BUSINESS TRANSACTIONS AND

THEIR ANALYSIS AS APPLIED

TO THE ACCOUNTING CYCLE
OF A SERVICE BUSINESS PART 2
The Accounting Cycle of a Service Business
Worksheet

• In a manual accounting system, a worksheet is a large

columnar sheet of paper specially designed to
conveniently arrange all the accounting information
required at the end of the period.
• Used to check whether ledger accounts are balanced
and adjusted.
• Serves as the source in the preparation of financial
statements and other closing and adjusting entries.
Step 5-6: Adjustments

• At the end of the reporting period, some accounts

in the general ledger would require updating. The
journal entries that bring the account up to date are
called the adjusting entries.
• One purpose of adjusting is for income and
expenses to be reported in the correct period.
• Adjusting entries ensure that both the revenue
recognition and matching principles are followed.
Accrual Basis versus Cash Basis

Accrual Basis Cash Basis

Revenues are Revenues are
recognized when recognized when cash
earned and expenses is received and
are recognized when expenses are recorded
incurred. when cash is paid.
Accrual Basis versus Cash Basis

Accrual Basis Cash Basis

Revenues are Revenues are
recognized when recognized when cash
earned and expenses is received and
are recognized when expenses are recorded
incurred. when cash is paid.
Non-GAAP
Accrual Basis versus Cash Basis

On December 1, 2015, FastForward paid $2,400 cash

for a twenty-four month business insurance policy.

Using the cash basis, the entire $2,400 would be

recognized as insurance expense in 2015. No insurance
expense from this policy would be recognized in 2016 or
2017, periods covered by the policy.
• Revenue Recognition – accounting standards require
that revenue is recognized when it is earned and the
amount can be measured reliably.
• Matching Principle – this principle directs a business to
report an expense on its income statement within the
same period as its related income.
The Accounting Period
 Example
• Assume that you are preparing the financial statements for February 2016.
Pedro Computer Repairs rendered services amounting to P25,000 for the
repair of the computer units of Juan on February 26, 2016. However, the
payment for these services of Pedro will be made on March 15, 2016. When
should you recognize the P25,000 as revenue, February or March?
• Assume that you are preparing the financial statements for February 2016.
The business gives a commission of 10% service income to its employees.
The commission is paid the following month. On February 2016, the total
service income for the month is P100,000. Thus, the employees are entitled
to a commission of P10,000. This amount will be paid on March 12, 2016.
When should the commission expense be recorded in the book of accounts
of the business, March or February?
• Assume that you are preparing the financial statements for February 2016.
On February 28, 2016, Pedro received payment from Juan amounting to
P25,000. This payment is for the repair of the computer units of Juan on
March 5, 2016. When should you recognize the P25,000 as revenue,
February or March?
Steps 5-6: Adjusting Entries

• Adjusting entries are made at the end of each

accounting period.
• Adjusting entries make it possible to report correct
amounts on the statement of financial position and
on the income statement.
• All adjusting entries affect at least one income
statement account and one statement of financial
position account.
Five Basic Sources of Adjusting Entries

1. Depreciation expense
2. Deferred expenses or prepaid expenses
3. Deferred income or unearned income
4. Accrued expenses or accrued liabilities
5. Accrued income or accrued assets
Framework for Adjustments
An adjusting entry is made at the end of an accounting
period to reflect a transaction or event that is not yet
recorded.
1. Depreciation

• Depreciation is a method of allocating the cost of an

asset to an expense over the accounting periods
that make up the asset’s useful life.
• Examples of asset that are subject to depreciation
are: Store, Office, Building, Equipment. These types
of assets lose their ability to provide useful service
as time passes.
Example:
The business bought a vehicle
for 1 million.
The vehicle cannot be of service
forever, it can only be used for a
limited period of time (its useful
life). Ex. 5 years, 10 years
On Day 1, the vehicle will be
valued at its acquisition price of 1
million.
As time passes and as it is being
used in the business, its value will
gradually diminish until it
became zero, but sometimes, the
asset can still be sold after the end
of its useful life for a minimal
amount (salvage value).
 Accrual Basis
Revenues are
recognized when
earned and expenses
are recognized when
incurred.

Since its value gradually

diminish over time, we need to
record an expense as it
consumes its useful life. This is
the idea of depreciation.
Recall that Pedro acquired computer equipment on February 15,
2016 for his repair shop business. The cost of the equipment is
P25,000. It is estimated to have a useful life of five years. It is
estimated that after five years, the office equipment can be sold at
a scrap value of P1,000. The company uses the straight line
method of depreciation.

So during that time, he made the following entry on the general

journal.
Recall that Pedro acquired computer equipment on February 15,
2016 for his repair shop business. The cost of the equipment is
P25,000. It is estimated to have a useful life of five years. It is
estimated that after five years, the office equipment can be sold at
a scrap value of P1,000. The company uses the straight line
method of depreciation.

