COLLEGE OF BUSINESS AND ACCOUNTANCY

Topic: Business Transaction and their Analysis Part 2

Learning Outcomes:
• Differentiate Accrual and Cash Accounting.
• Discuss the concept of Accrual Accounting and analyze how it improves the financial statements.
• Discuss the different concepts relating to adjustments.
• Identify and analyze the types of adjustments and their purposes.
• Illustrate how accounting adjustments link to the financial statement.
• Discuss the alternative methods of initial recording of income and expenses

Core Value/Biblical Principles:

Psalm 32:8
I will instruct you and teach you in the way you should go;
I will counsel you with my loving eye on you.

Learning Activities and Resources:

Most of us think in terms of cash. Did our bank balance go up or down? This is in essence what the cash basis
measures—changes in the cash balance. But consider your job (if you already have one) or the job of your
parents. When do you/they earn your/their salary— when you/they go to work or when you/they get paid?
When you/they go to work, you/they earn. That is when you/they accrue revenue under the accrual basis—
not when you/they get paid by your/their employer.

Introduction:
When you make an adjusting entry, you’re making sure the activities of your business are recorded accurately
in time. If you don’t make adjusting entries, your books will show you paying for expenses before they’re
actually incurred or collecting unearned revenue before you can actually use the money. We can infer how
important the time is. It is vital to make the adjusting entries on time, otherwise it will be useless.

Body:

ACCRUAL VS. CASH BASIS ACCOUNTING

There are two ways to do accounting:

Accrual accounting records the effect of each transaction as it occurs—that is, revenues are recorded when
earned and expenses are recorded when incurred.

The financial statements, except for the cash flow statement, are prepared on the accrual basis of accounting in
order to meet their objectives. Under the accrual basis, the effects of transactions and other events are
recognized when they occur and not as cash is received or paid. This means that the accountant records
revenues as they are earned and expenses as they are incurred. The timing of cash flows is relatively immaterial
for determining when to recognize revenues and expenses.

Financial statements prepared on the accrual basis inform users not only of past transactions involving the
payment and receipt of cash, but also of obligations to pay cash in the future, and of resources that represent
cash to be received in the future. Generally accepted accounting principles require that a business use the
accrual basis.

Cash-basis accounting records only cash receipts and cash payments. It ignores receivables, payables, and
depreciation. Only very small businesses use the cash basis of accounting.
ILLUSTRATION NO. 1

Mr. Bakasyonista paid the Sunset Beach Resort and Hotel in Siargao P7,000 on April 8, 2021 for a one-day super
deluxe accommodation on May 13, 2021.

Under accrual accounting, the receipt of P7,000 will be considered as revenues once they already rendered its
services on May 13.

In contrast, if cash basis is used, the hotel will recognize the revenue on April 8.

Expenses related to this revenue transaction will be incurred on May 13. Suppose a financial report is prepared at
the end of April, under accrual no revenue or expense will be reported; Under cash basis, revenues of will be
reported but the expenses will be recognized when incurred on May 13. Observe that the accrual basis provided a
better measure of the results of transactions.

PERIODICITY CONCEPT

Accounting information is valued when it is communicated early enough to be used for economic decision-
making. To provide timely information, accountants have divided the economic life of a business into artificial
time periods. This assumption is referred to as the periodicity concept.

Accounting periods are generally a month, a quarter or a year. The most basic accounting period is one year.
Entities differ in their choice of the accounting year— fiscal, calendar or natural. A fiscal year is a period of any
twelve consecutive months. A calendar year is an annual period ending on December 31. A natural business
year is a twelve-month period that ends when business activities are at their lowest level of the annual cycle.
A period of less than a year is an interim period. Some even adopt an annual reporting period of 52 weeks.

RECOGNITION AND DERECOGNITION

Per 2018 Conceptual Framework, recognition is the process of capturing for inclusion in the statement of
financial position or the statement(s) of financial performance an item that meets the definition of an asset, a
liability, equity, income or expenses. The amount at which an asset, a liability or equity is recognized in the
statement of financial position is referred to as its "carrying amount".

Recognition links the elements, the statement of financial position and the statement(s) of financial
performance. The statements are linked because the recognition of one item (or a change in its carrying
amount) requires the recognition or derecognition of one or more other items (or changes in the carrying
amount of one or more other items). For example:

(a) The recognition of income occurs at the same time as:

(i) the initial recognition of an asset, or an increase in the carrying amount of an asset; or
(ii) the derecognition of a liability, or a decrease in the carrying amount of a liability.

