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Adjusting the accounts
 

Adjusting the accounts

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A slide presentation of various problems on adjusting entries.

A slide presentation of various problems on adjusting entries.

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    Adjusting the accounts Adjusting the accounts Presentation Transcript

    • ADJUSTING THE ACCOUNTS Chapter 5
    • The Periodicity Concept
    • PERIODICITY CONCEPT• The periodicity concept is applied when accountants divide the life of a business entity into artificial time periods (year, quarter, etc.)
    • PERIODICITY CONCEPT• The most basic accounting period is one year.
    • Types of Accounting Periods
    • TYPES OF ACCOUNTING PERIODSFiscal year – any twelve consecutive months.Example – March 1, 2012 to February 28, 2013
    • TYPES OF ACCOUNTING PERIODS• Calendar year – an annual period ending December 31.
    • TYPES OF ACCOUNTING PERIODS• Natural business year – a twelve month period that ends when business activities are at their lowest level of the annual cycle.
    • TYPES OF ACCOUNTING PERIODSInterim period – a period of less than one year.
    • Revenue Recognition Principle When is revenue recognized?
    • REVENUE RECOGNITION PRINCIPLE Revenue is recognized when it is probable that economic benefits will flow to the enterprise and these economic benefits can be measured reliably.
    • REVENUE RECOGNITION PRINCIPLE In most cases, revenue is recognized in the accounting period when the services are rendered or the goods sold are delivered.
    • Expense recognition principle When are expenses recognized?
    • EXPENSE RECOGNITION PRINCIPLE Expenses are recognized in the income statement when it is probable that a decrease in future economic benefits related to a decrease in an asset or an increase in a liability has arisen, and that the decrease in economic benefits can be measured reliably.
    • EXPENSE RECOGNITION PRINCIPLE The expense recognition principle has three broad applications namely:
    • EXPENSE RECOGNITION PRINCIPLE 1. Direct association between the costs incurred and the earning of specific items of income. Example: sales commissions expense
    • EXPENSE RECOGNITION PRINCIPLE 2. Systematic and rational allocation – This is used when economic benefits are expected to arise over several accounting periods. This is often necessary in recognizing the expenses associated with the using up of assets. Example – insurance, rent, depreciation of equipment
    • EXPENSE RECOGNITION PRINCIPLE 3. Immediate recognition – This is applied when an expenditure produces no future benefits. Example: salaries
    • The Need for Adjustments
    • THE NEED FOR ADJUSTMENTS• Adjustments are necessary to reflect in the accounts information on economic activities that have occurred but have not yet been recorded.
    • THE NEED FOR ADJUSTMENTS• Adjustments ensure that the revenue recognition principle and the expense recognition principles are followed.
    • Types of Adjustments
    • TYPES OF ADJUSTMENTS• There are two general types of adjustments: adjustment for deferrals and adjustment for accruals.
    • TYPES OF ADJUSTMENTS• Deferral – is the postponement of the recognition of an “expense already paid but not yet incurred” or of “revenue already collected but not yet earned.”
    • TYPES OF ADJUSTMENTS• Accruals– is the recognition of an “expense already incurred” but not yet paid or “revenue earned but uncollected.”
    • Adjustment for Deferrals Prepaid Expenses
    • ADJUSTMENT – PREPAID EXPENSESExample 1: Prepaid RentOn May 1, Weddings “R” Us paid P12,000 for three months’ rent in advance. This resulted to an asset consisting of the right to occupy the office for two months. A portion of the asset expires and becomes an expense each day. By May 31, one-third of the asset had expired, and should be treated as an expense.
