Accounting 11A Financial Accounting and Reporting

Accounting Process for Service Operations

Adjusting the Accounts

STUDY OBJECTIVES

1. EXPLAIN THE TIME PERIOD ASSUMPTION.

2. EXPLAIN THE ACCRUAL BASIS OF ACCOUNTING.

3. EXPLAIN WHY ADJUSTING ENTRIES ARE NEEDED.

4. IDENTIFY THE MAJOR TYPES OF ADJUSTING ENTRIES.

5. PREPARE ADJUSTING ENTRIES FOR PREPAYMENTS.

6. PREPARE ADJUSTING ENTRIES FOR ACCRUALS.

7. DESCRIBE THE NATURE AND PURPOSE OF AN ADJUSTED TRIAL BAL-

ANCE.

8. PREPARE ADJUSTING ENTRIES FOR THE ALTERNATIVE TREATMENT OF

PREPAYMENTS.

Content is adopted from Warren, Reeve, Duchac (2009). Accounting. South-western Cengage Learning.
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Accounting 11A Financial Accounting and Reporting
Accounting Process for Service Operations
Time-Period Assumption

1. (S.O. 1) The time period (or periodicity) assumption assumes that the economic life of
a business can be divided into artificial time periods.

2. Accounting time periods are generally a month, a quarter, or a year. The accounting time
period of one year in length is usually known as a fiscal year.

Accrual Basis of Accounting

3. (S.O. 2) The revenue recognition and matching principles are used under the accrual basis
of accounting. Under cash basis accounting, revenue is recorded only when cash is
received and expenses are recorded only when paid.

4. Generally accepted accounting principles require accrual basis accounting rather than cash
basis accounting because the cash basis of accounting often leads to misleading financial
statements.

Revenue Recognition Principle

5. The revenue recognition

principle states that reve-
nue should be recognized
in the accounting period in
which it is earned.

Content is adopted from Warren, Reeve, Duchac (2009). Accounting. South-western Cengage Learning.
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Accounting 11A Financial Accounting and Reporting
Accounting Process for Service Operations
The Matching Principle

6. The matching principle dictates that

efforts (expenses) be matched with
accomplishments (revenues).

Adjusting Entries

7. (S.O. 3) Adjusting entries are

made in order for:
a. Revenues to be recorded
in the period in which they
are earned, and for ex-
penses to be recognized in
the period in which they
are incurred.
b. The revenue recognition
and matching principles to
be followed.

8. (S.O. 4) Adjusting entries are required every time financial statements are prepared. Ad-
justing entries can be classified as (a) prepayments (prepaid expenses or unearned reve-
nue) or (b) accruals (accrued revenues or accrued expenses).

Content is adopted from Warren, Reeve, Duchac (2009). Accounting. South-western Cengage Learning.
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Accounting 11A Financial Accounting and Reporting
Accounting Process for Service Operations
Prepayments
9. (S.O. 5) Prepaid expenses are expenses paid in cash and recorded as assets before they
are used or consumed.
a. Prepaid expenses expire with the passage of time or through use and consumption.
b. An asset-expense account relationship exists with prepaid expenses.
c. Prior to adjustment, assets are overstated and expenses are understated.
d. The adjusting entry results in a debit to an expense account and a credit to an asset
account.

e. Examples of prepaid expenses include supplies, insurance, and depreciation.

f. To illustrate a prepaid adjusting entry, assume on October 1, Kubitz Company pays
P2,400 cash to Sandy Insurance Co. for a one-year insurance policy effective October
1. The adjusting entry at October 31 is:
Insurance Expense (P2,400 X 1/12) .......................... 200
Prepaid Insurance ............................................... 200

Content is adopted from Warren, Reeve, Duchac (2009). Accounting. South-western Cengage Learning.
Rey Joseph M. Redoblado | 4
Accounting 11A Financial Accounting and Reporting
Accounting Process for Service Operations
10. Depreciation is the process of allocating the cost of an asset to expense over its useful life
in a rational and systematic manner.
a. The purchase of equipment or a building is viewed as a long-term prepayment of ser-
vices and, therefore, is allocated in the same manner as other prepaid expenses.
b. Depreciation is an estimate rather than a factual measurement of the cost that has
expired.
c. In recording depreciation, Depreciation Expense is debited and a contra asset account,
Accumulated Depreciation, is credited.
d. In the balance sheet, Accumulated Depreciation is offset against the asset account.
The difference between the cost of the asset and its related accumulated depreciation
is referred to as the book value of the asset.
e. To illustrate an adjusting entry for depreciation, assume Resch Co. purchases a ma-
chine for P6,000 cash on January 1, 2002. Assuming that annual depreciation is
P1,200, the adjusting entry at December 31, 2002 is:

Depreciation Expense ................................................ 1,200

Accumulated Depreciation¾Machinery .............. 1,200

Another Example:

Content is adopted from Warren, Reeve, Duchac (2009). Accounting. South-western Cengage Learning.
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Accounting 11A Financial Accounting and Reporting
Accounting Process for Service Operations

