Fundamentals of Accounting, Business, and

Management

Chapter 9

Accounting Cycle of a Service

Business
Chapter 9
Accounting Cycle of a Service Business
Introduction

Transactions and events are the starting points in the accounting cycle. By relaying on source
documents, transactions and events can be analyzed as to how they will affect performance and financial
positions. It can identify and describe transactions and events entering the accounting process. The
original written evidence contain information about the nature and the amounts of transactions.

Specific Objectives

At the end of the lesson, the students should be able to:

1. Describe the nature of transactions in a service business.

2. Record transactions of a service business in the general journal.
3. Post transactions in the ledger.
4. Prepare a trial balance.
5. Prepare adjusting entries.
6. Complete the account cycle.

Duration

Chapter 9: Accounting Cycle of a Service Business [3 Hours]

DISCUSSION

Accounting Cycle
The accounting cycle refers to a series of sequential steps or procedures performed to
accomplish the accounting process. The steps in the cycle and their aims follow:

Step 1 Identification of events to be recorded. (Identifying and analyzing)

Step 2 Transaction are recorded in the journal. (Journalizing)
Step 3 Journal entries are posted to the ledger. (Posting)
Step 4 Preparation of trial balance. (Unadjusted trial balance)
Step 5 Adjusting entries
Step 6 Adjusted trial balance (and/or worksheet)
Step 7 Financial Statements
Step 8 Closing journal entries are journalized and posted.
Step 9 Post-closing trial balance
Step 9 Reversing journal entries are journalized and posted.

In this Chapter, we will discuss the accounting cycle as applied by a service business is
one that offers services as its main product rather than physical goods.

This cycle is repeated each accounting period. The first three steps in the accounting
cycle are accomplished during the period. The fourth to the ninth steps generally occur at the end
of the period. The last step is optional and occurs at the beginning of the next period.

Posting
Posting, the third step in the accounting cycle, is the process of transferring data from the
journal to the appropriate accounts in the ledger. More specifically, posting is done by
transferring the amounts of debits and credits in a recorded journal entry to the ledger accounts.

Illustration 1: Posting
A business had the following transactions during the second week of January.
Date Transactions
Jan.8 Services worth P30,000 were rendered for cash.

Jan.9 Services worth P50,000 were rendered on account.

Jan.10 Cash amounting to P5,000 was disbursed for supplies expense.

Jan.11 Accounts receivable of P40,000 was collected

The transactions are recorded in the journal as follows:

JOURNAL
Date Account titles Debit Credit
2019
Jan.8 Cash 30,000
Service fees 30,000
to record service fees in cash
Jan. 9 Accounts receivable 50,000
Service fees 50,000
to record service fees on account
Jan.10 Supplies expense 5,000
Cash 5,000
to record cash disbursement for
Supplies expense
 Jan.11 Cash 40,000
Accounts receivable 40,000
to record the collection of accounts
Receivable

1. The Jan.8 transactions is posted as follows:

FROM:
JOURNAL
Date Account titles Debit Credit
2019
Jan.8 Cash 30,000
Service fees 30,000
to record service fees in cash

TO:
GENERAL LEDGER

Cash Service fees

Date Dr Cr Dr Cr Date
Beg.Bal. 40,000
Jan.8 30,000 30,000 Jan.8

2. The Jan. 9 transaction is posted as follows

FROM:
JOURNAL
Date Account titles Debit Credit
2019
Jan. 9 Accounts receivable 50,000
Service fees 50,000
to record service fees on account

TO:
GENERAL LEDGER

Accounts receivable Service fees

Date Dr Cr Dr Cr Date
Jan.9 50,000 30,000 Jan.8
50,000 Jan.9
 3. The Jan.10 transaction is posted as follows:
FROM:
JOURNAL
Date Account titles Debit Credit
2019
Jan.10 Supplies expense 5,000
Cash 5,000
to record cash disbursement for
Supplies expense