    • ADJUSTMENT – PREPAID EXPENSESExample 1: Prepaid Rent (continued)This transaction may be initially recorded in an asset account. This is called asset method. The initial entry on May 1:
    • ADJUSTMENT – PREPAID EXPENSESExample 1: Prepaid Rent (continued) Date Description PR Debit Credit 1-MayPrepaid Rent 12,000 Cash 12,000
    • ADJUSTMENT – PREPAID EXPENSESExample 1: Prepaid Rent (continued)Come May 31, an adjusting entry for the expired prepaid rent must be made. The adjusting entry is:
    • ADJUSTMENT – PREPAID EXPENSESExample 1: Prepaid Rent (continued) Date Description PR Debit Credit 31-MayRent Expense 4,000 Prepaid Rent 4,000
    • ADJUSTMENT – PREPAID EXPENSESExample 1: Prepaid Rent (continued)Alternatively, the transaction may be initially recorded in an expense account. Thus, the initial entry on May 1 is:
    • ADJUSTMENT – PREPAID EXPENSESExample 1: Prepaid Rent (continued) Date Description PR Debit Credit 1-MayRent Expense 12,000 Cash 12,000
    • ADJUSTMENT – PREPAID EXPENSESExample 1: Prepaid Rent (continued)Come May 31, an adjusting entry for the unexpired prepaid rent must be made. The adjusting entry is:
    • ADJUSTMENT – PREPAID EXPENSESExample 1: Prepaid Rent (continued) Date Description PR Debit Credit 1-MayPrepaid Rent 8,000 Rent Expense 8,000
    • ADJUSTMENT – PREPAID EXPENSES• Thus the following rules must be followed in adjustment for prepaid expenses:
    • ADJUSTMENT – PREPAID EXPENSES• When a prepaid expense was recognized in the initial entry (asset method), the adjusting entry will involve an amount that has already expired (expense).
    • ADJUSTMENT – PREPAID EXPENSES• When an expense was recognized in the initial entry (expense method), the adjusting entry will involve an amount that is not yet expired (asset).
    • ADJUSTMENT – PREPAID EXPENSES• The two methods will have the same effect, as will be shown in the following analysis:
    • ADJUSTMENT – PREPAID EXPENSES ` ASSET METHOD EXPENSE METHOD Initial Entry Prepaid Rent 12,000 Rent Expense 12,000 Cash 12,000 Cash 12,000 Adjusting Entry Rent Expense 4,000 Prepaid Rent 8,000 Prepaid Rent 4,000 Rent Expense 8,000 Prepaid Rent = 12,000 – 4,000 Prepaid Rent = 8,000 Prepaid Rent = 8,000 Rent Expense = 12,000 – 8,000 Rent Expense = 4,000 Rent Expense = 4,000
    • ADJUSTMENT – PREPAID EXPENSES• TIP: All adjusting entries include a balance sheet (real or permanent) account and an income statement (nominal or temporary) account.
    • ADJUSTMENT – PREPAID EXPENSESExample 2: SuppliesOn May 8, Weddings “R” Us purchased supplies, P18,000. During the month, the entity used supplies in the process of performing services for clients. There is no need to account for these supplies everyday since the financial statements will not be prepared until the end of the month. At the end of the accounting period, Gevera makes a careful physical inventory of the supplies. The inventory count showed that supplies costing P15,000 are still on hand.
    • ADJUSTMENT – PREPAID EXPENSESExample 2: Supplies (continued)Again the transaction maybe recorded in two ways: by debiting an asset or debiting an expense. The initial entries and adjusting entries for the two methods follow:
    • ADJUSTMENT – PREPAID EXPENSES• Example 2: Supplies (continued) ` ASSET METHOD EXPENSE METHOD Initial Entry Supplies 18,000 Supplies Expense 18,000 Cash 18,000 Cash 18,000 Adjusting Entry Supplies Expense 3,000 Supplies 15,000 Supplies 3,000 Supplies Expense 15,000 Supplies = 18,000 – 3,000 Supplies = 15,000 Supplies = 15,000 Supplies Expense = 18,000 – 15,000 Supplies Expense = 3,000 Supplies Expense = 3,000
    • Adjustment for deferrals Depreciation
    • ADJUSTMENT – DEPRECIATIONWhen an entity acquires long-lived assets such as buildings, vehicles, and equipment, it is basically prepaying for the usefulness of that asset. Because the usefulness of these assets extends beyond one year, a portion of their cost must be allocated as expense in each accounting period. This allocation is called depreciation.
    • ADJUSTMENT – DEPRECIATIONThree factors are involved in the computation of depreciation, namely:
    • ADJUSTMENT – DEPRECIATION1. Cost – the amount the entity paid to acquire the depreciable asset.
