Chapter 10 – Adjusting the Records

CHAPTER 10
ADJUSTING THE RECORDS
Topic Overview:
1. Gradual changes in financial position and performance
2. Items requiring adjustments
3. Preparation of adjusting and correcting entries

Chapter Objective:
At the end of this chapter, students must be able to:
1. Identify adjusting events
2. Compute adjustments and prepare adjusting entries
3. Prepare correcting entries

ADJUSTING THE RECORDS: An introduction

The journalizing stage of accounting normally captures transactions that have observable change on
element: assets, liability, equity, income and expense.

There are, however, events that cause silent or gradual changes on the elements of financial statements.
These are not directly observable and are not usually captured by the bookkeeping process because the
business processes are designed to capture and process transactions. Hence, accountants need to record
these accountable events in the accounting books via adjustments called “adjusting entries”.

These silent changes include:

1. Accruals of income and expenses

Income may have been earned or accumulated by the end of the accounting period but is not yet
recorded in the books because it is not yet collected. We call this accrued income.

Similarly, an expense may have been incurred or accumulated by the end of the accounting period but
is not yet recorded in the accounting books because it is not yet paid. We call this accrued expense.

In order to properly measure the income and asset and the expense and liability during the accounting
period, these accrued items must be booked via adjustments.

2. Expiration of prepayments and earnings of deferrals

Prepaid expenses are initially recorded as assets because they are not outright expense upon payment.
Prepaid expense will expire over time as expense. This gradual expiration cannot be captured by
journalizing so it must be recorded by adjusting entries.

Similarly, deferrals are income received in advance. They are also known as unearned income. These
are normally not recorded as outright income because they are not yet earned upon receipt. When
these are earned, they no longer cause an observable movement in asset and income and thus their
earning must be recorded via adjusting entries.

3. Usage of supplies
For practical considerations, the daily usage of supplies is not usually recorded piece by piece. The
expense for supplies used during a period is determined by physical count at the end of the reporting
period by comparing the supplies available for use and the supplies that remained at the end of the
period.

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Supplies are similar to prepayments that get used up throughout time. The used supplies are booked
as expense at year-end via an adjustment entry.

4. Decrease in value of receivables due to bad debts

There is always a risk that some or a portion of the receivables from customers or clients will not be
fully collected. This uncollectible portion is what we call bad debts. Prudence requires that the
uncollectible portion must be estimated and expensed as bad debt expense. The estimate of the
uncollectible receivable is called a provision for bad debts.

5. Gradual degradation or exhaustion of properties such as machineries, equipment, building,

furniture and fixtures and property improvements
Properties used by the business usually decrease in value brought by usage and or obsolescence in
value. This gradual reduction in value cannot be known unless the property is sold. Accounting takes
up this gradual degradation in value of property as a periodic expense in the book called “depreciation
expense”. The cost of the property less any estimated salvage value at its retirement is spread as
depreciation expense throughout its useful life.

6. Accounting errors
Although the correction of accounting errors can be made anytime they are discovered, it can also be
made during the preparation of adjusting entries.

It becomes necessary therefore to prepare adjusting entries to correct the misstatements caused by these
events to income, expense, assets or liability or capital. Adjusting entries are prepared at the end of the
accounting period before the closing of income and expenses.

ADJUSTING ENTRIES
These are entries required at the end of every reporting period to bring the balances of accounts up-to-
date and to allocate, on an accrual basis, revenue and expenses between current and future periods.

Adjusting entries are typically dated as of the last day of the reporting period and always involve a
statement of financial position or real accounts, and an income statement or nominal account. The
preparation of adjusting journal entry is an application of accrual basis accounting rather than cash basis
accounting.

LIST OF ITEMS REQUIRING ADJUSTMENTS

1. Accrual of income
2. Accrual of expense
3. Deferral of expense or prepayments
a. Asset method
b. Expense Method
4. Deferral of revenue or precollection
a. Liability Method
b. Revenue Method
5. Bad debts expense
a. Based on revenue
b. Based on accounts receivable
c. Aging of accounts

6. Depreciation expense

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ACCRUALS OF INCOME AND EXPENSE

Illustration 1: Accrual of Income

A client gave the business a ₱100,000 promissory note which pays 12% interest per annum on September
1, 2016. The note shall mature in 6 months on March 1, 2017.

Entire term of the note (6 months)

Term for accrued interest

Remaining term (2 months)
(4 months)

(March 1, 2017)
(Dec., 31, 2016)
(Sept., 1, 2016)

The total interest income from September 1, 2016 to March 1, 2017 is ₱6,000, computed as ₱100,000 x
12% x 6 months/12 months. This amount will be collected and be recorded in the books on March 1, 2017.
However, this interest income is earned as follows:

From September 1, 2016 to December 31, 2016 ₱100K x 12% x 4 mos./12 mos. ₱ 4,000
January 1, 2017 to March 1, 2017 ₱100K x 12% x 2 mos./12 mos. 2,000
Total interest from September 1,2016 to March 1, 2017 ₱ 6,000

The ₱4,000 earned in 2016 must be booked to properly reflect the income in Year 2016.

Adjusting Entry on December 31, 2016:

Date Account Debit Credit
Dec. 31, 2016 Accrued interest income ₱ 4,000
Interest income ₱ 4,000
To record the accrual of interest income

Note: The accrued interest income is an asset as of December 31, 2016.