(b) the recognition of expenses occurs at the same time as:

(i) the initial recognition of a liability, or an increase in the carrying amount o! a liability;
or
(ii) the derecognition of an asset, or a decrease in the carrying amount of an asset.
Derecognition is the removal of all or part of a recognized asset or liability from an entity's statement of
financial position. Derecognition normally occurs when that item no longer meets the definition of an asset or
of a liability:

(a) for an asset, derecognition normally occurs when the entity loses control of all or part of the recognized
asset; and
(b) for a liability, derecognition normally occurs when the entity no longer has a present obligation for all
or part of the recognized liability.

THE NEED FOR ADJUSTMENTS

Accountants make adjusting entries to reflect in the accounts information on economic activities that have
occurred but have not yet been recorded. Adjusting entries assign revenues to the period in which they are
earned, and expenses to the period in which they are incurred. These entries are needed to measure properly
the profit for the period, and to bring related asset and liability accounts to correct balances for the financial
statements.

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. Without adjusting entries, financial
statements may not fairly show the solvency of the entity in the balance sheet and the profitability in the income
statement.

RECOGNITION OF ACCRUALS AND DEFERRALS

Under the concept of matching principle cost should be recorded in the same accounting period as revenue
related to that cost. Each adjusting entry affects a balance sheet account (an asset or a liability account) and an
income statement account (income or expense account.

ACCRUAL is the recognition of "an expense already incurred but unpaid", or “Revenue earned but uncollected".

This adjustment deals with an amount unrecorded in any account; the entry, in effect, increases both a balance
sheet and an income statement account.

Accruing expenses to reflect expenses incurred during the accounting period that are unpaid and unrecorded.

Accrued Salaries. Entities pay their employees at regular intervals. It can be weekly, semi-monthly or monthly.
Weekly payrolls are usually made on Fridays (for five-day workweek) or Saturdays (for a six-day workweek).
Weddings "R" Us pays salaries every two Saturdays. Assume that the calendar for May appears as follows:
MAY
Su M T W Th F Sa
1 2 3 4 5 6
7 8 9 10 11 12 13
14 15 16 17 18 19 20
21 22 23 24 25 26 27
28 29 30 31

The office assistant and the account executive were paid salaries on May 13 and 27. At month-end, the
employees have worked for three days (May 29, 30 and 31) beyond the last pay period.

Each of the employee's salary rate is P7,800 per month or P300 per day (P7,800/26 working days). The expense
to be accrued is PI,800 (P300 x 3 days x 2 employees).

Salaries Expense (OE: E) 1,800

Salaries Payable (L) 1,800
Accrued Interest. On May 2, Perez-Manalo borrowed P210,000 from Metrobank. She issued a promissory note
that carried a 20% interest per annum. Both the interest and principal will be payable in one year. The note
issued to the bank accrues interest at 20% annually. At the end Of May, Perez-Manalo owed the bank P3,500
(see computation below) for interest in addition to the P210,000 loan. Interest is a charge for the use of money
over time. Interest expense is matched to a particular period during which the benefit—the use of borrowed
money—is received. The interest is a fixed obligation and accrues regardless of the results of the entity's
operations.

Interest rates are expressed at annual rates, so if interest is being calculated for less than a year, the calculation
must express time as a portion of a year. Thus, the interest expense (simple) incurred on this note during the month
is determined by the following formula:

Interest = Principal x Interest Rate x Length of Time

= P210,000 x 20% x 1/12 of a year
= P210,000 x .20 x 1/12
= P3,500

Interest Expense (OE: E) 3,500

Interest Payable (L) 3,500

Accruing revenues to reflect revenues earned during the accounting period that are uncollected and
unrecorded.

Accrued Consulting Revenues. Suppose 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.

Accounts Receivable (A) 5,300

Consulting Revenues (OE: l) 5,300

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".

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.

Allocating assets to expense to reflect expenses incurred during the accounting period.

Prepaid Rent. On May 1, Weddings "R" Us paid P8,000 for two months' rent in advance. This expenditure
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-half of the asset had expired, and should be treated as an
expense. The analysis of this economic event is shown below:

Rent Expense (OE: E) 4,000

Prepaid Rent (A) 4,000

Prepaid Insurance. Weddings "R" Us acquired a one-year comprehensive insurance coverage on the service
vehicle and paid P14,400 premiums. In a manner similar to prepaid rent, prepaid insurance offers protection
that expires daily.

Insurance Expense (OE: E) 1,200

Prepaid Insurance (A) 1,200
Supplies. On May 8, Weddings the "R" process Us purchased of performing supplies, services P 18,000 for
During the month, the entity used supplies in clients. There is no need to account for these supplies every day
since the financial statements will not be prepared until the end of the month. At the end of the accounting
period, Perez-Manalo makes a careful physical inventory of the supplies. The inventory of the supplies. The
inventory count showed that supplies costing P15,000 are still on hand.