TO:
GENERAL LEDGER

Supplies expense Cash

Date Dr Cr Dr Cr Date
Jan.10 5,000 Beg.Bal 40,000
Jan.8 30,000 5,000 Jan.10

4. The Jan.11 transaction is posted as follows:

FROM:
JOURNAL
Date Account titles Debit Credit
2019
Jan.11 Cash 40,000
Accounts receivable 40,000
to record the collection of accounts
Receivable

TO:
GENERAL LEDGER

Cash Accounts receivable

Date Dr Cr Dr Cr Date
Beg.Bal 40,000 Jan.9 50,000
Jan. 8 30,000 40,000 Jan.11
5,000 Jan.10
Jan.11 40,000
The ending balances of the accounts are determined as follows:

GENERAL LEDGER

Accounts
Cash receivable
Date Dr Cr Dr Cr Date
Beg.Bal 40,000 Jan.9 50,000
Jan. 8 30,000 40,000 Jan.11
5,000 Jan.10
Jan.11 40,000
End.Bal
. 105,000 End.Bal. 10,000
INCOME EXPENSES
Dr Cr Dr Cr
30,000 Jan.8 Jan.10 5,000
50,000 Jan.9
80,000 End.Bal. End.Bal. 5,000

Preparation of a Trial Balance

A trial balance is a list of general ledger accounts and their balances. It is prepared to check the
equality of total debits and total credits in the ledger. The preparation of the trial balance creates
a starting point for the preparation of the financial statements.

Types of Trial Balance

a. Unadjusted trial balance – this is prepared before adjusting entries are made. Adjusting
entries, and consequently financial statements, cannot be prepared unless the total debits
and credits in the unadjusted trial balance are equal.

b. Adjusted trial balance – this is prepared after adjusting entries but before the financial
statements are prepared.

c. Post-closing trial balance – this is prepared after the closing process.

Errors revealed by a trial balance

The trial can reveal errors that caused the total debits and total credits to be unequal.
Examples:
1. Journalizing, or posting one-half of an entry, i.e., a debit without a credit, or vice versa.
2. Recording the part of an entry for a different amount than the other part.
3. Errors of Transplacement (slide error) on one side of an entry.
4. Error of Transposition on one side of an entry.

➢ Transplacement error is committed when the number of digits in an amount is incorrectly

increased or decreased, for example, a P1,000 amount is recorded as P100 or P10,000.
 ➢ Transposition error is committed when digits in an amount are interchanged, for
example, a P15,652 amount is recorded as P15,625 or P15,265.

Errors not revealed by a trial balance

The trial balance cannot reveal errors that do not cause the total debits and total credits to
be unequal. Examples:
1. Omitting entirely the entry for a transaction.
2. Journalizing or posting an entry twice.
3. Using wrong account with the same normal balance as the correct account.
4. Wrong computation with the same erroneous amount posted to debit and credit sides.

Illustration 1: Unadjusted Trial Balance Preparation

Mr. Tiger Astig started a laundry business called “Tiga Laba Laundry Shop” on January 1, 2019.
The following were the transactions during the first week of operations:
Jan. Transactions
1 Provided P500,000 cash as initial investment to the business.
2 Acquired washing machine for P200,000 cash.
3 Acquired dryer machine for P100,000 cash.
4 Purchased supplies for P20,000 cash.
5 Rendered laundry services worth P15,000 on cash basis.
6 Rendered laundry services worth P10,000 on account.
7 Paid P2,500 to an employee representing her week’s salary.

