Adjusting Entries

ALDRIN C. CASTRO

BSBA MAJOR IN INTERNAL AUDITING

2013

THEORETICAL ACCOUNTING Time Period Assumption – the process of dividing the economic life of a business into artificial time periods; also known as periodicity concept Accounting Periods 1. Calendar Year – a twelve-month period that ends on December 31 2. Natural Business Year – a twelve-month period that ends on any month when the business is at the lowest or experiencing slack season Two Methods of Recognizing Revenues and Expenses: 1. Cash-Basis Accounting – revenue is recorded when cash is received, and an expense is recorded when cash is paid; cash-basis accounting is not in accordance with GAAP 2. Accrual Basis of Accounting – transactions that change a company’s financial statements are recorded in the periods in which the events occur; accrual basis of accounting is the principle supported by GAAP Revenue and Expense Recognition Principles Revenue Recognition Principle – is recognized when it is probable that economic benefits will flow to the enterprise and these economic benefits can be measured reliably [PAS No. 18, Revenue] 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 of a liability has arisen, and that the decrease in economic benefits can be measured reliably Three Broad Applications of the Matching Principle 1. Cause and Effect Association – the expense is recognized when the revenue is already recognized; also known as direct association; examples: cost of merchandise inventory, doubtful accounts, warranty expense, sales commission 2. Systematic and Rational Allocation – some costs are expensed by simply allocating them over the periods benefited; examples: depreciation of property, plant and equipment, amortization of intangibles, and allocation of prepaid rent, insurance and other prepayments 3. Immediate Recognition – the cost incurred is expensed outright because of uncertainty of future economic benefits or difficulty of reliably associating certain costs with future revenue; examples: officers’ salaries and most administrative expenses, advertising and most selling expenses, amount to settle lawsuit and worthless intangibles Adjusting Entries – involve changing account balances at the end of the period from what is the current balance of the account to what is the correct balance for proper financial reporting  Each adjusting entry affects a balance sheet account (an asset or a liability account) and an income statement account (income or expense account)  Cash should not be included in any adjusting entries that you will make Adjusting entries are necessary for three situations: 1. Prepayments 2. Accruals 3. Estimates Characteristics of the Two General Types of Adjustments 1. Accruals – the recognition of “an expense already incurred but unpaid”, or “revenue earned but uncollected” a. This adjustment deals with an amount unrecorded in any account; the entry, in effect, increases both a balance sheet and an income statement account b. Accruals would be required in two cases: i. Accruing expenses to reflect expenses incurred during the accounting period that are unpaid and unrecorded ii. Accruing revenues to reflect revenues earned during the accounting period that are uncollected and unrecorded 2. Deferrals – the postponement of the recognition of “an expense already paid but not yet incurred”, or of “revenue already collected but not yet earned”; also known as prepayments a. This adjustment deals with an amount already recorded in a balance sheet account; the entry, in effect, decreases the balance sheet account and increases an income statement account b. Deferrals would be needed in two cases: i. Allocating assets to expense to reflect expenses incurred during the accounting period (example: prepaid insurance, supplies and depreciation) ii. Allocating revenues received in advance to revenue to reflect revenues earned during the accounting period (example: subscriptions) Types of Adjusting Entries 1. Accruals a. Accrued Revenues – revenues earned but not yet received in cash or recorded b. Accrued Expenses – expenses incurred but not yet paid in cash or recorded 2. Deferrals a. Prepaid Expenses – expenses paid in cash and recorded as assets before they are used or consumed; also known as deferred expense b. Unearned Revenues – cash received and recorded as liabilities before revenue is earned; also known as deferred revenues Two Approaches for Recording Deferrals 1. Deferred Revenues – represents a liability of the business since cash was collected for service that has not been rendered yet a. Liability Method b. Income Method 2. Deferred Expense – represents an advance payment for service or expense still to be incurred or used up in the future a. Asset Method b. Expense Method

ALDRIN C. CASTRO

BSBA MAJOR IN INTERNAL AUDITING

2013

Other Terminologies 1. Book Value – the difference between the cost of a depreciable asset and its related accumulated depreciation; also known as carrying amount, carrying value, acquisition cost, or unexpired cost 2. Fair Value – the amount for which an asset could be exchanged or a liability settled, between knowledgeable and willing parties in an arm’s length transaction; also known as market value, or fair market value HIERARCHY OF ADJUSTING ENTRIES

ADJUSTING ENTRIES

ACCRUALS

ACCRUED REVENUES

DEFERRALS

DEFERRED REVENUES

ACCRUED EXPENSES

LIABILITY METHOD

INCOME METHOD

DEFERRED EXPENSES

ASSET METHOD

EXPENSE METHOD

INITIAL ENTRY!