To record the collection of the interest on March 1, 2017:

Date Account Debit Credit
Mar. 1, 2017 Cash ₱ 6,000
Accrued interest income ₱ 4,000
Interest income 2,000
To record the collection of interest

Note: Without the adjustment, the income of 2016 would be understated while the income of 2017 will be
overstated by ₱4,000 if the interest is recorded only when received.

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Illustration 2: Accruals of Expense

The business pays ₱24,000 semi-monthly salaries to its employee every 18th and 3rd of the month.

₱24,000 salaries expense

12 days 3 days
Dec., 19, 2016

Dec. 31, 2016

Jan. 3, 2017
What adjustment would be needed by December 31, 2016?

Analysis:
December 19, 2016 to December 31, 2016 (₱24K x 12 days/15 days) ₱ 19,200
January 1, 2017 to January 3, 2017 (₱24K x 3 days/15 days) 4,800
Salaries expense from December 19, 2016 to January 3, 2017 ₱ 24,000

Adjusting Entry on December 31, 2016:

Date Account Debit Credit

Dec. 31, 2016 Salaries expense ₱ 19,200
Accrued salaries expense ₱ 19,200
To record the accrual of salaries expense

Note: The accrued salaries expense is a liability as of December 31, 2016.

To record the payment of salaries on January 3, 2017:

Date Account Debit Credit

Jan. 3, 2017 Accrued salaries expense ₱ 19,200
Salaries expense 4,800
Cash ₱ 24,000
To record the collection of interest

Note: Without the adjustment, the salaries expense of 2016 would be understated while the expense of 2017
will be overstated by ₱19,200 if the ₱24,000 salaries is recorded only during payment.

EXPIRATION OF PREPAYMENTS
The adjustment for the expiration of prepaid expenses depends upon the methods of accounting which is
used in recording the prepaid expense in the books.

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Alternative methods of recording prepayments:

1. Assets method – the prepayment is initially recorded upon payment as an asset, “Prepaid expense” or
“Deferred expense”. At the end of the reporting period, the expired portion is computed and adjusted
as expense.
2. Expense method – the prepayment is initially recorded upon payment as an expense. At the end of the
reporting period, the unexpired portion is computed and is adjusted as an asset.

Summary of accounting treatment:

Date of transaction End of period adjustment
Asset method Prepaid expense XX Expense XX
Cash XX Prepaid expense XX
Expense Method Expense XX Prepaid expense XX
Cash XX Expense XX

Illustration 1: Prepaid rent

On October 1, 2016, the business paid ₱100,000 for the rental of an office space covering October 1, 2016
to September 30, 2017.

Entire term of the ₱100,000 rent expense

3 months 9 months

Sept. 30, 2017

Dec., 31, 2016
Oct. 1, 2016

Breakdown of rental expense:

October 1, 2016 to December 31, 2016 (₱100K x 3 mos./12 mos.) ₱ 25,000

January 1, 2017 to September 30, 2017 (₱100K x 9 mos./12 mos.) 75,000
Rent expense for October 1, 2016 to September 30, 2017 ₱ 100,000

Under the Asset Method:

Date of transaction:
Date Account Debit Credit
Oct. 1, 2016 Prepaid rent ₱ 100,000
Cash ₱ 100,000
To record the prepayment of rental

Adjusting Entry:
Date Account Debit Credit
Dec. 31, 2016 Rent expense ₱ 25,000
Prepaid rent ₱ 25,000
To record the expired portion of the rental prepayment

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In the asset section of the Balance sheet:

Prepaid rent
₱ 100,000 ₱ 25,000
₱ 75,000

In the Income statement:

Rent expense
₱ 25,000
₱ 25,000

Note: Under the asset method, the expired portion (expense) is set-up in the adjustment process.

Under the Expense Method:

Date of transaction:
Date Account Debit Credit
Oct. 1, 2016 Rent expense ₱ 100,000
Cash ₱ 100,000
To record the prepayment of rental

Adjusting Entry:
Date Account Debit Credit
Dec. 31, 2016 Prepaid rent ₱ 75,000
Rent expense ₱ 75,000
To record the unexpired portion of the rental prepayment

In the Income statement:

Rent expense
₱ 100,000 ₱ 75,000
₱ 25,000

In the asset section of the Balance sheet:

Prepaid rent
₱ 75,000
₱ 75,000

Note: Either method essentially come up with the same asset and expense figures as of December 31,
2016.

Illustration 2: Prepaid insurance

On May 1, 2016, the business paid ₱24,000 for a one-year fire insurance of its building. The business
reports at the end of every calendar year.