The journal entries for the above transactions are as follows:

Jan. 1 Cash 500,000
Astig, Capital 500,000
to record the owner's contribution
2 Equipment - Washing machine 200,000
Cash 200,000
to record the acquisition of
equipment
3 Equipment - Dryer 100,000
Cash 100,000
to record the acquisition of
equipment
4 Prepaid supplies 20,000
Cash 20,000
to record the purchase of supplies
5 Cash 15,000
Service fees 15,000
to record service fees in cash
6 Accounts receivable 10,000
Service fees 10,000
to record service fees on account
7 Salaries expense 2,500
 Cash 2,500
to record salaries expense

The journal entries are posted to the ledger as follows:

ASSETS
Cash Accounts receivable
Jan. 1 500,000 Jan. 6 10,000
200,000 Jan. 2
100,000 3
5 15,000 20,000 4
2,500 7
515,000 322,500 Bal. 10,000
Bal. 192,500
515,000 515,000

Equipment -Washing Equipment - Dryer

Jan. 2 200,000 Jan. 3 100,000
Bal. 200,000 Bal. 100,000

Prepaid supplies
Jan. 4 20,000
Bal. 20,000

EQUITY
Astig, Capital
500,000 Jan.1
500,000 Bal.

INCOME EXPENSES
Service fees Salaries expense
15,000 Jan. 5 Jan. 7 2,500
10,000 6
25,000 Bal. Bal. 2,500
The unadjusted trial balance is prepared as follows:
Tiga Laba Laundry Shop
Unadjusted Trial Balance
January 7, 2019

Accounts Debit Credit

Cash P 192,500
Accounts receivable 10,000
Prepaid supplies 20,000
Equipment- Washing 200,000
Equipment - Dryer 100,000
Astig, Capital P500,000
Service fees 25,000
Salaries expense 2,500
Totals P525,000 P525,000

Adjusting entries
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.

Our subsequent discussions n adjusting entries are subdivided into the following:
1. Accruals of income and expenses
2. Recognition of depreciation expense and bad debts expense
3. Deferrals of income and expenses (splitting of mixed accounts)

Illustration 1: Adjusting entries – Accruals of Income and expense

ABC Co. is preparing its financial statements for the period ended December 31, 2019. Adjustment are
needed for the following:

Case #1. Accrual of income – Interest income

ABC Co. received a 12%, P100,000, one-year, note receivable on interest on the note are due on April 1,
2019.

➢ Concepts:
a. Notes receivable give rise to interest income.
b. Interest income is earned due to passage of time.

➢ Given information:
a. ABC Co. uses a calendar year period. Therefore, the current accounting period ends on
December 31, 2019.
b. Interest on the note is collectible on April 1, 2019.
 ➢ Analysis:
As of December 31, 2019 (end of accounting period), interest income should have been earned
because there is already a passage of time (from April 1 to December 31, 2019) although interest
will only be collected in the next accounting period (i.e. April 1, 2020)

➢ Conclusion:
Interest income shall be accrued for the 9 months covering April 1 to December 31, 2019.

The interest income is accrued as follows:

Formula:
i=Prt
Where:
i = interest
P = principal
r = rate
t = time
• Principal (P) is the P100,000 face amount of the note.
• Rate ( r ) is the 12% interest rate
• Time ( t ) is the expired time of 9 months (i.e April 1 to December 31, 2019) over the total of 12
months in a year.

❖ Interest = (100,000 x 12% x 9/12) = 9,000

Step 1: Transaction analysis

➢ Accounts affected: “Interest receivable” (asset) and “Interest income” (income)

➢ Effect on accounts: Interest receivable is increased. Interest income is increased.

➢ Debit/Credit Asset is increased through debit. Income is increased through

credit.

Step 2: Adjusting journal entry (AJE)

The adjusting entry for the accrued interest income is as follows:
Dec. 31,
2019 Interest receivable 9,000
Interest income 9,000
to accrue interest income earned but
not yet collected

In the next accounting period, the collection of the interest is recorded as follows:
April 1,
2020 Cash 12,000
Interest receivable 9,000
Interest income 3,000
to record the collection of interest
 The cash collection pertains to the 1 year total interest covering the months of April 1,
2019 to March 31, 2020. This is computed as follows: i = Prt (100,000 x 12% x 12/12) = 12,000.

