250,000

Less: Allowance for Bad Debts 20,000
Net realizable value P230,000

4. Progress Check
a) Define the two kinds of accruals.
b) How are bad debts incurred?
c) Why is there a need to make adjusting entries for accruals and bad debts?

5. Assignment (Optional)
Answer end-of- Chapter 4 problems 2, 5, & 6.

6. Assessment
Answer end-of-Chapter 4 problem 11 in one hour.

7. References

Manuel, Zenaida Vera-Cruz (2018) 21st Century Accounting Process, Basic Concepts and
Procedures, Manila, Philippines: Zenaida Vera-Cruz Manuel.

Ballada, Win. (2020) Basic Financial Accounting and Reporting, Cavite, Philippines:
Dom Dane Publishers & Made Easy Books.

Cabrera, Ma. Elenita B. & Cabrera, Gilbert Anthony B. (2018) Financial Accounting and
Reporting,Manila, Philippines: GIC Enterprises & Co., Inc.

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 COLLEGE OF ACCOUNTANCY
C-AE13: Financial Accounting and Reporting
First Semester | AY 2020-2021

Ferrer, Rodiel C. & Millan, Zeus Vernon B. (2017) Fundamentals of Accountancy,

Business and Management, Part 1, Baguio City, Philippines: Bandolin Enterprise.

Warren, Carl S., Reeve, James M., & Duchac, Jonathan E. ((2015) Accounting 25th
Edition, Pasig City, Philippines: Cengage Learning Asia Pte Ltd (Philippine Branch).

Gilbertson, Claudia B., Lehman, Mark W., & Gentene, Debra H. (2017) Century 21
Accounting Multi-column Journal 10th Edition, Boston, MA 02210 USA: Cengage
Learning.

Wild, John; Kwok, Winston; Venkatesh, Sundar; Shaw, Ken W. & Chiappetta,
Barbara. (2016) Fundamental Accounting Principles 2nd Edition, 2 Penn Plaza, New York:
McGraw-Hill Education.

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