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Entire term of the ₱24,000 insurance expense

8 months 4 months

April 30, 2017

Dec., 31, 2016
May 1, 2016

The ₱24,000 insurance expense shall be broken as follows:

May 1, 2016 to December 31, 2016 (₱24,000 x 8 mos./12 mos.) ₱ 16,000
January 1, 2017 to April 30, 2017 (₱24,000 x 4 mos./12 mos.) 8,000
Total one-year insurance expense ₱ 24,000

Under the Asset Method:

Journal entry upon payment:

Date Account Debit Credit
May 1, 2016 Prepaid insurance ₱ 24,000
Cash ₱ 24,000
To record the prepayment of one year-insurance

Year-end Adjusting Entry:

Date Account Debit Credit
Dec. 31, 2016 Insurance expense ₱ 16,000
Prepaid insurance ₱ 16,000
To record the expired portion of the insurance prepayment

Under the Expense Method:

Journal entry upon payment:

Date Account Debit Credit
May 1, 2016 Insurance expense ₱ 24,000
Cash ₱ 24,000
To record the prepayment of one year-insurance

Year-end Adjusting Entry:

Date Account Debit Credit
Dec. 31, 2016 Prepaid insurance ₱ 8,000
Insurance expense ₱ 8,000
To record the unexpired portion of the insurance prepayment

Distinction between deferred expenses and accrued expenses

Are the expenses
already incurred? already paid?
Deferred expenses No Yes
Accrued expenses Yes No

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USAGE OF SUPPLIES
The recording of used supplies as expense could not be practically done on a daily or per-usage basis. For
practicality consideration, used supplies (supplies expense) are recorded as an adjusting entry at the end
of the accounting period using the inventory method. Under this method, the quantities and value of
supplies are determined at the end of the accounting period. Missing supplies are presumed used.
The supplies expense is established by the following analysis:

Beginning supplies ₱ XXX

Add: Supplies purchased XXX
Supplies available for use ₱ XXX
Less: Ending supplies XXX
Supplies used (Supplies expense) ₱ XXX

Supplies are similar to prepayments which may be initially recorded by the asset method or expense
method.

Illustration
On May 1, 2016, the business purchased a total of ₱20,000 office supplies. At the end of the current year
(December 31, 2016), supplies worth ₱4,000 still remained unused. There were ₱7,000 unused supplies
at the end of the prior year (December 31, 2015).

The supplies expense for the year 2016 shall be computed as:

Beginning supplies (12/31/2015) ₱ 7,000

Supplies purchased in 2016 20,000
Supplies available for use ₱ 27,000
Less: Ending supplies (12/31/2016) 4,000
Supplies used (Supplies expense) ₱ 23,000

Under the Asset Method:

Journal entry upon purchase:

Date Account Debit Credit
May 1, 2016 Office Supplies ₱ 20,000
Cash ₱ 20,000
To record the purchased of office supplies

Year-end Adjusting Entry:

Date Account Debit Credit
Dec. 31, 2016 Office supplies expense ₱ 23,000
Office supplies ₱ 23,000
To record the used portion of the office supplies

Under the Expense Method:

Journal entry upon payment:

Date Account Debit Credit
May 1, 2016 Office supplies expense ₱ 20,000
Cash ₱ 20,000
To record the purchased of office supplies

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Year-end Adjusting Entry:

Date Account Debit Credit
Dec. 31, 2016 Office supplies ₱ 4,000
Office supplies expense ₱ 4,000
To record the unused portion of the office supplies

EARNING OF DEFERRALS
Deferrals or income received or collected in advance are not earned by the business upon receipt. This is
earned by the business as it renders its part on the contract or as time passes.

Advanced income may be initially recorded using:

a. Liability method – the advanced income is initially recorded as a liability as unearned income or
deferred income upon receipt. Eventually, the realized or earned portion by the business is recorded
as income by an adjusting entry.
b. Income method – the advanced income is initially recorded as an income upon receipt. Eventually,
the unearned portion is recorded as a liability by an adjusting entry.

Summary of accounting treatment:

Date of transaction End of period adjustment
Liability method Cash XX Unearned income XX
Unearned income XX Income XX
Income Method Cash XX Income XX
Income XX Unearned income XX

Illustration:
On July 1, 2016, the business received ₱200,000 advanced rental from a lessee. The advanced rent covers
two years from July 1, 2016 to June 30, 2018. The business reports financial statements every December
31.

Entire term of the ₱200,000 rent income

6 months 18 months
June 30, 2018
Dec. 31, 2016
July 1, 2016

The rent income shall be broken as follows:

July 1, 2016 to December 31, 2016 (₱200,000 x 6 mos./24 mos.) ₱ 50,000

January 1, 2017 to June 30, 2018 (₱200,000 x 18 mos./24 mos.) 150,000
Total one-year rental income ₱ 200,000

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Under the Liability Method:

Journal entry upon collection of cash:

Date Account Debit Credit
July 1, 2016 Cash ₱ 200,000
Unearned rent income ₱ 200,000
To record the collection of advance rental

Year-end Adjusting Entry:

Date Account Debit Credit
Dec. 31, 2016 Unearned rent income ₱ 50,000
Rent income ₱ 50,000
To record the earned portion of the rent income

In the liability section of the Balance sheet:

Unearned rent income

₱ 50,000 ₱ 200,000
₱150,000

In the Income statement:

Rent income
₱ 50,000
₱ 50,000

Note: Under the liability method, the earned portion (expense) is set-up in the adjustment process.

Under the Income Method:

Journal entry upon collection of cash:

Date Account Debit Credit
July 1, 2016 Cash ₱ 200,000
Rent income ₱ 200,000
To record the receipt of advance rental

Year-end Adjusting Entry:

Date Account Debit Credit
Dec. 31, 2016 Rent income ₱150,000
Unearned rent income ₱150,000
To record the unearned portion of advance rental

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In the Income statement:

Rent income
₱ 150,000 ₱ 200,000
₱ 50,000

In the Balance sheet:

Unearned rent income

₱ 150,000
₱ 150,000

Note: Under the income method, the unearned portion (expense) is set-up in the adjustment process.

