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Fundamentals of Accountancy, Business and Management

END OF PERIOD ADJUSTMENTS

At the end of the reporting period, the remaining steps in the accounting cycle have to be accomplished;
the financial statements have to be prepared to assess the financial condition and results of operations of the business.
To achieve these objectives, special procedures must be undertaken to update and adjust some accounts shown in the
Trial Balance. These special procedures are accounting entries known as Adjusting Journal Entries or simply
adjustments.

Normally, the Trial Balance at the end of the accounting period does not show all the information needed in
the preparation of the financial statements. This means that some assets, liabilities, revenues and expenses are not
completely or correctly stated. In some cases, there may be revenue and expenses applicable to the last few days or
last month of the period which are not yet included in the Trial Balance because they are not yet collected or paid. Or,
there may be some expenses paid and revenues received during the period but were not fully used up or earned in the
said period.
For these and other similar cases, corrections and updating are necessary to reflect information that have
occurred during the period but not yet recorded during the same period. Such corrections, if not done, will cause
overstatement or understatement in some accounts thereby resulting in incorrect financial statements. The financial
statements then will not show the correct financial condition and profitability, among others, of the business.

One of the functions of accounting is to inform the different parties such as the owners, managers,
investors, government agencies and other financial institutions that use the financial statements to judge the business
operations and financial condition. It is therefore important that the financial statements are fairly presented.

CASH BASIS VERSUS ACCRUAL BASIS ACCOUNTING

To begin with the adjustments, it is important to know the distinction between the accrual and cash bases
accounting. In accrual basis accounting, one recognizes a revenue as it is earned and an expense as it is
incurred, regardless of when the revenue is received or when the expense is paid. In a cash basis accounting, on the
other hand, revenue and expense are recognized / recorded only when they are received and paid, respectively.

It is generally accepted principle that a business uses the accrual basis accounting which means that
income should be recorded when earned and expenses when incurred.

The adjustments for both service and merchandising business are the same except for the adjustment for
Merchandise Inventory at the end of the reporting period in the case of a merchandising concern.

These adjustments include:

1. Accrued expenses – to take up unrecorded and unpaid expenses

2. Accrued revenue / income – to take up unrecorded and uncollected revenue
3. Prepaid expenses – to transfer or apportion costs of assets to expense; or to set up a portion of the
amount previously expensed as an asset
4. Depreciation – to allocate costs of fixed assets to expense
5. Deferred or unearned revenue – to apportion revenues to two or more accounting periods
6. Bad debts – to recognize estimated uncollectible accounts
7. Merchandise inventory – to set up the ending inventory and record the cost of goods sold

Only the first five adjustments will be illustrated and discussed in the course. The remaining two will be
discussed under the merchandising concern.

ACCRUED EXPENSES

These are expenses which have already been incurred, but have not yet been taken up in the accounts
because they have not yet been paid. Normally, these expenses are taken up only when paid or when the bill or invoice
is received from the supplier. Accrued expenses not recognized will understate expenses and overstate income.
Consequently, liabilities will be understated and capital, overstated.

One example to illustrate an accrued expense is in the case of Rent.

Edge Enterprises normally pays its monthly rental of P10,000 at the end of the month. On December 31,
however, Edge Enterprises has not paid its rental for the month. In as much as the expense is already incurred but not
yet paid, proper adjustment should be recorded to reflect the expense and the corresponding liability accounts, thus:
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2022
Dec. 31 Rent expense 10,000
Rent payable 10,000

Another example is in the case of a Note Payable. Assume that on November 1, 2022, M. Company
issued a P30,000, 90 day, 18% note. The note matures on January 30, 2023 at which date the principal and the interest
due on the note will be paid. On December 31, 2022 (the end of the accounting period), interest covering the months of
November and December 2022 amount to P900 (computed as P30,000 x 18% x 60 days / 360 days). This interest,
however, has not yet been taken up in the accounts because the expense, together with the principal, will be paid only
when the note matures.