11. Unearned revenues are revenues received and recorded as liabilities before they are
earned.
a. Unearned revenues are subsequently earned by rendering service to a customer.
b. A liability-revenue account relationship exists with unearned revenues.
c. Prior to adjustment, liabilities are overstated and revenues are understated.
d. The adjusting entry results in a debit to a liability account and a credit to a revenue
account.
e. Examples of unearned revenues include rent, magazine subscriptions, and customer
deposits for future service.

f. To illustrate an unearned revenue adjusting entry, assume on October 1, Schoen Co.

receives P3,000 cash from a renter in payment of monthly rent for the period October
through December. At October 31, the adjusting entry to record the rent earned in Oc-
tober is:

Unearned Rent Revenue ............................................. 1,000

Rent Revenue (P3,000 X 1/3) ............................. 1,000

Accruals

12. (S.O. 6) Accrued revenues are revenues earned but not yet received in cash.
a. Accrued revenues may accumulate with the passing of time as in the case of interest
and rent, or through services performed but not billed or collected.
b. An asset-revenue account relationship exists with accrued revenues.
c. Prior to adjustment, both assets and revenues are understated.

Content is adopted from Warren, Reeve, Duchac (2009). Accounting. South-western Cengage Learning.
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Accounting 11A Financial Accounting and Reporting
Accounting Process for Service Operations
d. The adjusting entry results in a debit to an asset account and a credit to a revenue
account.

e. To illustrate an accrued revenue adjusting entry, assume in October, Mayer, a dentist,

performs P800 of services for patients who are not billed until November. The adjusting
entry at October 31 is:
Accounts Receivable ................................................... 800
Dental Fees Earned ............................................ 800

13. Accrued expenses are expenses incurred but not yet paid or recorded.
a. Accrued expenses result from the same causes as accrued revenues and include inter-
est, rent, taxes, and salaries.
b. A liability-expense account relationship exists with accrued expenses.
c. Prior to adjustment, both liabilities and expenses are understated.
d. The adjusting entry results in a debit to an expense account and a credit to a liability
account.

e. To illustrate an accrued expense adjusting entry, assume Schwenk Company incurs

salaries of P4,000 during the last week of October that will be paid in November. The
adjusting entry on October 31 is:

Salaries Expense ......................................................... 4,000

Salaries Payable ................................................. 4,000

Content is adopted from Warren, Reeve, Duchac (2009). Accounting. South-western Cengage Learning.
Rey Joseph M. Redoblado | 7
Accounting 11A Financial Accounting and Reporting
Accounting Process for Service Operations
14. Each adjusting entry affects one balance sheet account and one income statement account.

Content is adopted from Warren, Reeve, Duchac (2009). Accounting. South-western Cengage Learning.
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Accounting 11A Financial Accounting and Reporting
Accounting Process for Service Operations

The data needed to determine adjustments for the two-month period ending July 31,2010, are
as follows:

a. During July, Music Depot provided guest disc jockeys for WHBD for a total of 120 hours.
For information on the amount of the accrued revenue to be billed to WHBD, see the
contract described in the July 3,2010, transaction at the end of chapter 2.
b. Supplies on hand at July 31, P175.
c. The balance of the prepaid insurance account relates to the July 1, 2010, transaction at
the end of chapter 2.
d. Depreciation of the office equipment is P60.
e. The balance of the unearned revenue account relates to the contract between Music
Depot and WHBD, described in the July 3, 2010, transaction at the end of chapter 2.
f. Accrued wages as of July 31,2010, were P120.

INSTRUCTIONS
1. Prepare adjusting journal entries. You will need the following additional accounts:

18 Accumulated Depreciation – Office Equipment

22 Wages Payable
57 Insurance Expense
58 Depreciation
2. Post the adjusting entries, inserting balances in the accounts in the accounts affected.

3. Prepare an adjusted trial balance.

Content is adopted from Warren, Reeve, Duchac (2009). Accounting. South-western Cengage Learning.
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Accounting 11A Financial Accounting and Reporting
Accounting Process for Service Operations
Adjusted Trial Balance

15. (S.O. 7) After all adjusting entries have been journalized and posted an adjusted trial bal-
ance is prepared. This trial balance shows the balances of all accounts, including those
that have been adjusted, at the end of the accounting period.

16. The purpose of an adjusted trial balance is to prove the equality of the total debit balances
and the total credit balances in the ledger after all adjustments have been made.

17. The accounts in the adjusted trial balance contain all data that are needed for the prepara-
tion of financial statements.