Either method essentially comes up with the same liability and income figures as of December 31, 2016.

Illustration 2
The business received ₱90,000 advanced payment from a client for janitorial services to be provided
between September 1, 2016 to February 28, 2017.

Entire term of the ₱90,000 service income

4 months 2 months
Sept. 1, 2016

Dec., 31, 2016

Feb. 28, 2017

The service income shall be broken as follows:

Sept. 1, 2016 to December 31, 2016 (₱90,000 x 4 mos./6 mos.) ₱ 60,000

January 1, 2017 to February 28, 2017 (₱90,000 x 2 mos./6 mos.) 30,000
Total service income ₱ 90,000

Under the Liability Method:

Journal entry upon collection of cash:

Date Account Debit Credit
Sept. 1, 2016 Cash ₱ 90,000
Unearned service income ₱ 90,000
To record the collection of advance service income

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Year-end Adjusting Entry:

Date Account Debit Credit
Dec. 31, 2016 Unearned service income ₱ 60,000
Service income ₱ 60,000
To record the earned portion of the service income

Under the Income Method:

Journal entry upon collection of cash:

Date Account Debit Credit
Sept. 1, 2016 Cash ₱ 90,000
Service income ₱ 90,000
To record the collection of advance service income

Year-end Adjusting Entry:

Date Account Debit Credit
Dec. 31, 2016 Service income ₱ 30,000
Unearned service income ₱ 30,000
To record the unearned portion of advance service income

Distinction between deferred income and accrued income

Income
Already earned or
realized? Already collected?
Deferred income No Yes
Accrued income Yes No

PROVISION FOR BAD DEBTS

There is always a possibility that receivables from clients will not be fully collected. An uncollectible
receivable is called “bad debt expense”.

There are two methods of recording bad debts expense:

1. Direct write-off method
2. Allowance method

Under the Direct Write-off Method:

1) The bad debt expense is recorded when a specific account is ascertained or proven to be uncollectible
(which may not occur in the period of sale).
2) This method is theoretically undesirable because it:
a) Makes no attempt to match revenues and expenses;
b) Does not result in receivables being stated at net realizable value in the statement of financial
position.

Net realizable value is the net expected amount to be collectible from receivable after adjusting for expected
unrecoverable accounts.

Illustration – Direct Write-off Method

In 2016, the business made ₱400,000 service income from various clients. ₱100,000 of which is on
account wherein 2% is expected to be non-collectible. In 2017, ₱1,400 were actually proven to be non-
collectible.

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Journal Entry in 2016 – None.

Journal Entry in 2017:

Date Account Debit Credit
Dec. 31, 2017 Bad debt expense ₱ 1,400
Accounts receivables ₱ 1,400
To record bad debt expense

This method is employed for taxation purposes; hence, this method is also called the Tax Method of
recording bad debts.

Allowance Method
Bad debt expense is estimated and recorded as expense in the year the business sells the goods or services
on account. This method is justified because the business incurs loss at the moment it sells goods or
services to non-paying customers and not later when the receivable is actually determined to be
uncollectible.

This method better matches cost or expenses against revenue and results in receivable valuation which is
a more realistic portrayal of the economic value of the receivable. This is the one prescribed by generally
accepted accounting principles (GAAP); hence, it is called the GAAP Method.

Methods of Estimating Bad Debts under the allowance method

Method Description
1. % of account sales method Bad debt expense is equal to % of account sales or revenues made on credit.
2. % of receivables method The required balance of allowance for bad debts is computed as a percentage
of the ending receivable balance. Bad debt expense is determined based on
the change in the balance of the allowance account.
3. Aging of accounts method Each individual customer account is aged and an estimate of uncollectibility
is assigned based on previous experience on each age of receivable accounts
turning to be bad debts. The balance computed is the required ending balance
of allowance for bad debts. Bad debt expense is then determined based on the
change in the balance of the allowance account.

The percent of sales method is applicable to merchandising businesses. The computation of bad debts
expense based on account sales will be discussed in Chapter 14, under Accounting for merchandising
concern. The percentage of receivable method will be discussed here. The aging of accounts method will be
covered in detail in more advanced accounting subjects.

Pro-forma Entries under the Allowance Method

Regardless of the method used in estimating bad debts, the following entries will be prepared in relation
to bad debts:

The adjusting entry for estimated bad debts expense is recorded as follows:

Date Account Debit Credit

XXX Bad debt expense ₱ XXX
Allowance for bad debts ₱ XXX
To record estimated bad debt expense

The write-off of worthless or uncollectible accounts is recorded as follows:

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Date Account Debit Credit

XXX Allowance for bad debts ₱ XXX
Accounts receivable ₱ XXX
To record writing off of accounts receivable

If the business recovered accounts previously written off, the journal entries are:
Date Account Debit Credit
XXX Accounts receivable ₱ XXX
Allowance for bad debts ₱ XXX
To record re-establishment of accounts previously written off

XXX Cash ₱ XXX

Accounts receivable ₱ XXX
To record collection of accounts previously written off

The allowance for bad debts account is a contra-asset account and is presented as a deduction against the
amount of accounts receivables in the statement of financial position. Net realizable value is computed as
follows:
Net Realizable value = Accounts receivable less Allowance for bad debts.