In order to avoid this error, an adjustment must be done on December 31, 2022 to record the interest
expense incurred during November and December 2022. The adjusting journal entry would be a debit to an expense
account and a credit to a liability account. Since the expense will not be paid until January 30, 2023, recognition of the
expense gives rise to a liability. The adjusting entry is:

2022
Dec. 31 Interest expense 900
Interest payable 900

Interest expense, being a nominal account, will be shown in the Statement of Comprehensive Income
among other expenses while the liability account Interest Payable will be shown in the Statement of Financial Position,
under current liabilities.

ACCRUED REVENUE

Unrecorded revenues or accrued revenues are income that are already earned but not yet taken up in the
accounts because they have not yet been received.

For instance, on December 31, 2022, Alpha Company, a management consultancy firm has completed its
special management service to a client who has agreed to pay P75,000 but at which date, Alpha Company has not
received the payment from the client, nor has issued the bill to the client. Since the revenue is already earned, said
income should form part of the revenues of the period in which it was earned although it has not yet been received. An
adjusting entry therefore is necessary in order to update the pertinent revenue account by debiting an asset account,
usually a receivable, and crediting the proper revenue account, to wit:

2022
Dec. 31 Accounts receivable 75,000
Service revenue 75,000

Failure to recognize this revenue will result in understatement of Accounts Receivable and Service
Revenue. If receivable is collected in 2023 and the company only recognizes revenue at that time, Service Revenue in
2023 will then be overstated.

Accrued revenue also applies to interest on Notes Receivable. Assume that on December 1, 2022, F.
Company received a P50,000, 60 day, 12% note. On December 31, 2022, the company has earned interest for 30 days
or P500 (computed as P50,000 x 12% x 30 / 360). The total interest for the whole 60 days, however, will be received
only on January 30, 2023 when the note matures.

The portion of interest that was earned in 2022, therefore, should be taken up in the accounts. The
adjusting entry to recognize the accrued interest on this note is:

2022
Dec. 31 Interest receivable 500
Interest revenue 500

PREPAID EXPENSES

Prepaid expenses are advanced payments for services or expenses still to be incurred or used in the near
future. These are assets which in most cases may have shelf lives that run only for a few months but would require
adjustments allocate the portion already consumed to an expense account.

One example of prepaid expense is office supplies. It is common to many businesses to buy office
supplies good for few months, which are replenished from time to time so that the supplies never actually runs out.
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Other examples are payments made ahead of the incurrence of the expense like insurance, rent, interest, etc. Prepaid
expenses are classified in the statement of financial position as current assets.

At the end of the period, special procedures must be taken up to split up the unadjusted account balance
into its expired or expense portion and its unexpired or unused or asset portion.

The adjusting journal entry for prepaid expenses depends on the method used in recording its payment or
acquisition. These methods are the ASSET method and the EXPENSE method.

When the advance payment is debited to an asset account, then the method used is called the asset
method. When the advance payment is debited to an expense account, then the method is called the expense
method.

Under the ASSET method, the payment which is debited to an asset account appears in the trial balance
as asset when in reality, a portion or all of the amount has already been used or consumed. If the account is left
unadjusted, the assets will be overstated, the expense – understated and the income – overstated.

Under the EXPENSE method, on the other hand, the payment is debited to an expense account. It
appears in full amount as expense in the trial balance, when in reality, a portion of it may still be unused or unexpired. If
no adjustment is made to correct the balance of the account, the expense for the period will be overstated, the assets –
understated and the income – understated.

Regardless of the method used to record the payment or acquisition, the accounting objectives in making
adjustment is to present the correct balances in reporting the business assets and expenses for the period.

To illustrate, assume that on Oct. 1, 2022, F Company paid P36,000 for one year insurance policy effective
that same date. The company’s accounting period ends December 31. The journal entries to record the transaction and
the corresponding adjustments on Dec. 31, 2022 are as follows:

Asset method

2022
Oct. 1 Prepaid insurance 36,000
Cash 36,000

Dec. 31 Insurance expense 9,000

Prepaid insurance 9,000

Account balances as of Dec. 31, 2022 after adjustments are:

Prepaid insurance P27,000

Insurance expense 9,000

Prepaid Insurance Insurance Expense

Oct. 1 36,000 Dec. 31 9,000 Dec. 31 9,000

Expense method

2022
Oct. 1 Insurance expense 36,000
Cash 36,000

Dec. 31 Prepaid insurance 27,000

Prepaid insurance 27,000

Account balances as of Dec. 31, 2022 after adjustments are:

Prepaid insurance P27,000

Insurance expense 9,000

Insurance Expense Prepaid Insurance

Oct. 1 36,000 Dec. 31 27,000 Dec. 31 27,000

It should be noted that regardless of the method used, the account balances at the end of the period after
recording the adjustments would be the same.
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DEPRECIATION

Most assets acquired by the business are regarded useful to its operation over several accounting periods.
Land, building, machinery, equipment, furniture and fixtures and similar assets known as property, plant and
equipment or fixed assets can serve the needs of the business from 5 to 20 years or possibly 50 years.

Fixed assets are recorded at their acquisition costs, which in addition to the purchase price, includes
freight, insurance, installation and other expenses incurred in bringing the assets for use. Discounts granted for prompt
payment, for assets acquired on credit, are deducted to arrive at the net acquisition cost.

Fixed assets, with the exception of land, have limited useful lives and as such are subject to depreciation.
Depreciation is the process of allocating in a systematic manner the cost of fixed assets over its useful life.
Depreciation is the decrease in value of a fixed asset caused by wear and tear, action of the elements, passage of time
and obsolescence. Because fixed assets have finite economic useful lives (except for land which has an infinite useful
life), each accounting period benefiting the use of the assets should be charged a portion of its acquisition costs. At the
end of the economic useful life, a fixed asset may still command a price known as the “scrap value” or disposal value or
“salvage value” or “residual value”. Therefore, the total amount that will be charged as depreciation expense over the
economic useful life of the asset is the acquisition cost less the scrap value.

The objective of depreciation is to charge each accounting period benefiting from the use of the asset – an
expense. Depreciation also brings down the book value or carrying amount of the asset from the original acquisition
cost to its estimated scrap value or salvage value. Thus, an adjusting journal entry should be made by debiting
depreciation expense and crediting the asset account. However, instead of directly crediting the asset account, a
contra-asset account is credited which is presented in the Statement of Financial Position as a direct deduction from the
asset to which it relates to arrive at the asset’s book value or carrying amount. This contra-asset account is called
accumulated depreciation.

There are three (3) factors to be considered in determining depreciation:

1. Cost of the asset which is the acquisition price plus incidental expenses necessary to acquire the
asset and make it ready for use.
2. Scrap value (or salvage value / residual value) which is the remaining value of the asset at the end of
its useful life, if the asset is sold.
3. Useful or production life of the asset which may be expressed in number of years or number of
machine hours, or number of units produced.

The simplest and most used method of depreciation is known as the straight-line method, which results
in equal periodic charges for depreciation. The formula is:

𝐶𝑜𝑠𝑡 − 𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑉𝑎𝑙𝑢𝑒

𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 =
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑙𝑖𝑓𝑒 (𝑖𝑛 𝑦𝑒𝑎𝑟𝑠)

To illustrate, assuming that EP Company follows the calendar year for its accounting period. On January
1, 2021, the company bought a machinery for a total cost of P140,000, including incidental expenses, with an estimated
life of 10 years, after which the asset could be sold for P20,000. Using the straight-line method, the annual depreciation
expense is P12,000 computed as follows:

𝑃140,000 − 𝑃20,000
𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = = 𝑃12,000
10 𝑦𝑒𝑎𝑟𝑠

On December 31, 2021, the adjusting journal entry to record the depreciation expenses for the year is:

Dec. 31 Depreciation expense 12,000

Accumulated depreciation 12,000

In the December 31, 2021 Statement of Financial Position, the machinery would be presented among the
assets as follows:

Machinery 140,000
Less: Accumulated depreciation 12,000
Carrying amount 128,000

It should be noted that the contra-account, Accumulated Depreciation (with a credit balance) is deducted
from the asset. The difference of P128,000 is the book value or the carrying amount of the asset at year-end.
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At the end of each year, for 10 years, a similar adjusting entry should be recorded. Thus at the end of the
5th year, the asset would have a book value of P80,000 (P140,000 – P60,000). At the end of 10 years, the Accumulated
Depreciation account will have a balance of P120,000 and the book value of the asset would be equal to the scrap
value.