Supplies Expense (OE: E) 3,000

Supplies (A) 3,000

Allocating revenues received in advance to revenue to reflect revenues earned during the accounting period.

Unearned Referral Revenues . On May 15, Weddings "R" Us received P10,00 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.

Unearned Referral Revenues (L) P4,000

Referral Revenues (OE: I) 4,000

RECOGNITION OF DEPRECIATION EXPENSE

Under the concept of systematic and rational allocation, costs that provide economic benefits over several
accounting periods but cannot be directly associated with the earning of revenues are recognized as expenses
over the periods where the economic benefits are consumed.

Service Vehicle and Office Equipment. Suppose that Weddings "R" Us estimated that the service vehicle,
which was bought on May 4, will last for seven years (eighty-four months) and with a salvage value of P84,000.
The office equipment that was acquired on May 5 will have a useful life of five years (sixty months) and will be
worthless at that time. Substitution of the pertinent amounts into the basic formula will yield depreciation for
service vehicle and office equipment for the month as P4,000 [(P420,000-84,000)/84 months] and P1,000
(P60,000/60 months), respectively. These amounts represent the cost allocated to the month, thus reducing
the asset accounts and increasing the expense accounts.

Depreciation Expense-Service Vehicle (OE: E) 4,000

Accumulated Depreciation-Serv. Vehicle (A) 4,000

Depreciation Expense-Office Equipt. (OE: E) 1,000

Accumulated Depreciation-Off. Equipt. (A) 1,000

RECOGNITION OF BAD DEBT EXPENSE

Under the concept of immediate recognition, a cost that produces no future economic benefits or an asset
that ceases to provide future economic benefits is recognized immediately as an expense.

One application of this concept is the recognition of bad debts expense. In the case above, the P500 account
receivable is immediately charged as bad debt expense because it ceased to provide future economic benefits,
i.e ., it became uncollectible.
Bad Debt Expense. Assume that an entity made credit sales of in 2022 and prior experience indicates an
expected 1% average uncollectible accounts rate based on credit sales. The contra account—Allowance for
Uncollectible Accounts has a normal credit balance and is shown in the balance sheet as a deduction from
Accounts Receivable. The allowance account needs to be increased by P11,000 (P1,100,000 x 1%) because
accounts receivable in that amount is doubtful of collection.

Uncollectible Accounts Expense (OE: E) 11,000

Allowance for Uncollectible Accounts (A) 11,000

Throughout the accounting period, when there is positive evidence that a specific account is definitely
uncollectible, the appropriate amount is written off against the contra account. For example, if a P1,500
receivable was considered uncollectible, that amount would be written off as follows:

Allowance for Uncollectible Accounts (A) 1,500

Accounts Receivable (A) 1,500

No entry is made to Uncollectible Accounts Expense, since the adjusting entry has already provided for an
estimated expense based on previous experience for all receivables.

ACCOUNTS ARE CLASSIFIED INTO ONE OF THE FOLLOWING:

1. REAL ACCOUNTS. Are accounts which are not closed at the end of the accounting period. These
accounts include all the balance sheet accounts, except the owner’s drawings account.

2. NOMINAL ACCOUNT. Accounts which are closed at the end of the accounting period. These accounts
include all income statement accounts, drawings account, clearing accounts and suspense accounts.

3. MIXED ACCOUNTS. Accounts have both real and nominal account components. These accounts are
subject to adjustments.

METHODS OF INITIAL RECORDING OF INCOME AND EXPENSES

INCOME

1. LIABILITY METHOD – under this method, cash receipts from items of income are initially credited
to a liability account. At the end of the period, the earned portion is recognized as income while the
unearned portion remains as liability.

2. INCOME METHOD – under this method cash receipts from items of income are initially credited to
an income account. At the end of the period, the unearned portion is recognized as liability while the
earned portion remains as income.
ILLUSTRATION NO. 2
A business rents out its building to various tenants. On July 1, 2022, the business receives one-year rent in
advance of P120, 000 from one of the tenants. Rent per month is P10,000.

LIABILITY METHOD INCOME METHOD

July 1, 2022 July 1, 2022

Cash 120,000 Cash 120,000
Unearned Rent 120,000 Rent Income 120,000
to record the receipt of 1-year rent in advance to record the receipt of 1-year rent in advance

Earned Portion (Used-up portion) - Pertains to the first six months of the 1-year rent in advance covering
the months of July 1 to December 31, 2022.

Unearned portion (Unused) - Pertains to the remaining months of January 1 to June 30, 2022. The unearned
portion is recognized as liability as of December 31, 2022.