So during that time, he made the following entry on the general

journal.
Feb. 15, 2016 Year 1 Year 2 Year 3 Year 4 Year 5
P25,000 P1,000
Feb. 15, 2016 Year 1 Year 2 Year 3 Year 4 Year 5
P25,000 P1,000
Feb. 15, 2016 Year 1 Year 2 Year 3 Year 4 Year 5
P25,000 P1,000

Using the straight line method,

the P24,000 decrease in value
should be allocated over its useful
life.
If the business will not enter adjusting entries to
record the depreciation, the books of account will still
show the value of P25,000 on Year 5 even if its actual
value is only P1,000.
Feb. 15, 2016 Year 1 Year 2 Year 3 Year 4 Year 5
P25,000 P20,200 P15,400 P10,600 P5,800 P1,000

To compute for the annual depreciation using straight

line method, the following formula is used:
Going back to our time period, we are currently preparing
the financial statements for February 2016 transactions.
If the annual depreciation is P4,800 and the computer was
acquired on February 15, 2016, then it only incurred half-
month depreciation for the purpose of preparing the
February 2016 financial statements.
If adjustments for depreciation will be correctly entered every
month, the financial statements will show the balance of the
computer as:
Examples:
• A company purchased new furniture at a cost of $14,000 on September 30.
The furniture is estimated to have a useful life of 8 years and a salvage value
of $2,000. The company uses the straight-line method of depreciation. How
much depreciation expense will be recorded for the furniture for the first
year ended December 31? 
• A company purchased new furniture at a cost of $14,000 on September 30.
The furniture is estimated to have a useful life of 8 years and a salvage value
of $2,000. The company uses the straight-line method of depreciation. What
is the book value of the furniture on December 31 of the first year? 
• A company purchased new furniture at a cost of $16,000 on January 1. The
furniture is estimated to have a useful life of 6 years and a $1,000 salvage
value. The company uses the straight-line method of depreciation. What is
the book value of the furniture on December 31 of the first year?  
 2. Deferred Expenses or Prepaid Expenses
• These are the items that have been initially recorded
as assets but are expected to become expenses over
time or through the operations of the business.
 Recall that on February 19, 2016, Pedro purchased P5,000 worth of office
supplies on account. By the end of the month, P2,000 worth of supplies
are still unused.

No supplies expense was charged on February 2016 even though

P3,000 worth of supplies were already used.
Step 1: Determine what the current account balance equals.
Step 2: Determine what the current account balance should equal.
Step 3: Record an adjusting entry to get from step 1 to step 2.
Step 1: Determine what the current account balance equals.
Step 2: Determine what the current account balance should equal.
Step 3: Record an adjusting entry to get from step 1 to step 2.
Examples:
• On April 1, a company paid the $1,350 premium on a three-year
insurance policy with benefits beginning on that date. What will
be the insurance expense on the annual income statement for
the year ended December 31? 
• On May 1, a two-year insurance policy was purchased for
$18,000 with coverage to begin immediately. What is the
amount of prepaid that would appear on the company's income
statement for the first year ended December 31?
• A company's Office Supplies account shows a beginning balance
of $600 and an ending balance of $400. If office supplies
expense for the year is $3,100, what amount of office supplies
was purchased during the period?  
 3. Deferred Income or Unearned Income
• These are items that have been initially recorded as
liabilities but are expected to become income over
time or through the operations of the business.
On February 15, 2016, Pedro entered into a contract with Makisig to maintain the
computers of Makisig for 2 months starting February 15, 2016 up to April 15, 2016. On
the same date, Makisig paid the total contract amount of P40,000 full.

The P40,000 advance payment was received on February.

But revenues should be recognized as follows:

10,000 20,000 10,000
Step 1: Determine what the current account balance equals.
Step 2: Determine what the current account balance should equal.
Step 3: Record an adjusting entry to get from step 1 to step 2.
Step 1: Determine what the current account balance equals.
Step 2: Determine what the current account balance should equal.
Step 3: Record an adjusting entry to get from step 1 to step 2.
Examples:
• On May 1, Sellers Marketing Company received $1,500 from Franco Marcelli for a
marketing campaign effective from May 1 this year to April 30 of the following year.
The Cash receipt was recorded as unearned fees and at year-end on December 31,
$1,000 of the fees had been earned. The adjusting entry on December 31 would be:
• On January 1, Eastern College received $1,200,000 from its students for the spring
semester that it recorded in Unearned Tuition and Fees. The term spans four months
beginning on January 2 and the college spreads the revenue evenly over the months
of the term. What amount of tuition revenue should the college recognize on
February 28? 
• On April 1, Griffith Publishing Company received $1,548 from Santa Fe, Inc. for 36-
month subscriptions to several different magazines. The company credited Unearned
Fees for the amount received and the subscriptions started immediately. What is the
adjusting entry that should be recorded by Griffith Publishing Company on December
31 of the first year? On the second year?
 4. Accrued Expenses or Accrued
Liabilities
• These are items of expenses that have been incurred
but have not been recorded and paid.
 On February 29, 2016, Pedro received the electric bill for the month of
February amounting to P3,800. Pedro will pay the bill on March 2016.