MUSIC DEPOT
Adjusted Trial Balance
July 31, 2010
Debit Credit
Balances Balances
Cash ............................................................................. 12,780
Accounts Receivable .................................................... 4,750
Supplies ....................................................................... 175
Prepaid Insurance ........................................................ 2,475
Office Equipment .......................................................... 5,000
Accumulated Depreciation—Office Equipment ............ 60
Accounts Payable ........................................................ 5,680
Wages Payable ............................................................ 120
Unearned Revenue ...................................................... 3,600
Lee Chang, Capital ...................................................... 10,500
Lee Chang, Drawing .................................................... 1,700
Fees Earned ................................................................. 20,500
Wages Expense ........................................................... 2,520
Office Rent Expense .................................................... 2,750
Equipment Rent Expense ............................................ 1,100
Utilities Expense ........................................................... 860
Music Expense ............................................................. 2,810
Advertising Expense .................................................... 1,600
Supplies Expense ........................................................ 855
Insurance Expense ...................................................... 225
Depreciation Expense .................................................. 60
Miscellaneous Expense ............................................... 800
40,460 40,460

Content is adopted from Warren, Reeve, Duchac (2009). Accounting. South-western Cengage Learning.
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Accounting 11A Financial Accounting and Reporting
Accounting Process for Service Operations
Alternative Treatment

18. (S.O. 8) Under the alternative treatment, at the time an expense is prepaid, an expense
account is debited, and when unearned revenues are received a revenue account is cred-
ited.

19. The alternative treatment of prepaid expenses and unearned revenues has the same effect
on the financial statements as the procedures described in the chapter.

20. When a prepaid expense is initially debited to an expense account,

a. No adjusting entry will be required if the prepayment is fully expired or consumed before
the next financial statement date.
b. If the prepayment is not fully expired or consumed, an adjusting entry is required.
c. Prior to adjustment an expense account is overstated and an asset account is un-
derstated.
d. The adjusting entry results in a debit (increase) to an asset account and a credit (de-
crease) to an expense account.
e. To illustrate the adjusting entry, assume Gonzalez Company purchases P1,200 of sup-
plies and debits Office Supplies Expense. At the next financial statement date, P300
of supplies are on hand. The adjusting entry is:

Office Supplies ........................................................... 300

Office Supplies Expense ..................................... 300

21. When an unearned revenue is initially credited to a revenue account, the procedures are
similar to those described above for prepaid expenses. In this case, however,
a. Prior to adjustment, a revenue account is overstated and a liability account is un-
derstated.
b. The adjusting entry results in a debit to a revenue account and a credit to a liability
account.

Content is adopted from Warren, Reeve, Duchac (2009). Accounting. South-western Cengage Learning.
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Accounting 11A Financial Accounting and Reporting
Accounting Process for Service Operations

Content is adopted from Warren, Reeve, Duchac (2009). Accounting. South-western Cengage Learning.
Rey Joseph M. Redoblado | 12
Accounting 11A Financial Accounting and Reporting
Accounting Process for Service Operations
20 MINUTE QUIZ
Circle the correct answer.
True/False

1. Since companies find it desirable and necessary to report the results of their activities fre-
quently, the time period assumption assumes that the economic life of a business can be
divided into artificial time periods.
True False

2. The revenue recognition principle dictates that revenue be recognized in the period in which
it was received rather than when it was earned.
True False

3. Monthly and quarterly time periods are commonly referred to as fiscal periods.
True False

4. Payments of expenses that will benefit more than one accounting period are referred to as
prepaid expenses.
True False

5. Cost less accumulated depreciation is a measurement of the current value of an asset such
as equipment or a building.
True False

6. Depreciation is the allocation of the cost of an asset to expense over its useful life in a
rational and systematic manner.
True False

7. The adjusting entry for unearned revenues results in a debit to an asset account and a
credit to a revenue account.
True False

8. A contra-asset account is an account whose balance is deducted from a related asset in

the financial statements.
True False

9. When accrual basis accounting is applied, adjusting entries are not necessary.
True False

Content is adopted from Warren, Reeve, Duchac (2009). Accounting. South-western Cengage Learning.
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Accounting 11A Financial Accounting and Reporting
Accounting Process for Service Operations
10. Adjustments for accrued expenses are necessary to record the obligations that exist at the
balance sheet date and to recognize the expenses that are applicable to the current ac-
counting period.
True False

Multiple Choice

1. The recording of wages earned but not yet paid is an example of an adjustment that
a. recognizes an accrued expense.
b. recognizes an unrecorded revenue.
c. apportions revenues between two or more periods.
d. apportions costs between two or more periods.

2. A list of the accounts and their balances after all adjustments have been made is known as
a. adjusting entries.
b. adjusted trial balance.
c. book values.
d. accrued accounts.

3. Prior to recording of adjusting entries, revenues exceed expenses by P40,000. Adjusting

entries for accrued wages of P5,000 and depreciation expense of P5,000 were made. Net
income for the year would be
a. P40,000.
b. P35,000.
c. P30,000.
d. none of the above.

4. The adjustment for depreciation is an example of

a. recognizing an accrued expense.
b. apportioning costs between two or more periods.
c. apportioning revenues between two or more periods.
d. recognizing an unrecorded revenue.

5. Most businesses choose fiscal years which correspond to

a. the calendar year.
b. any twelve-month period.
c. their natural business year.
d. any of the above.

Content is adopted from Warren, Reeve, Duchac (2009). Accounting. South-western Cengage Learning.
Rey Joseph M. Redoblado | 14