The allowance for bad debts, ending may be computed as follows:

Allowance for bad debts, beginning ₱ XXX

Add: Bad debts expense (squeeze) XXX
Recovery of accounts written off XXX
Total ₱ XXX
Less: Accounts written off XXX
Allowance for bad debts, end ₱ XXX

Percent of Receivable Method

Under the percent of receivable method, the estimated bad debt rate multiplied to the balance of accounts
receivable is the required allowance for bad debts (i.e. ending balance of allowance). The bad debt
expense is established by analyzing the allowance account, using the following T-account:

Allowance for bad debts

P XXX Beginning balance
Accounts written-off P XXX ???? Bad debt expense
*Ending balance P XXX
*This is the required allowance which is computed as bad debt ratio x Accounts receivable balance.

Illustration – Percent of Receivable Method

Before preparation of financial statements at December 31, 2017, the business has ₱200,000 accounts
receivables from various customers. Based on past experience, about 5% of receivables will not be
collected. On April 4, 2017, ₱4,000 accounts were proven to be uncollectible. The allowance for bad debts
as of December 31, 2016 last year has a balance of ₱5,000.

Journal Entry in 2017:

Date Account Debit Credit
April 4, 2017 Allowance for bad debts ₱ 4,000
Accounts receivable ₱ 4,000
To record the write-off of bad debts proven to be non-collectible

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The bad debt expense shall be computed as follows:

Allowance for bad debts

₱ 5,000 Beginning balance
Accounts written-off ₱ 4,000 9,000 Bad debt expense
*Ending balance ₱ 10,000

*This is computed as ₱200,000 x 5% = ₱ 10,000.

Adjusting Entry for 2017:

Date Account Debit Credit
Dec. 31, 2017 Bad debt expense ₱ 9,000
Allowance for bad debts ₱ 9,000
To record estimated bad debt expense

Alternatively, the bad debts expense may be computed by work-back computation as follows:

Allowance for bad debts, beginning ₱ 5,000

Add: Bad debts expense (SQUEEZE) 9,000 This is established by reverse computation
starting from the bottom.
Recovery of accounts written off 0
Total ₱ 14,000
Less: Accounts written off ( 4,000 )
This is the required balance and is the first
Allowance for bad debts, end (₱200,000 x 5%) ₱ 10,000 to be computed.

The net realizable value is computed as follows:

Net Realizable value: ₱200,000 less ₱10,000 = ₱ 190,000.

Bad debt expense is not much of an issue when it comes to service businesses due to the fact that services
are normally sold for cash. Businesses involved in trading are particularly exposed to bad debts due to the
volume of their transactions made on credit with customers. Trading businesses uses any of the
aforementioned methods of estimating bad debts.

PROVISION FOR DEPRECIATION

Long-term assets such as building, machineries, equipment, furniture and fixture, improvements to
properties wears out by regular use or become obsolete by the passage of time. This gradual decrease in
value of these properties throughout their years of useful life is called depreciation expense.

At the end of every accounting period, depreciation is estimated and expensed via an adjusting entry.

Pro-forma adjusting entry:

Date Account Debit Credit
XXX Depreciation expense ₱ XXX
Accumulated Depreciation ₱ XXX
To record depreciation expense

The accumulated depreciation account is a contra-asset and is presented as a deduction against the
pertinent property account in the statement of financial position. The cost of the asset less the
accumulated depreciation is called the book value.

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Depreciable cost
Cost is what is paid for to acquire or purchase the property. Usually, this value does not become totally
zero at the end of the useful life of the property. Properties are still saleable at the end of their service life.
The estimated net realizable value from the ultimate disposal of the property at the end of its useful life is
called residual value. The residual value is the disposal proceeds less estimated cost of disposal.

For purposes of depreciation, only the decrease in value of the property throughout its service life is
expensed through periodic provision of depreciation. This is called depreciable cost.

Depreciable cost is simply: Cost less residual value.

The depreciable cost is periodically expensed every accounting period throughout the useful life of the
property using the method of depreciation (depreciation policy) that is adopted by the business.
Depreciation should start when the asset is available for use.

Useful life is
a. the period over which an asset is expected to be available for use by a business; or
b. the number of production or similar units expected to be obtained from the asset by the business.

Common Methods of Estimating Depreciation

1. Straight line method
2. Production output or work-hours method
3. Sum-of-the-year’s digit method
4. Declining balance method

Straight-line Method
The depreciable cost of the asset is simply spread over as expense over the useful life. This method results
in uniform depreciation expense throughout the life of the property.

Illustration 1
On January 1, the business purchased an equipment costing ₱100,000. The same is expected to be used
for 10 years after which it will be sold for ₱10,000 as scrap.

(₱100,000 – ₱10,000)
Annual depreciation = = ₱ 9,000/year
10 years

Adjusting entry every year-end:

Date Account Debit Credit
Dec. 31 Depreciation expense ₱ 9,000
Accumulated Depreciation ₱ 9,000
Note:
1. The book value of the equipment shall be ₱ 91,000 as of December 31.
2. There shall be another ₱9,000 depreciation per year until the depreciable cost is fully exhausted through depreciation
expense.
3. The book value of the property shall likewise decrease ₱9,000 per year until it equals the residual value at the end of
the useful life of the asset.