9- mos. Interest
Apr. 1 to Dec. 31, 2019
(100,000 x 12% x 9/12) =
1 year interest: 9,000 recognized in 2019
Apr.1, 2019 to Mar.31,
2020:
(100,000 x 12% x 12/12) = 3 mos. Interest
12,000 Jan.1 to Mar. 31, 2020:
(100,000 x 12% x 3/12) =
3,000 recognized in 2029

Case #2: Accrual of income – Rent income

ABC Co. rent out is building to a tenant for a monthly rent of P50,000. As of December 31, 2019, the
tenant has not yet paid the rent for the month of December.

➢ Concepts:
Income is recognized when earned rather than when collected – accrual basis of accounting

➢ Given information:
The tenant has already used the building in December but has not yet paid.

➢ Conclusion:
Rent income for the month of December shall be accrued on December 31, 2019.

Step 1: Transaction analysis

➢ Accounts affected: “Rent receivable” (asset) and “Rent income (income)
➢ Effect on accounts: Rent receivable is increased. Rent income is increased.

➢ Debit/Credit Asset is increased through debit. Income is increased through

credit.

Step 2: Adjusting journal entry (AJE)

The adjusting entry is as follows:
Dec. 31, 2019 Rent receivable 50,000
Rent income 50,000
to accrue rent income

When the rent is collected in the next accounting period, it will be recorded as follows:
 Dec. 31, 2019 Cash 50,000
Rent receivable 50,000
to record the collection of the Dec.2019
rent

Observe that rent income is recognized in 2019 when it was earned rather than in 2020
when it was collected.
Case #3: Accrual of expense – Interest expense
ABC Co. issued a 12% P100,000, one-year, note payable on October 1, 2019. The principal and
interest are due on October 1, 2020.

➢ Concepts:
a. Notes payable give rise to interest expense
b. Interest expense is incurred due to passage of time.

➢ Given information:
a. Interest on the note is payable on October 1, 2020 (i.e., in the next accounting
period.)
b. The current accounting period ends on December 21, 2019.

➢ Analysis:
As of December 31, 2019 (end of accounting period), interest expense is incurred
because there is already a passage of time.(October 1 to December 31, 2019), although
interest will only be paid in the next accounting period (i.e, October 1, 2020).

➢ Conclusion:
Interest expense shall be accrued for the 3 months covering October 1 to December 31,
2019.
The interest expense is accrued as follows:
Formula

i=Prt

• Principal (P) = P100,000 face amount

• Rate (r) = 12%
• Time (t) = expired time of 3 months ( i.e., October 1 to December 31, 2019) over 12 months in a
year.
• Interest = (100,000 x 12% x 3/12) = 3,000
Step 1: Transaction analysis
➢ Accounts affected: “Interest expense” (expense) and “Interest payable” (liability)

➢ Effect on accounts: Interest expense is increased. Interest payable is increased.

➢ Debit/Credit Expense is increased through debit. Liability is increased

 through credit.

Step 2: Adjusting journal entry (AJE)

The adjusting entry for the accrued interest expense is as follows:
Dec. 31, 2019 Interest expense 3,000
Interest payable 3,000
to accrue interest expense incurred
but not yet paid.

In the next accounting period, the payment of the interest is recorded as follows:

Oct. 1, 2020 Interest payable 3,000

Interest expense 9,000
Cash 12,000
to record the payment of interest

The cash payment pertains to the total 1-year interest covering the months of Oct. 1, 2019 to Sept.
30, 2020. This is computed as follows: i = Prt (100,000 x 12% x 12/12) = 12,000.

3-mos. Interest
Oct.1 to Dec. 31, 2019:
(100,000 x 12% x 3/12) =
P3,000 recognized in 2019
1 year interest:
Oct.1, 2019 to Sept.30,
2020:
(100,000 x 12% x 12/12) =
12,000 9- mos. Interest
Jan.1 to Sept.30, 2020:
(100,000 x 12% x 9/12) =
9,000 recognized in 2020

Case #4: Accrual of expense – Utilities expense

The cost of electricity used for the month of December 2019 is P4,000. The electricity bill was received
and paid in January 2020.