Expense Cash

Cash Revenue

Cash Liability

Cash Revenue

Asset Cash

Expense Cash

Revenue Liability

Expense Asset

Asset Expense

SUBSEQUENT ENTRY! (adjusting entry)

Asset Revenue

Expense Liability

Liability Revenue

*journal entries highlighted in red color are the journal entries used in cash-basis accounting SUMMARY OF ADJUSTING ENTRIES Type of Adjustment Prepaid Expenses: Asset Method Expense Method Depreciation Unearned Revenues: Liability Method Income Method Accrued Expenses Accrued Revenues

Account Balances Before Adjustment Balance Sheet Account Income Statement Account

Account Debited

Adjusting Entry Account Credited

Assets Overstated Assets Understated Assets Overstated

Expenses Understated Expenses Overstated Expenses Understated

Expense Prepaid Expense (A) Expense

Prepaid Expense (A) Expense Contra Asset

Liabilities Overstated Liabilities Understated Liabilities Understated Assets Understated

Income Understated Income Overstated Expenses Understated Income Understated

Unearned Revenues (L) Revenue Expense Receivable (A)

Revenues Unearned Revenues (L) Payable (L) Revenues

References:  Accounting Principles, 7th Edition, Weygandt, Kieso, Kimmel  21st Century Accounting Process, Zenaida Vera Cruz Manuel  Basic Accounting, 2011 Issue – 16th Edition, Win Ballada, CPA, MBA, Susan Ballada, CPA  Financial Accounting, Volume 1, 2012 Edition, Conrado T. Valix, Jose F. Peralta, Christian Aris M. Valix  Theory of Accounts, Volume 1, 2012 Edition, Conrado T. Valix, Christian Aris M. Valix  Intermediate Accounting, Sixth Edition, J. David Spiceland, James F. Sepe, Mark W. Nelson

ALDRIN C. CASTRO

BSBA MAJOR IN INTERNAL AUDITING

2013

PRACTICAL ACCOUNTING ACCRUALS (1) ACCRUED REVENUES Wedding R Us agreed to arrange a rush wedding for a couple on May 31. The entity intended to charge fees of P5300 for the services, which is earned but unbilled. Prepare the journal entries Solution: Accounts Receivable P 5300 Sales P 5300 (2) ACCRUED EXPENSES Accrued Salaries (this approach is also used for other similar types of accruals) An entity pays its employees every Friday with a fixed salary of P3750 per week. The entity has five employees and the December 31 cut-off happens to be a Wednesday. Prepare the journal entry to record these adjustments Solution: Salaries Expense P 11,250 Salaries Payable P 11,250 Computation: 3750 x (3/5) x 5 = 11,250 Accrued Interest Healthway Clinic issued a 45-day, 18% note for a P100,000 cash loan extended by RP Finance. The note is dated December 1, 2012. Prepare the journal entries Solution: Interest Expense P 1500 Interest Payable P 1500 Computation: 100,000 x 0.18 x (30/360) = 1,500 Depreciation Formula for Depreciation: Annual Depreciation = (Cost – Scrap Value) / Useful Life Carla Motor Repair Service acquired on Jan 1, 2012 a machinery and equipment with an estimated life of 6 years, with no scrap value, for P75,000. The building, worth P100,000, was newly constructed on March 1, 2013 with an estimated life of 10 years, scrap value of P10,000. The furniture and fixtures, worth P30,000, were acquired Jan 1, 2013 with a useful life of 10 years, scrap value of P3,000. Prepare the adjusting entries Solution: [For the machinery and equipment] Depreciation Expense – Machinery and Equipment P 12,500 Accumulated Depreciation – Machinery and Equipment P12,500 Computation: 75,000 / 6 [For the building] Depreciation Expense – Building P 7,500 Accumulated Depreciation – Building P 7,500 Computation: Annual Depreciation: (100,000 – 10,000) / 10 = 9,000 Depreciation Expense: 9,000 x (10/12) = 7,500 [For the furniture and fixtures] Depreciation Expense – Furniture and Fixtures P 2,700 Accumulated Depreciation – Furniture and Fixtures P 2,700 Computation: (30,000 – 3,000) / 10 = 2,700 DEFERRALS (1) DEFERRED REVENUES On August 1, 2013, Marasigan Company received a P48,000 check for 2 years’ rent paid in advance. Prepare the journal entry Solution: Initial Entry: LIABILITY METHOD Initial Entry: INCOME METHOD 08/01/2013 Cash (A) P 48,000 08/01/2013 Cash (A) P 48,000 Unearned Rent Revenue (L) P 48,000 Rent Revenues (R) P 48,000 Subsequent Entry: LIABILITY METHOD Subsequent Entry: INCOME METHOD 12/31/2013 Unearned Rent Revenue (L) P 10,000 12/31/2013 Rent Revenues (R) P 38,000 Rent Revenues (R) P 10,000 Unearned Rent Revenue (L) P 38,000 Computation: 48,000 x (5/24) = 10,000 Computation: 48,000 – [48,000 x (5/24)] = 38,000 Summary of Account Balances at 12/31/2013 Summary of Account Balances at 12/31/2013 Cash (A) P 48,000 Cash (A) P 48,000 Unearned Rent Revenue (L) P 38,000 Unearned Rent Revenue (L) P 38,000 Rent Revenues (R) P 10,000 Rent Revenues (R) P 10,000