Illustration 2
The business made a purchase of machinery costing ₱100,0000 on March 30, 2016. The machinery is
expected to last 3 years with a residual value of ₱10,000.

The depreciation expense and book value of the machinery shall be as follows from 2016 through 2019:

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As of December of Year 2016 2017 2018 2019

Depreciation expense ₱ 22,5002 ₱ 30,0001 ₱ 30,0001 **₱ 7,5003
Accumulated depreciation 22,5004 52,5005 82,500 90,000
(previous year balance, add
depreciation expense for the year)
Book value 77,500- 47,500- 17,500- 10,0006
Note:
1. Annual depreciation = [(₱100,000 – ₱10,000) / 3 years] = ₱30,000
2. ₱ 30,000 x 9 mos./12 mos. = ₱ 22,500
3. ₱ 30,000 x 3 mos./12 mos. = ₱7,500
4. ₱ 0 + ₱ 22,500=₱ 22,500
5. ₱ 22,500 + ₱ 30,000=₱ 52,500
6. Note book value at end of service life equals the salvage value.

Alternatively, the straight line depreciation can be computed by getting the straight-line rate, computed
as follows:

1
Straight line rate =
Useful life

This is 1/3 or 33.33%.

The periodic annual depreciation can be computed as depreciable cost x depreciation rate. Hence, ₱90,000
x 33.33% = ₱30,000/year.

It should be noted that once depreciation is commenced, it will be continued even if the asset is not
actively used because depreciation does not occur only through usage but also through passage of time
due to obsolescence.

Observe that the straight line method provides equal depreciation expense over the service life of the
asset. The straight line method simply presumes that the asset has uniform service utility throughout its
life.

Production output or work-hours method

The provision depreciation expense is variable depending on the output produced over expected output
of the asset or work-hours used over the expected work-hours usage of the asset. The depreciable cost is
simply presumed exhausted over the service life in hours or output.

Illustration
On July 1, 2016, the business purchased a machinery for ₱1,000,0000. The machinery is expected to be
sold for ₱200,000 after 1,000,000 service hours. The machinery was used 52,000 hours during 2016.

The depreciation expense for 2016 shall be computed as:

(₱1,000,000 – ₱200,000)
Depreciation expense = x 52,000 hours
1,000,000 hours

Depreciation expense = ₱ 41,600

This is the amount of depreciation expense without regard to the actual number of months the property
is used during the period.

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The adjusting entry at December 31, 2016 shall be:

Date Account Debit Credit

Dec. 31, 2016 Depreciation expense ₱ 41,600
Accumulated Depreciation ₱ 41,600

Sum of the Year’s Digit (SYD) Method

The sum of the year’s digit method provide for a declining depreciation as the asset gets older.

The annual depreciation is computed as a factor of the remaining life over the sum of all the digits
throughout the useful life.

Illustration
On the January 1, 2016, the business purchased an equipment with a cost of ₱100,000 and expects a
₱25,000 salvage value after its 5-year useful life. The business uses the sum-of-the-year’s digit method.

The depreciable cost of an asset with a five year useful life shall be depreciated based on the following
factor:

Year 1 Year 2 Year 3 Year 4 Year 5

5/15 4/15 3/15 2/15 1/15

The denominator is arrived at by adding all the digits in the useful life of the asset (i.e. 5 + 4 +3 +2 +1).
This mathematical series can be conveniently computed by the formula:

Sum of year’s digit = Life in years x (Life in years +1)

2
Thus, [5 x (5 + 1)/2] = 15.

The depreciation expense throughout the useful life of the equipment shall be:

Year Computation Depreciation Accumulated Book

expense depreciation value
Year 1 5/15 x (₱100,000 – ₱25,000) ₱ 25,000 ₱ 25,000 ₱ 75,000
Year 2 4/15 x (₱100,000 – ₱25,000) 20,000 45,000 55,000
Year 3 3/15 x (₱100,000 – ₱25,000) 15,000 60,000 40,000
Year 4 2/15 x (₱100,000 – ₱25,000) 10,000 70,000 30,000
Year 5 1/15 x (₱100,000 – ₱25,000) 5,000 75,000 25,000
Total depreciable cost ₱ 75,000

These are the amounts of depreciation expense that will be recorded by adjusting entries at the end of
each year.

Declining balance method

Similar to the SYD, the declining balance method provides for a declining depreciation expense
throughout the useful life of the asset. The difference with the SYD is that it initially ignores salvage value.
The salvage value is simply considered near the end of the useful life of the asset. The depreciation
expense in the terminal years is adjusted to ensure that the remaining book value equals the salvage value
of the property.

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Examples of the declining balance method:

1. Double declining balance method – provides a periodic depreciation expense equivalent to double the
straight line rate
2. 150% declining balance method – provides a periodic depreciation expense equivalent to 150% of
the straight line rate

Illustration
The business purchased an equipment costing ₱100,000 on January 1, 2016. It is expected to last for five
years after which it is expected to be sold at a scrap of ₱10,000. The business uses the double declining
balance method in depreciating the equipment.