➢ Concepts:
Expense is recognized when incurred (used) rather than when paid – accrual basis of accounting.

➢ Given information:
The electricity bill, although paid in January 2020, pertains to the cost of electricity used in
December 2019.

➢ Conclusion:
Utilities expense shall be accrued in December 2019.
Step 1: Transaction analysis
➢ Accounts affected: “Utilities expense” (expense) and “Utilities payable”
(liability)

➢ Effect on accounts: Utilities expense is increased. Utilities payable is increased.

➢ Debit/Credit Expense is increased through debit. Liability is increased

through credit.

Step 2: Adjusting journal entry (AJE)

The adjusting entry is as follows:
Dec. 31, 2019 Utilities expense 4,000
Utilities payable 4,000
to accrue unpaid utilities

In the next accounting period, the payment of the electricity bill is recorded as follows:

Jan. 2020 Utilities payable 4,000

Cash 4,000
to record the payment of the Dec.2019
electricity bill

Case #5: Accrual of expense – Salaries expense

Employees earned total salaries of P100,000 in December 2019. However, the salaries were paid only in
January 2020.
Step 1: Transaction analysis
➢ Accounts affected: “Salaries expense” (expense) and “Salaries payable”
(liability)

➢ Effect on accounts: Salaries expense is increased. Salaries payable is increased.

➢ Debit/Credit Expense is increased through debit. Liability is increased

through credit.

Step 2: Adjusting journal entry (AJE)

The adjusting entry for the accrued salaries is as follows:
Dec. 31, 2019 Salaries expense 100,000
Salaries payable 100,000
to accrue salaries expense

The Concept of Systematic and Rational Allocation

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 expense over the periods where the economic benefits are consumed.
 One application of this concept is the recognition of depreciation expense. The
expenditure to acquire equipment is initially recorded as asset.

Illustration 2: Adjusting entries – Depreciation and Bad Debts

Case #1: Depreciation expense

On January 1, 2019, a business acquired equipment for P20,000. The business expects to use the
equipment over the next 4 years.

The entry on January 1, 2019 to record the acquisition is as follows:

Jan. 1. 2019 Equipment 20,000
Cash 20,000
to record the acquisition of equipment

On December 31, 2019, the equipment has already been used for 1 year out of its total
useful life of 4 years. Thus, one-fourths of the cost should be recognized as expense.

The annual depreciation expense is computed as follows:

Cost P20,000
Divide by: Useful life 4
Annual depreciation expense P5,000

Depreciation = Allocation of cost over the

useful life of a depreciable asset.

Year 1 depreciation
expense: P5,000

Year 2 depreciation
Cost of equipment with 4 expense: P5,000
– year useful life is initially
recognized as asset:
Year 3 depreciation
P20,000.
expense: P5,000

Year 4 depreciation
expense: P5,000
Step 1: Transaction analysis
➢ Accounts affected: “Depreciation expense” (expense) and “Accumulated
 depreciation” (contra - asset)
➢ Effect on accounts: Depreciation expense is increased. Accumulated
depreciation is increased.

➢ Debit/Credit Expense is increased through debit. Contra - asset is

increased through credit.

Step 2: Adjusting journal entry (AJE)

The adjusting entry is as follows:
Dec. 31, 2019 Depreciation expense 5,000
Accumulated depreciation 5,000
to record the depreciation expense for
the period

The carrying amount of the equipment as of December 31, 2019 is determined as

follows:
Equipment P20,000
Accumulated depreciation (5,000)
Equipment – net P15,000

Case #2: Bad debts expense

A business has a total accounts receivable of P2,000 on December 31, 2019 before any adjustments. Of
the total amount, it was estimated that P500 is doubtful of collection.