(2) DEFERRED EXPENSES On October 1, 2011, Calaguas Company acquired a 3-year insurance policy for P36,000. Prepare the journal entry Solution: Initial Entry: ASSET METHOD Initial Entry: EXPENSE METHOD 10/01/2013 Prepaid Expense (A) P 36,000 10/01/2013 Insurance Expense (E) P 36,000 Cash (A) P 36,000 Cash (A) P 36,000

ALDRIN C. CASTRO

BSBA MAJOR IN INTERNAL AUDITING

Subsequent Entry: ASSET METHOD Insurance Expense (E) P 3,000 Prepaid Expense (A) P 3,000 Computation: 36,000 x (3/36) = 3,000 Summary of Account Balances at 12/31/2013 Cash (A) (P 36,000) Prepaid Expense (A) P 33,000 Insurance Expense (E) P 3,000 12/31/2013

Subsequent Entry: EXPENSE METHOD Prepaid Insurance (A) P 33,000 Insurance Expense (E) P 33,000 Computation: 36,000 – [36,000 x (3/36)] = 33,000 Summary of Account Balances at 12/31/2013 Cash (A) (P 36,000) Prepaid Expense (A) P 33,000 Insurance Expense (E) P 3,000 12/31/2013

Rule of thumb for calculating the number of days: EXCLUDE the first date, INCLUDE the last date

DIVISION RULES

MULTIPLICATION RULES

SUBTRACTION RULES

ADDITION RULES

ACCOUNTING ANALYTICAL TOOLS AND TECHNIQUES (1) THE T-ACCOUNTS ANALYSIS (for Assets and Expenses) DEBIT CREDIT Beginning Balance Cash Expenses Ending Balance Ending Balance (2) ALGEBRAIC ANALYSIS End Bal = Beg Bal + Cash paid – Expenses Incurred (3) ARITHMETIC ANALYSIS NON-SIMULTANEOUS CHANGE ↑ ↑ x + y = Ans ↑ ↑ x + y = Ans ↓ ↓ x + y = Ans ↓ ↓ x + y = Ans ↑ ↑ x – y = Ans ↑ ↓ x – y = Ans ↓ ↓ x – y = Ans ↓ ↓ x – y = Ans ↑ ↑(y & ∆x) (x) * (y) = Ans ↑ ↑(x & ∆y) (x) * (y) = Ans ↓ ↓(y & ∆x) (x) * (y) = Ans ↓ ↓(x & ∆y) (x) * (y) = Ans ↑ ↑ (x) / (y) = Ans ↑ ↓ (x) / (y) = Ans ↓ ↓ (x) / (y) = Ans ↓ ↑ (x) / (y) = Ans General Assumption: The amount of change should be the same FORMULAS TO REMEMBER: Annual Depn = (C – SV) / L I = PRT F = P + I or F = P(1 + RT) A = L + OE NI = Inc – Expn C = Cost SV = Salvage Value L = Useful Life I = Interest