    • ADJUSTMENT – DEPRECIATION2. Estimated salvage value – the amount the asset can probably be sold for at the end of its useful life. It is also known as scrap value.
    • ADJUSTMENT – DEPRECIATION3. Estimated useful life– the estimated number of periods that an entity can make use of the asset. It is an estimate, not an exact measurement.
    • ADJUSTMENT – DEPRECIATIONAccountants estimate periodic depreciation using different method. The simplest procedure is called the straight-line method, with the formula:
    • ADJUSTMENT – DEPRECIATIONDepreciation Expense =Depreciable cost / Estimated useful lifeDepreciable cost = Asset cost – Salvage value
    • ADJUSTMENT – DEPRECIATIONThe asset account is not directly reduced when recording depreciation expense. Instead, an account with a balance directly deducted to the balance of another account is used. We call this a contra account.
    • ADJUSTMENT – DEPRECIATIONIn adjustments for depreciation, the contra account Accumulated Depreciation is used to record reduction to the property, plant, and equipment account.
    • ADJUSTMENT – DEPRECIATIONExample 3: Suppose that Weddings “R” Us estimated that the service vehicle, which was bought on May 4 for P420,000, will last for seven years (84 months) and with a salvage value of P84,000. As a matter of company policy, the period May 4 to May 31 is considered a whole month. The depreciation adjustment and pertinent computations follow:
    • ADJUSTMENT – DEPRECIATIONDepreciation Expense =Depreciable cost / Estimated useful lifeDepreciable cost = Asset cost – Salvage valueDepreciation Expense = (420,000-84,000) / 84 moDepreciation Expense = 4,000 per month
    • ADJUSTMENT – DEPRECIATION Date Description PR Debit Credit 31-MayDepreciation Expense - Service Vehicle 4,000 Accumulated Depreciation - Service Vehicle 4,000 Service Vehicle P420,000 This account is presented in the statement of financial Less: Accumulated Depreciation (4,000) position as a direct deduction to the account “Service Net Book Value P416,000 Vehicle.”
    • Adjustment for deferrals Unearned Revenues
    • ADJUSTMENT – UNEARNED REVENUESWhen an entity receives cash for services to be rendered in the future, the amount received is referred to as unearned revenue. Once service has been rendered, an adjustment is required to reflect the correct amount of revenue and liability in the financial statements.
    • ADJUSTMENT – UNEARNED REVENUESExample 4: Unearned RevenueOn May 15, Weddings “R” Us received P10,000 as an advance payment for referrals made. Assume that by the end of the month, one of the three couples referred has already taken their marriage vows and as a result the amount of P4,000 pertaining to the referred event has been realized.
    • ADJUSTMENT – UNEARNED REVENUESExample 4: Unearned Revenue (continued)As with prepayments, cash received before the rendering of services may be recorded in two ways. The debit to cash may be accompanied by a credit to a liability account (liability method) or a credit to a revenue account (revenue method).
    • ADJUSTMENT – UNEARNED REVENUESExample 4: Unearned Revenue (continued)The pertinent entries under the two methods follow:
    • ADJUSTMENT – UNEARNED REVENUESExample 4: Unearned Revenue (continued) ` LIABILITY METHOD REVENUE METHOD Initial Entry Cash 10,000 Cash 10,000 Unearned Revenues 10,000 Referral revenues 10,000 Adjusting Entry Unearned Revenue 4,000 Referral Revenues 6,000 Referral Revenues 4,000 Unearned Revenues 6,000UnearnedThe adjusting entry under the Revenues = 10,000 – 4,000 Unearnedadjusting entry under the The Revenues = 6,000Unearnedliability method involves the Revenues = 6,000 revenue method involves the amount already earned. Referral Revenues unearned. 6,000 amount still = 10,000 –Referral Revenues = 4,000 Referral Revenues = 4,000
    • Adjustment for accruals Accrued Expenses
    • ADJUSTMENT FOR ACCRUED EXPENSESThere are instances that an entity incurs expenses before actual cash payment are made. If the accounting period ends on a date that does not coincide with the scheduled cash payment date, an adjusting entry is needed to reflect the expense incurred since the last payment. This happens often in salaries, utilities, and interest.