The straight line rate is 1/5 or 20%. The double declining rate shall be 2 x 20% = 40%.

The cost of the equipment shall be depreciated as follows:

Depreciation Accumulated Book

expense depreciation value
Year 1 ₱100,000 x 40% ₱ 40,000 ₱ 40,000 ₱ 60,000
Year 2 ₱ 60,000 x 40% 24,000 64,000 36,000
Year 3 ₱ 36,000 x 40% 14,400 78,400 21,600
Year 4 ₱ 21,600 x 40% 8,640 87,040 12,960
Year 5 ₱ 12,960 – ₱10,000 salvage value* 2,960 90,000 10,000
Total depreciable cost ₱ 90,000
Note:
1. Note that the declining rate is imposed on the cost less accumulated depreciation without initially considering
the residual value. The residual value is merely considered at end of the life of the equipment.
2. This is merely an adjustment to ensure that the remaining book value is the residual value.*

Assuming that a 150% declining rate is used, the declining rate shall be 150% x 20% = 30%. In this case,
30% would be constantly multiplied to the declining book value following the same method as applied
above.

The sum of the year’s digit method and the declining balance method is premised on the assumption that
assets are more productive in their initial years compared to their terminal years and hence a larger
portion of their cost must be accordingly expensed during their early service years.

CORRECTING ENTRY
A correcting entry is an entry made to correct an accounting error in recording.

Illustration
A collection of ₱10,000 cash for payment of receivable was recorded as ₱100,000.

Entry made:
Date Account Debit Credit
Cash ₱ 100,000
Accounts receivables ₱100,000

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Correcting Entry:
Date Account Debit Credit
Accounts receivables ₱ 90,000
Cash ₱ 90,000
To correct the improper recording of ₱10,000 collection as ₱100,000

Look at the effect of the adjustment on the misstated cash and receivable accounts:

Cash
Wrong debit ₱ 100,000 Correction credit
₱ 90,000 entry
Correct debit entry ₱ 10,000

Accounts receivables
Correction debit entry ₱ 100,000 Wrong credit entry
₱ 90,000
₱ 10,000 Correct credit entry

The offsetting effect of the wrong entry and the correcting entry will bring back the correct and should be
entry as follows:

Date Account Debit Credit

Cash ₱ 10,000
Accounts receivables ₱ 10,000

This is the art of basic error correction – a skill required in auditing.

Are adjusting entries the same as correcting entries?

No, as previously discussed adjusting entries are required every reporting period so that the financial
statements of the company shall reflect the balances of accounts on accrual method of accounting.
Adjusting entries always involve a statement of financial position or real accounts, and an income
statement or nominal account.

A correcting entry is necessary only if an error is discovered in an account. Correcting entries may include
any combination of income statement or nominal accounts and statement of financial position or real
accounts.

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CHAPTER 10: REVIEW QUESTIONS – THEORETICAL AND COMPUTATIONAL

PROBLEM 10-1 True or False (Basic of Adjusting entries)

On the space provided, indicate whether the following statement is “True” or “False”.
_______1. Adjusting journal entry is needed because the journalizing aspect of accounting normally
captures transactions that have observable change on the elements of the financial
statements. This phase cannot usually capture the impact of silent or gradual changes on the
elements of the financial statements.
_______2. Adjusting entries are entries at the beginning of the next accounting period to properly adjust
on accrual basis, revenues and expenses.
_______3. Adjusting entries are usually composed of one nominal account and one real account.
_______4. Adjusting entries are the same as correcting entries.

PROBLEM 10-2 True or False Accrual of Income and Expense

On the space provided, indicate whether the following statement is “True” or “False”.
_______1. Adjusting entry to record accrued revenue will require debit to income and credit to liability.
_______2. Accrued interest income account is an expense account.
_______3. Adjusting entry to record accrued expense will require a debit to expense and credit to
liability.
_______4. Accrued interest expense account is an expense account.

PROBLEM 10-3 Accrual of Income

On July 1, 2016, Abelleda Company received a 330-day note from a customer amounting to ₱800,000, 10%
interest. Prepare the adjusting entry on December 31, 2016.

PROBLEM 10-4 Accrual of Income

Baglan Company rented out office equipment to a lessee. On December 31, 2016, the unrecorded rent
income earned was ₱15,000. Prepare the adjusting entry on December 31, 2016.

PROBLEM 10-5 Accrual of Expense

On August 1, 2016, Caricativo Company issued a 180-day note to a supplier amounting to ₱600,000, 15%
interest. Prepare the adjusting entry on December 31, 2016.

PROBLEM 10-6 Accrual of expense

On December 31, 2016, Acosta Company has unpaid and unrecorded salaries of ₱25,000. Prepare the
adjusting entry on December 31, 2016.

PROBLEM 10-7 True or False Prepayments- expense and Asset method

On the space provided, indicate whether the following statement is “True” or “False”.
_______1. The company is using “expense method” if the account appearing on the unadjusted trial
balance relating to prepayment is an expense account.
_______2. The adjusting entry to record prepayments under the expense method will require a debit to
expense and credit to an asset account.
_______3. The company is using “asset method” if the account appearing on the unadjusted trial balance
relating to prepayment is an asset account.