(for Liabilities, Owner’s Equity, and Revenues) DEBIT CREDIT Beginning Balance Income Cash Ending Balance Ending Balance End Bal = Beg Bal + Cash received – Income Accrued SIMULTANEOUS CHANGE ↑ ↑ ↑ x + y = Ans ↓ ↓ ↓ x + y = Ans ↑ ↓ ᴓ x + y = Ans ↓ ↑ ᴓ x + y = Ans ↑ ↑ ᴓ x – y = Ans ↓ ↓ ᴓ x – y = Ans ↑ ↓ ↑↑ x – y = Ans ↓ ↑ ↓↓ x – y = Ans ↑ ↑ ↑↑ (∆x & ∆y) (x) * (y) = Ans ↓ ↓ ↓↓ (∆x & ∆y) (x) * (y) = Ans ↑ ↓ ↑ (if xy) (x) * (y) = Ans ↓ ↑ ↓ (if xy) (x) * (y) = Ans ↑ ↑ ↓ (if x>y); ↑ (if xy); ↓ (if xy or xy or x (c + d) Then Case 2: If (a + b) < (c + d) Then (a + b) – (c + d) = e (c + d) – (a + b) = e

Reviewer for Accounts Receivable

Prepared by Aldrin C. Castro

Consequently, any part of this literal equation can be solved using algebraic rules as a tool for manipulation. Sources and References:  Financial Accounting Volume One (2012); Condrado T. Valix, Jose F. Peralta, Christian Aris M. Valix  Practical Accounting One (2011); Condrado T. Valix, Christian Aris M. Valix  Theory of Accounts Volume One (2012); Condrado T. Valix, Christian Aris M. Valix  Basic Accounting (2011); Win Ballada, Susan Ballada  Accounting Principles (7th Edition); Weygandt, Kieso, Kimmel

Reviewer for Accounts Receivable

Prepared by Aldrin C. Castro THEORIES

___ 1) Which method of recording bad debt loss is consistent with accrual accounting? A) Allowance method B) Direct writeoff method C) Percent of sales method D) Percent of accounts receivable method ___ 2) A method of estimating bad debts that focuses on the income statement rather than the statement of financial position is the allowance method based on A) Direct writeoff B) Aging the trade accounts receivable C) Credit sales D) The balance in the trade accounts receivable ___ 3) A method of estimating uncollectible accounts that emphasizes asset valuation rather than income measurement is the allowance method based on A) Aging the receivables B) Direct writeoff C) Gross sales D) Credit sales less returns and allowances ___ 4) The advantage of relating an entity’s bad debt experience to accounts receivable is that this approach A) Gives a reasonably accurate measurement of receivables in the statement of financial position B) Relates bad debt expense to the period of sale C) Is the only generally accepted method for measuring accounts receivable D) Makes estimates of uncollectible accounts unnecessary ___ 5) When a specific customer’s account receivable is written off as uncollectible, what will be the effect on net income under the allowance and direct writeoff method? A) No effect under both allowance method and direct writeoff method B) Decrease under both allowance method and direct writeoff method C) No effect under allowance method and decrease under direct writeoff method D) Decrease under allowance method and no effect under direct writeoff method ___ 6) When the allowance method of recognizing uncollectible accounts is used, the entry to record the writeoff of a specific account would A) Decrease both accounts receivable and the allowance for uncollectible accounts B) Decrease accounts receivable and increase the allowance for uncollectible accounts C) Increase the allowance for uncollectible accounts and decrease net income D) Decrease both accounts receivable and net income ___ 7) When an entity uses the allowance method for recognizing uncollectible accounts, the entry to record the writeoff of a specific uncollectible account A) Affects neither net income nor working capital B) Affects neither net income nor accounts receivable C) Decreases both net income and accounts receivable D) Decreases both net income and working capital ___ 8) When the allowance method of recognizing bad debt expense is used, the entries at the time of collection of an account previously written off would A) Decrease the allowance for doubtful accounts B) Increase net income C) Have no effect on the allowance for doubtful accounts D) Have no effect on net income ___ 9) An entity uses the allowance method to recognize doubtful accounts expense. What is the effect of a collection of an account previously written off? A) No effect on both allowance for doubtful accounts and doubtful accounts expense

B)