The expense was incurred on February.

Accrual Basis
Payment will be made on March.
Revenues are
recognized when
earned and expenses
are recognized when
incurred.
Step 1: Determine what the current account balance equals.
Step 2: Determine what the current account balance should equal.
Step 3: Record an adjusting entry to get from step 1 to step 2.
Step 1: Determine what the current account balance equals.
Step 2: Determine what the current account balance should equal.
Step 3: Record an adjusting entry to get from step 1 to step 2.
 Example:
• A company recorded 2 days of accrued salaries of $1,400 for its
employees on January 31. On February 9, it paid its employees $7,000
for these accrued salaries and for other salaries earned through
February 9. The January 31 and February 9 journal entries are:
• On December 1, Milton Company borrowed $300,000, at 8% annual
interest, from the Tennessee National Bank. Interest is paid when the
loan matures one year from the issue date. What is the adjusting entry
that Milton would need to make on December 31, the calendar year-
end?
• Sanborn Company has 10 employees, who earn a total of $1,800 in
salaries each working day. They are paid on Monday for the five-day
workweek ending on the previous Friday. Assume that year ended
December 31, is a Wednesday and all employees will be paid salaries
for five full days on the following Monday. The adjusting entry needed
on December 31 is: 
 5. Adjusting Entries to Record Accrued
Income or Accrued Assets
• There are income items that have been earned but have
not been recorded and paid by the customer. In short,
these are receivables of the business.
 On February 28, 2016, Pedro repaired the computer of Jose for P15,000. Jose
was on an out-of-town trip so he could not pay Pedro. He told Pedro that he
will pay for their services on March 1, 2016.
The revenue was earned on February.

Accrual Basis
Payment will be made on March. Revenues are
recognized when
earned and expenses
are recognized when
incurred.
Step 1: Determine what the current account balance equals.
Step 2: Determine what the current account balance should equal.
Step 3: Record an adjusting entry to get from step 1 to step 2.
Step 1: Determine what the current account balance equals.
Step 2: Determine what the current account balance should equal.
Step 3: Record an adjusting entry to get from step 1 to step 2.
Example:

• Sanborn Company rents space to a tenant for $2,200 per month. The
tenant currently owes rent for November and December. The tenant
has agreed to pay the November, December, and January rents in full
on January 15 and has agreed not to fall behind again. The adjusting
entry needed on December 31 is: 
• On November 1, Jovel Company loaned another company $100,000
at a 6.0% interest rate. The note receivable plus interest will not be
collected until March 1 of the following year. The company's annual
accounting period ends on December 31. The amount of interest
revenue that should be reported in the first year is:  
 Step 7: Preparation of Financial
Statements
• Statement of Financial Position (SFP) – This statement includes the amounts of the
company’s total assets, liabilities and owner’s equity which in totality provides the
financial position of the company on a specific date.
• Statement of Comprehensive Income (SCI) – Contains the results of the company’s
operations for a specific period of time. This can be prepared on a monthly,
quarterly or yearly basis.
• Statement of Changes in Equity (SCE) – This statement is prepared prior to
preparation of the Statement of Financial Position in order to obtain the ending
balance of the equity to be used in the SFP. All changes, whether increases or
decreases to the owner’s interest on the company during the period, are reported
here.
• Cash Flow Statement – Provides an analysis of inflows and/or outflows of cash
from/to operating, investing and financing activities.
 Preparing Financial Statements
from an Adjusted Trial Balance
Step 1— Prepare income statement using revenue and expense
accounts from trial balance.
Step 2—Prepare statement of owner’s equity using capital and
withdrawals accounts from trial balance; and pull net income
from step 1.
Step 3—Prepare balance sheet using asset and liability account
from trial balance; and pull updated capital balance.
Step 4—Prepare statement of cash flows from changes in cash
flows for the period (illustrated later in the book).
 Pedro Computer Repairs
Statement of Comprehensive Income
For the month Ended February 29, 2016
 Pedro Computer Repairs
Statement oF OWNER’S EQUITY
For the month Ended February 29, 2016

Pedro, Capital, beg. P 200,000

Add: Net Income 39,000
Less: Withdrawals -
Pedro, Capital, end P 239,000