Cluver Aedrian M.

Amodia ACC III (1171) | MSA – 1 (2:30 – 3:30 pm)

Accountants use adjusting entries to apply accrual accounting to transactions that cover more than one accounting
period. This section, provides the essential terms that you will encounter in the study of adjusting entries. These terms
are very important for you to demonstrate SLO e & f. Be sure to fully understand these terms and how these terms are
being used in making the adjusting entries.

1. ACCRUAL – means the recognition of an “expense already incurred but unpaid”, or revenue earned but
uncollected”.
A. Accrued Income – refers to income already earned by the entity but not collected yet at the end of the
accounting period (when the adjusting entries are required). Therefore, it gives rise to a trade or non-trade
receivable.
B. Accrued Expenses – refers to expenses already incurred by the entity but not paid yet at the end of the
accounting period (when the adjusting entries are required). Therefore, it gives rise to a non-trade payable.
2. DEFERRAL – is the postponement of the recognition of “an expense already paid but not yet incurred”
(opposite of accrued expense), or of “revenue already collected but not yet earned (opposite of accrued
income).
A. Pre-collected Income (deferred Income) – refers to cash received but before services is rendered or goods
are delivered (account title use is unearned revenue for service concern or customers’ deposit for
merchandising).
B. Prepaid Expenses (Deferred Expense) – refers to expenses paid in advance a portion of which or the entire
amount has not expired or consumed at the end of their porting or accounting period. The expenditures
that are normally paid in advance are rentals, insurance, advertising, supplies, and taxes.
3. DEPRECIATION – is the expired allocated cost of tangible assets. These assets such as buildings,
machineries, motor vehicles, furniture, equipment and other similar items are long-lived assets, that help the
business entity generate income and are useful for more than a year. The cost of the asset is allocated over its
estimated useful life. The allocated cost which is charged to operations is called depreciation.
4. UNCOLLECTIBLE ACCOUNTS (DOUBTFUL ACCOUNTS) – refers to an estimated amount of
receivable that is doubtful of collection. This is allowed in accounting to show a better matching of income
and expenses. This is computed based on credit sales/revenue for the period or the outstanding accounts
receivable balance.
5. SOLVENCY – is the ability of a company to meet its long-term debts and financial obligations. Solvency
demonstrates a company’s ability to continue operations into the foreseeable future.
6. LIQUIDITY – this is the ability of the company to pay its short-term obligations on time or as it becomes
due and demandable.
7. PROFITABILITY – is the ability of the company to use its resources to generate revenues in excess of its
expenses. In other words, this is a company's capability of generating profits from its operations.
8. Reversing Entry (RE) – is a journal entry which is the exact opposite of a related adjusting entry made at
the end of the accounting period. This is a technique in bookkeeping to simplify the recording of regular
transactions in the next accounting period. RE is normally prepared at the beginning of the next accounting
period. Therefore, this is the first entry that should appear in the general journal.
9. SALVAGE VALUE – refers to the estimated amount that the asset can probably be sold for at the end of
its estimated useful life.

Essential Knowledge
Why is adjusting entries necessary?
Adjusting entries are needed in order to measure properly the profit for the period and to bring related asset and
liability accounts to correct balances for the financial statements to be fairly stated. Without adjusting entries, the
financial statements may not fairly show the solvency, liquidity and profitability of the entity in the statement of
financial position and income statement.
When is adjusting entries being prepared?
Normally adjusting entries are prepared at the end of the accounting period. If the balance sheet date ends on
December 31, (calendar year) then adjusting entries are dated Dec. 31 or ends any month of the year (if Fiscal year).
What are the effects of omitting adjustments?
(Take note of its dual effect). When an accountant failed to include the proper adjusting entries, the resulting financial
statements will not accurately reflect the financial position and the performance of the entity.
1. Failure to Recognize Accrued Expenses – Net profit is overstated (w/c will also result to overstatement of owner’s
equity) and the liability is understated.
2. Failure to Recognize Accrued Income – Net profit is understated (w/c will also result to understatement of owner’s
equity) and the asset is understated.
3. Failure to Recognize the Expired/Used Portion of Prepaid Expenses – Net profit is overstated (w/c will also result
to overstatement of owner’s equity) and asset is overstated.
4. Failure to Recognize the Earned/Income Portion of Deferred Income – Net profit is understated (w/c will also result
to understatement of owner’s equity) and overstatement of liability.
5. Failure to Recognize Depreciation – asset is overstated, expense is understated (w/c will resulted to overstatement
of owner’s equity).
6. Failure to recognize doubtful accounts – asset is overstated, expense is understated (w/c will resulted to
overstatement of owner’s equity).