No effect on allowance for doubtful accounts and decrease in doubtful accounts expense C) Increase in allowance for doubtful accounts and no effect on doubtful accounts expense D) Increase in allowance for doubtful accounts and decrease in doubtful accounts expense ___ 10) When an accounts receivable aging schedule is prepared, a series of computations is made to determine the estimated uncollectible accounts. The resulting amount from this aging schedule A) When added to the total accounts written off during the year is the desired credit balance of the allowance for doubtful accounts at year-end B) Is the amount of doubtful accounts expense for the year C) Is the amount that should be added to the beginning allowance for doubtful accounts to get the doubtful accounts expense for the year D) Is the amount of desired credit balance of the allowance for doubtful accounts to be reported at year end

PLEASE ANSWER FIRST BEFORE LOOKING AT THE ANSWERS  ANSWERS: 1) A 2) C 3) A 4) A 5) C 6) A 7) A 8) D 9) C 10) D

Reviewer for Accounts Receivables

Prepared by Aldrin C. Castro PROBLEMS

Problem #1 The following data are available on December 31, 2012 for Naïve Company: Sales 8,000,000 Accounts Receivable 2,000,000 Allowance for Doubtful Accounts – January 1 100,000 Accounts written off 130,000 Recovery of accounts previously written off 20,000 Required: Prepare the adjusting entry for doubtful accounts under each of the following method: a. Percentage of sales – The estimate is 3% b. Percentage of accounts receivable – The estimate is 8% c. Aging – The estimate is P200,000 Problem #2 Orr Company prepared an aging of accounts receivable on December 31, 2011 and determined that the net realizable value of the accounts receivable was P2,500,000. Additional information is available as follows: Allowance for Doubtful Accounts on January 1 280,000 Accounts written off as uncollectible 230,000 Accounts Receivable on December 31 2,700,000 Uncollectible accounts recovery 50,000 For the year ended December 31, 2011, what amount should be recognized as doubtful accounts expense? A) 230,000 B) 200,000 C) 150,000 D) 100,000 Problem #3 Roanne Company uses the allowance method of accounting for uncollectible accounts. During 2011, Roanne had charged P800,000 to bad debt expense, and wrote off accounts receivable of P900,000 as uncollectible. What was the decrease in working capital? A) 900,000 B) 800,000 C) 100,000 D) 0 Problem #4 Mill Company’s allowance for doubtful accounts was P1,000,000 at the end of 2011 and P900,000 at the end of 2010. For the year ended December 31, 2011, Mill reported doubtful accounts expense of P160,000 in its income statement. What amount did Mill debit to the appropriate account in 2011 to write off uncollectible accounts? A) 60,000 B) 100,000 C) 160,000 D) 260,000 Problem #5 The following information pertains to Tara Company’s accounts receivable on December 31, 2011: Days Outstanding Estimated Amount Estimated Uncollectible 0 – 60 1,200,000 1% 61 – 120 900,000 2% Over 120 1,000,000 60,000 During 2011, Tara wrote off P70,000 in accounts receivable and recovered P40,000 that had been written off in prior years. Tara’s January 1, 2011, allowance for uncollectible accounts was P100,000 Under the aging method, what amount of allowance for uncollectible accounts should Tara report on December 31, 2011? A) 90,000 B) 100,000 C) 130,000 D) 190,000 Problem #6 The following accounts were abstracted from Manchester Company’s unadjusted trial balance on December 31, 2011: Debit Credit Accounts Receivable 5,000,000 Allowance for Doubtful Accounts 40,000 Net Credit Sales 20,000,000 Manchester estimates that 3% of the gross accounts receivable will become uncollectible. What amount should be recognized as doubtful accounts expense for 2011? A) 110,000 B) 150,000 C) 190,000 D) 600,000 Problem #7 Barr Company showed the following at year-end: Allowance for doubtful accounts (debit balance) (16,000) Net sales 7,100,000 Barr estimates its uncollectible receivables at 2% of net sales. What is the allowance for doubtful accounts at year end? A) 158,000 B) 144,500 C) 142,000 D) 126,000 Problem #8 Capetown Company began operations on January 1, 2010. Capetwon has found that its estimated bad debt expense has been consistently higher than actual bad debts. Management proposes lowering the percentage from 3% of credit sales to 2%. Credit sales for 2011 totaled P5,000,000, and accounts written off as uncollectible during 2011 totaled P550,000. What is the bad debt expense for 2011? A) 150,000 B) 100,000 C) 550,000 D) 240,000