    • ADJUSTMENT FOR ACCRUED EXPENSESExample 5: SalariesWedding “R” Us has a 6-day workweek, and pays salaries every two Saturdays. Assume that the last pay day was on May 27. The next pay day will be on June 10. At month-end the employees have already worked for three days (29, 30, and 31) since the last pay day. The salary for these days are rightfully an expense of May, and the liabilities should reflect that the entity owes the employees salaries for these days.
    • ADJUSTMENT FOR ACCRUED EXPENSESExample 5: Salaries (continued)Each of the employee’s salary rate is P7,800 per month or P300 per day (P7,800/26 days). Assuming we are to adjust for the salaries for the office assistant and the account executive, the total accrued salaries will be:2 employees x 3 days x P300 per day = P 1,800
    • ADJUSTMENT FOR ACCRUED EXPENSESExample 5: Salaries (continued)The adjusting entry will be: Date Description PR Debit Credit 31-MaySalaries Expense 1,800 Salaries Payable 1,800 This reflects that the entity has already benefited This reflects that the entity owes the employees from the services rendered by the employees for for the services rendered for May 29, 30, and 31, May 29, 30, and 31, and thus an expense must be and thus a liability must be recognized. recognized.
    • ADJUSTMENT FOR ACCRUED EXPENSESExample 6: InterestOn May 2, Gevera borrowed P210,000 from Metrobank. She issued a promissory note that carried a 20% interest per annum. Both the interest and principal are payable in one year. By the end of the month, Gevera owes the bank interest amounting to P3,500 computed as follows:
    • ADJUSTMENT FOR ACCRUED EXPENSESExample 6: Interest (continued)Interest = Principal x Interest rate x Time lapsedInterest = P210,000 x 20% x 1 mo/12 moInterest = P 3,500
    • ADJUSTMENT FOR ACCRUED EXPENSESExample 6: Interest (continued)The adjusting entry will be: Date Description PR Debit Credit 31-MayInterest Expense 3,500 Interest Payable 3,500
    • ADJUSTMENT FOR ACCRUED EXPENSESUncollectible AccountsEntities often allow clients to purchase goods or services on credit. Some of these accounts will never be collected; hence there is a need to reflect these as charges against income.
    • ADJUSTMENT FOR ACCRUED EXPENSESUncollectible Accounts (continued)In practice, an expense is recognized for the estimated uncollectible accounts in the current period, rather than when specific accounts actually become uncollectible, to produce a better matching of income and expenses.
    • ADJUSTMENT FOR ACCRUED EXPENSESUncollectible Accounts (continued)The estimated uncollectible accounts is recorded by debiting an expense and crediting a contra- asset account: Allowance for Uncollectible Accounts which is shown as a direct deduction to the Accounts Receivable account.
    • ADJUSTMENT FOR ACCRUED EXPENSESUncollectible Accounts (continued)Estimates of uncollectible accounts may be based on credit sales for the period or on the accounts receivable balance.The difference between the two methods will be demonstrated in the following section.
    • ADJUSTMENT FOR ACCRUED EXPENSESExample 7: Uncollectible AccountsAssume that an entity made credit sales of P1,100,000 in 2011 and prior experience indicates an expected 1% average uncollectible accounts rate based on credit sales.
    • ADJUSTMENT FOR ACCRUED EXPENSESExample 7: Uncollectible Accounts (continued)The Allowance for Uncollectible Accounts needs to be increased by P11,000, which is 1% of P1,100,000. The amount computed is the amount of adjustment.
    • ADJUSTMENT FOR ACCRUED EXPENSESExample 7: Uncollectible Accounts (continued)The adjusting entry is: Date Description PR Debit Credit 31-DecUncollectible Accounts Expense 11,000 Allowance for Uncollectible Accounts 11,000 This account is shown as a direct deduction to the Accounts Receivable balance.