At the end of 10 years, when the asset is fully depreciated, the following transactions may happen:

1. If the asset is sold for P20,000, no gain or loss will be reported and the following journal entry should be made
to record the sale:

Cash 20,000
Accumulated depreciation 120,000
Machinery 140,000

2. If the asset is sold for P24,000, there will be a gain of P4,000 and the entry to record the sale would be:

Cash 24,000
Accumulated depreciation 120,000
Machinery 140,000
Gain on sale of machinery 4,000

3. And, if the machinery is sold for P15,000, a loss of P5,000 will be recorded as follows:

Cash 15,000
Accumulated depreciation 120,000
Loss on sale of machinery 5,000
Machinery 140,000

If however, the asset is sold on April 1, 2025 for P120,000, two (2) journal entries would be needed. One
is to update the depreciation on the asset, because the depreciation expense is usually recorded only at the end of the
period. The other journal entry is to record the sale, thus:

2025
April 1 Depreciation expense 3,000
Accumulated depreciation 3,000

Cash 120,000
Accumulated depreciation 51,000
Machinery 140,000
Gain on sale of machinery 31,000

The gain is computed as follows:

Selling price 120,000
Less: Carrying amount, April 1, 2025
Acquisition cost of the asset 140,000
Less: Accumulated depreciation (4 years & 3 months) 51,000 89,000
Gain on sale 31,000

Computation of depreciation:
Annual depreciation 12,000
Accumulated depreciation, April 1, 2025:
From 2021-2024 (12,000 x 4) 48,000
From Jan. 1 – March 31, 2024 (12,000 x 3 months / 12 months) 3,000
51,000

DEFERRED OR UNEARNED REVENUE

Deferred revenues refer to cash received in advance for services or goods even before the service is rendered
or goods are delivered. For such advances, the business has an obligation to perform the services or to deliver the
goods. This obligation is known as Unearned Revenue. This is a liability account.

In a real estate business, a company usually requires tenants to pay several months’ rental in advance. The
amount received constitutes payment for services that are to be rendered over two (2) or more accounting periods. At
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the time the amount is received, the entire amount is regarded as “revenue which has not yet been earned”, an
“unearned revenue”, because the services for which the payment was made has not yet been rendered.

At the end of the accounting period, it is important that the portion collected by the company representing
income not yet earned must be separated from the portion that has been earned. The unearned portion is presented as
a current liability in the Statement of Financial Position. Unlike other liabilities which are payable in cash, this liability is
payable in the forms of services to be rendered or goods to be delivered by the business.

There are two (2) alternative methods of recording Income Received in Advance – the liability method and the
revenue method. If at the time of receipt of the advance payment, a liability account is credited, then the method is
called liability method. But if at the time of receipt, a revenue account is credited, then the method is used is the
revenue method. It does not really matter which method is used. What is important is that at the end of the accounting
period, when the financial statements are prepared, the accounts are adjusted to reflect the unearned or liability
component and the earned or revenue component.

To illustrate, assume that on October 1, 2021, ABC Company received a one year rental from a tenant who, per
lease contract, agreed to pay P40,000 per month. The company’s accounting period ends December 31. The entries to
record the receipt of the advance payment and the adjustment are:

Liability method:

2021
Oct. 1 Cash 480,000
Unearned rent 480,000

Dec. 31 Unearned rent 120,000

Rent income 120,000

The account balances on December 31, after adjustment are:

Unearned rent 360,000
Rent income 120,000

Unearned Rent Rent Income

Dec. 31 120,000 Oct. 1 480,000 Dec. 31 120,000

Revenue method:

2021
Oct. 1 Cash 480,000
Rent income 480,000

Dec. 31 Rent income 360,000

Unearned rent 360,000

The account balances on December 31, after adjustment are:

Rent income 120,000
Unearned rent 360,000

Rent Income Unearned Rent

Dec. 31 360,000 Oct. 1 480,000 Dec. 31 360,000

It will be observed that the same results are obtained under both the liability and revenue methods of
accounting for income collected in advance.

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