LIABILITY METHOD INCOME METHOD

December 31, 2022 December 31, 2022

Unearned Rent 60,000 Rent Income 60,000
Rent Income 60,000 Unearned Rent 60,000
to recognize the earned portion of the 1-year rent to recognize the earned portion of the 1-year rent in
in advance advance

EXPENSES

1. ASSET METHOD – under this method cash disbursements for items of expenses are initially debited
to an asset account. At the end of the period, the incurred portion (‘used up’ or ‘expired’) is
recognized as expense while the unused portion remains as asset.

2. EXPENSE METHOD – under this method, cash disbursements for items of expenses are initially
debited to an expense account. At the end of the period, the unused portion (‘not yet incurred’ or
‘unexpired’) is recognized as asset while the incurred portion remains as expense.

ILLUSTRATION NO. 3
A business repays one-year insurance for P120,000 on October 1, 2022. The prepayment of insurance is
recorded as follows:

ASSET METHOD EXPENSE METHOD

Oct. 1, 2022 Oct. 1, 2022

Prepaid Insurance 120,000 Insurance Expense 120,000
Cash 120,000 Cash 120,000
to record the prepayment of 1-year insurance to record the prepayment of 1-year insurance

Earned Portion (Used-up portion) - Pertains to the first three months of the 1-year prepaid insurance
covering the months of Oct. 1 to December 31, 2022.

Unearned portion (Unused) - Pertains to the remaining months of January 1 to September 30, 2022. The
not yet incurred portion is recognized as asset as of December 31, 2022.
 ASSET METHOD EXPENSE METHOD

December 31, 2022 December 31, 2022

Insurance Expense 3 0,000 Prepaid Insurance 30,000
Prepaid Insurance 30,000 Insurance Expense 30,000
to recognize the expired portion of the 1-year to recognize the unexpired portion of the 1-year
insurance insurance

PROBLEM 2: FOR CLASSROOM DISCUSSION

Accruals, depreciation, and bad debts

Provide the adjusting entries on December 31, 20x1
1. Entity A entered a 1-year contract for a billboard advertising on August 1, 20x1. The monthly rent for
the billboard is P200,000, payable at the start of each month. Entity A has paid the rentals for the
months of August to November 20x1.

2. Entity A received a 10%, P180,000, one-year, note receivable from a customer on October 31, 20x1.
Both the principal and interest on the note are due on November 1, 20x2.

3. Entity A acquired a machine on November 30, 20?1 for P420,000. The machine has an estimated useful
life of 8 years.

4. Entity A has total accounts receivable of P890,000 as of December 31, 20x1. Of that amount, P45,000
were doubtful of collection.

Splitting of mixed accounts

5. On May 1, 20x1, Entity B received one-year advanced rent P480,000 from one of its tenants. The
advanced months of May 1, 20x1 to April 30, 20x2.

a. Provide the journal entry to record the collection 1, 20x1 under each of the following methods:
i. Liability method

ii. Income method

b. Provide the adjusting entries on December 31, 20x1 under each of the methods listed above.
i. Liability method

ii. Income method

6. On August 1, 20x1, Entity C paid one-year insurance of P360,000.
a. Provide the journal entry to record the prepayment on August 1, 20?1 under each of the following
methods:
i. Asset method

ii. Expense method

b. Provide the adjusting entries on December 31, 20x1 under each of the methods listed above.
i. Asset method

ii. Expense method

Life Application:

A business needs to record the true and fair values of its expenses, revenues, assets, and liabilities. Adjusting
entries follows the accrual principle of accounting and make necessary adjustments which are not recorded
during the previous accounting year. The adjusting journal entry generally takes place on the last day of the
accounting year and majorly adjusts revenues and expenses.

Adjusting Entries are made after trial balances but before the preparation of annual financial statements. Thus,
these entries are very important towards the representation of accurate financial health of the company.

Summary:

• Adjusting entries are entries made prior to the preparation of financial statements to update certain
accounts so that they reflect correct balances as of the designated time.
• Purpose of adjusting entries
1. To take up unrecorded income and expense of the period.
2. To split mixed accounts into their real and nominal elements.
• Adjusting entries normally involve the following: (1) Accruals of income and expenses; (2) Recognition
of depreciation expense and bad debts expense; and (3) Deferrals of income and expenses (splitting of
'mixed accounts').
• The three expense recognition principles are (1) Matching; (2) Systematic & rational allocation; and
(3) Immediate recognition. Accounts are also classified into the following: (1) Real accounts; (2)
Nominal accounts; and (3) Mixed accounts.
• Advanced collections of income are recorded using either the (1) Liability method or (2) Income
method.
• Prepayments of expenses are recorded using either the (1) Asset method or (2) Expense method.

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References:
Financial Accounting and Reporting (fundamentals) [by: Millan, Zeus Vernon B. (2021)]
Basic Financial Accounting and Reporting: Domdane Publishers and Made Easy [Ballada, Win. (2019)]