    • ADJUSTMENT FOR ACCRUED EXPENSESExample 7: Uncollectible Accounts (continued)The adjusting entry is: Date Description PR Debit Credit 31-DecUncollectible Accounts Expense 11,000 Allowance for Uncollectible Accounts 11,000 Accounts Receivable (assumed amount) P150,000 Allowance for Uncollectible Accounts (11,000) Accounts Receivable – net P139,000
    • ADJUSTMENT FOR ACCRUED EXPENSESExample 8: Uncollectible AccountsAssume that the Accounts Receivable balance as of December 31, 2011 is P200,000. The entity’s experience shows that 3% of the outstanding accounts receivables will become uncollectible. The Allowance for Uncollectible Accounts has a credit balance of P4,000 before adjustment.
    • ADJUSTMENT FOR ACCRUED EXPENSESExample 8: Uncollectible Accounts (continued)Take note that the amount of uncollectible accounts is based on the balance of accounts receivable. If the rate of uncollectible accounts is based on the balance of accounts receivable, the amount computed will be the required balance of the Allowance for Uncollectible Accounts.
    • ADJUSTMENT FOR ACCRUED EXPENSESExample 8: Uncollectible Accounts (continued)An analysis of the Allowance account follows: ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS Date Description JR Debit Date Description JR Credit 1-JanBeginning balance 4,000 31-DecAdjustment ? Ending Balance 6,000 The ending balance is computed by multiplying the ending Accounts Receivable Balance by the estimated rate of uncollectible accounts.
    • ADJUSTMENT FOR ACCRUED EXPENSESExample 8: Uncollectible Accounts (continued)An analysis of the Allowance account follows: ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS Date Description JR Debit Date Description JR Credit 1-JanBeginning balance 4,000 31-DecAdjustment ? Ending Balance 6,000 P2,000,000 x 3% = P6,000
    • ADJUSTMENT FOR ACCRUED EXPENSESExample 8: Uncollectible Accounts (continued)An analysis of the Allowance account follows: ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS Date Description JR Debit Date Description JR Credit 1-JanBeginning balance 4,000 31-DecAdjustment ? Ending Balance 6,000 The amount of adjustment will be computed as follows: 4,000 + n = 6,000 n = 6,000 – 4,000 n = 2,000
    • ADJUSTMENT FOR ACCRUED EXPENSESExample 8: Uncollectible Accounts (continued)An analysis of the Allowance account follows: ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS Date Description JR Debit Date Description JR Credit 1-JanBeginning balance 4,000 31-DecAdjustment 2,000 Ending Balance 6,000 The amount of adjustment will be computed as follows: 4,000 + n = 6,000 n = 6,000 – 4,000 n = 2,000
    • ADJUSTMENT FOR ACCRUED EXPENSESExample 7: Uncollectible AccountsThe adjusting entry is: Date Description PR Debit Credit 31-DecUncollectible Accounts Expense 2,000 Allowance for Uncollectible Accounts 2,000 Accounts Receivable P200,000 Allowance for Uncollectible Accounts (6,000) Accounts Receivable – net P194,000 The balance of the Allowance Account is composed of: Beginning Balance 4,000 Adjustment 2,000 Ending Balance 6,000
    • Adjustment for accruals Accrued Revenues
    • ADJUSTMENT FOR ACCRUED REVENUESAn entity may provide services during the period that are neither paid for by clients nor billed at the end of the period. An adjusting entry must be made to reflect the asset that the entity acquired through the provision of services.
    • ADJUSTMENT FOR ACCRUED REVENUESExample 8: Accrued RevenuesSuppose that Weddings “R” Us agreed to arrange a rush but simple civil wedding for a madly-in-love couple in the afternoon of May 31. The entity intended to charge fees of P5,300 for the services, which is earned but unbilled. An adjusting entry must be made as shown below:
    • ADJUSTMENT FOR ACCRUED EXPENSESExample 5: Salaries (continued)The adjusting entry will be: Date Description PR Debit Credit 31-MayAccounts Receivable 5,300 Consulting Revenues 5,300 This reflects that the client owes the entity a certain amount forthe entity has already earned This reflects that services already rendered. revenue because services has been rendered, though the amount is still uncollected.