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_______4. The adjusting entry to record prepayments under the asset method will require a debit to
expense and credit to an asset account.

PROBLEM 10-8-Deferral of expense or prepayments-Asset and Expense method

On August 1, 2016, Apasao Company purchased a two-year insurance policy for ₱28,800. Give the
adjusting entries assuming the company uses:
a. Asset method
b. Expense method

PROBLEM 10-9 Usage of supplies-Asset and Expense method

On April 1, 2016, Arabia Company purchased a total of ₱20,000 for various office supplies. On December
31, 2016, supplies worth P8,000 still remained unused. There were ₱12,000 unused supplies on
December 31, 2015.

Required: Prepare the adjusting entries assuming the company uses:

a. Asset method
b. Expense method

PROBLEM 10-10 True or False –Deferral of Revenue or Precollection-Liability and Income method
On the space provided, indicate whether the following statement is “True” or “False”.
_______1. The company is using “liability method” if the account appearing on the unadjusted trial
balance relating to precollection is an income account.
_______2. The adjusting entry to record precollection under the liability method will require a debit to
income and credit to liability account.
_______3. The company is using “Income method” if the account appearing on the unadjusted trial
balance relating to precollection is a liability account.
_______4. The adjusting entry to record precollection under the income method will require a debit to
liability and credit to an income account.

PROBLEM 10-11 Deferral of revenue or precollection-Liability and Revenue Method

Balanag Company is engaged in constructing and renting out office space to various businesses. On
February 28, 2016, one tenant gave ₱96,000 cash for three-years’ rent.

Required: Give the adjusting entries assuming the company uses:

a. Liability method
b. Revenue method

PROBLEM 10-12 True or False Bad debts

On the space provided, indicate whether the following statement is “True” or “False”.
_______1. Adjusting entry to record bad debts expense is debit expense and credit a contra-asset
account.
_______2. Allowance for bad debts account is an expense account.
_______3. Under the direct write-off method, writing off of accounts receivable will decrease the bad
debts expense and accounts receivable.
_______4. Under the allowance method, writing off of accounts receivable will decrease the allowance
for bad debts and accounts receivable.

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_______5. Under the allowance method, recovery of accounts that were previously written off will
increase the net income.

PROBLEM 10-13 Bad debts-Based on Accounts receivable

The company estimates that 5% of the Accounts receivable will be uncollectible. The total credit sales for
the year were ₱2,000,000, accounts receivable was ₱400,000. The company wrote off ₱10,000 accounts
which was deemed to be worthless and the allowance for bad debts beginning of the year was ₱5,000.

Required:
1. Under the direct write-off method, prepare the journal entry to recognize the bad debts expense.
2. Under the allowance method, prepare the adjusting entry as of the end of the year.
3. Under the allowance method, compute for the net realizable value as of the end of the year.

PROBLEM 10-14 True or False – Depreciation

On the space provided, indicate whether the following statement is “True” or “False”.
_______1. Depreciation is the systematic allocation of a depreciable cost of an asset over its useful life.
_______2. The adjusting entry to record depreciation will require a debit to depreciation expense and
credit to allowance for bad debts.
_______3. One of the reasons for depreciation is the passage of time the asset is being used.
_______4. Land, as a rule, is not depreciated.
_______5. An item of property, plant and equipment should be depreciated when it is available for use.

PROBLEM 10-15 Depreciation-Straight-line method of Depreciation

X Co acquires a building on January 1, 2016 at a cost of ₱5,000,000. The building has an estimated useful
life of 40 years and an estimated salvage value of ₱1,000,000.

Required:
1. Prepare the adjusting entry on December 31, 2016.
2. Compute for the net book value as of December 31, 2016.

PROBLEM 10-16 Depreciation-Straight-line method of Depreciation

Aileen Gacad Co acquired a machine on July 1, 2016 at a cost of ₱440,000. The machine has an estimated
salvage value of ₱40,000 and is being depreciated using straight-line method at a rate of 20%.

Required:
1. Prepare the adjusting entry on December 31, 2016.
2. Compute for the net book value as of December 31, 2016.

PROBLEM 10-17 Different Depreciation Methods

Danny Baldovino Co. purchased machinery on January 1, 2016. The following information regarding this
asset and its acquisition is available:

Cost ₱ 3,300,000
Residual value ₱ 300,000
Estimated useful life 5 years

Required:

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Prepare the depreciation table for 2 years under the following methods:
1. Straight-line method.
2. Straight-line method and assume that the date of acquisition is April 1, 2016.
3. Sum of the years’ digits
4. Sum of the years’ digits and assume that the date of acquisition is April 1, 2016.

PROBLEM 10-18 Correcting Entries

1. ABC Company acquired a building on January 1, 2016 at a cost of ₱4,000,000. The building has an
estimated useful life of 40 years and an estimated salvage value of ₱500,000. The following entry
was recorded by the company on December 31, 2016:

Depreciation expense ₱100,000

Accumulated depreciation ₱100,000

2. ABC Company is engaged in constructing and renting out of office space to various businesses. On
September 1, 2016, one tenant gave ₱240,000 cash for six month’s rent. The company used the
liability method in recording. The following entry was recorded by the company on December 31,
2016:
Unearned rent income ₱110,000
Rent income ₱110,000

Required:
Prepare the entries to correct the above items.

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