Accrued Expense
Under Accrual Accounting expense is recognized in the accounting period in which goods and services are used up
(incurred) to produce revenue and not when the entity pays for those goods and services. Simply means the entity shall
recognize the expense on the period in which it is incurred or used up. When at the end of the accounting period there
are expenses incurred but unpaid these comprise the accrued expenses. Example: Unpaid salaries, taxes, utilities
(light, water & telephone), rent (though in many times rent are usually prepaid), SSS, Phil Health and HDMF
contributions and many more

Accrued Income
Under Accrual Accounting revenue or income is recognized in the accounting period when goods are delivered or
services are rendered or performed. Simply means the entity shall recognize the revenue on the period in which it is
earned regardless whether or not cash is received. When at the end of the accounting period there are revenue earned
but not collected this is an accrued income or revenue that requires and adjusting entry. Example: Uncollected services
already performed or rendered (Accounts Receivable), interest already earned but no collected (Interest Receivable),
rent earned but not collected (Rent Receivable), commission earned but not collected yet (Commission Receivable)
and many more related accounts.

Prepaid Expenses
Some expenses are customarily paid in advance (which is the opposite of accrued expense) and may benefit more than
one period. These expenditures are generally debited to an asset account (though some authors prefer expense
approach). At the end of the accounting period, the estimated amount that has expired during the period or that has
benefited the period is transferred from the asset account to an expense account thru preparation of adjusting journal
entries (AJE).

Provision for Depreciation

When an entity acquires long-lived assets, such as building, service vehicles, computers, equipment or furniture, it is
basically buying or prepaying for the usefulness of that asset. These assets help generate income for the entity,
therefore a portion of the cost of the assets should be reported as expense in each accounting period. Proper
accounting requires the allocation of the cost of the asset over its estimated useful life, that portion of the cost
allocated to any of the accounting period is called depreciation. There are varied methods of estimating or computing
the depreciation (other methods shall be taken up in the higher accounting courses). This subject shall only discuss the
straight-line method.

FORMULA IN THE COMPUTATION OF DEPRECIATION USING THE STRAIGHT-LINE METHOD

Depreciation = Cost minus Salvage value over the estimated useful life (C-SV/L) Bear in mind, that the salvage value
is not included in the computation of depreciation. In case, the asset has no salvage value then the formula is cost
divided by its estimated useful life. Always remember that the allocation cost is based on estimates that the
management believes that the asset shall be useful.

Provision for Uncollectible Accounts or Doubtful Accounts

When an entity allows customers or clients to avail of the services or goods on credit this transaction gives rise to an
accounts receivable. Some of these accounts will never be collected (therefore should be written off) or doubtful of
collection at the end of the accounting period. In practice, an expense is recognized for the estimated uncollectible
accounts (doubtful accounts) in the current period, rather than when the specific accounts actually become
uncollectible(worthless). This practice shows a better matching of income and expenses. The estimated uncollectible
accounts may be based on credit sales for the period or on the accounts receivable balance. In practice, uncollectible
accounts normally happen on business engaged in buying and selling (though there are service concern who also
experience uncollectible accounts example schools). Estimation based on credit sales will be illustrated once we
discuss the merchandising concern. For this topic, let us limit our discussion based on the accounts receivable.