Step 1: Transaction analysis

➢ Accounts affected: “Bad debt expense” (expense) and “Allowance for bad
debts” (contra - asset)

➢ Effect on accounts: Bad debts expense is increased. Allowance for bad debts is
increased.

➢ Debit/Credit Expense is increased through debit. Contra - asset is

increased through credit.

Step 2: Adjusting journal entry (AJE)

The adjusting entry is as follows:
Dec. 31, 2019 Bad debts expense 500
Allowance for bad debts 500
to record the bad debts expense for
the period

After recording the adjusting entry, the carrying amount of the receivable is
brought equal to the estimated collectible amount of P1,500.
Accounts receivable P2,000
 Allowance for bad debts (500)
Accounts receivable – net P1,500

The Concept of Immediate Recognition

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

Expense recognition principles Description

1. Matching - Cost that are directly associated with
the earning of revenue are recognized
as expenses in the same period where
the related revenue is recognized.
- Application: The cost of inventory is
initially recognized as asset and
charged as expense (i.e., Cost of goods
sold) when the inventory is sold.
2. Systematic and rational allocation - Cost that are not directly associated
with the earning of revenue recognized
as expenses over the periods the
economic benefits are consumed.
- Application: The cost of equipment is
initially recognized as asset and
charged as expense (i.e., Depreciation)
over the periods the equipment is used.
3. Immediate recognition - Cost that do not provide future
economic benefits or asset that cease to
provide future economic benefits are
recognized immediately as expense.
- Application: An account receivable that
becomes doubtful of collection is
immediately recognized as expense
(i.e., Bad debts expense).

Real, Nominal and Mixed Accounts

Accounts are also classified into one of the following:

1. Real Accounts (Permanent accounts) – are accounts which are not closed at the end of
the accounting period. These accounts include all balance sheet accounts, except the
“Owner’s drawings” account.

2. Nominal Accounts (Temporary accounts) – are 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.
A clearing account is an account used temporarily to store amounts that will
eventually be transferred to another account. An example is the “Income summary”
which store amounts of income and expenses during the period. The balance of the
 Income summary account represents the profit or loss during the period. The Income
summary is closed the Owner’s capital account before the financial statements are
prepared.
A suspense account is an account used temporarily to store discrepancies in the
accounts pending their analysis and permanent classification. An example is the Cash
storage or overage account which is temporarily used to record cash storages or overages
pending their investigation.

3. Mixed accounts – Accounts that have both real and nominal account components. These
accounts are subject to adjustment
Mixed accounts include unadjusted prepayments (prepaid assets) and deferrals
(unearned income) that have both expired and unexpired components.
➢ The expired portion is the nominal account component while the unexpired portion is the
real account component.
➢ At the end of the period, adjusting entries are needed to separate these components
because the nominal account component is presented in the income statement while the
real account component is presented in the balance sheet.

After adjustments:
Before adjustments:
Real account (presented
Mixed account in the balance sheet)
(Real and Adjusting entry
Nominal
(to separate the two
Account
components) Nominal account
Component)
(presented in the
income statement)

Methods of Initial Recording of Income and Expenses

Income
Advanced collection of income may initially be recorded using either the (1) liability
method or (2) income method.

1. Liability method – under this method, cash receipts from items 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 3.1: Liability method vs. Income method
A business rents out its building to various tenants. On April 1, 2019 the business receives one-
year rent in advance of P120,000 from one of its tenants. Rent per month is P10,000.

The receipt of the advance rent is recorded as follows:

Liability method Income method

April 1, 2019 April 1, 2019
Cash 120,000 Cash 120,000
Unearned rent 120,000 Rent income 120,000
to record the receipt of 1-year rent in to record the receipt of 1-year rent in
advance. advance

a. Earned portion (used up) - pertains to the first 9 months of the 1-year rent in advance
covering the months of April 1 to December 31, 2019. This portion is computed as
follows:
(10,000 rent per month x 9 months) = 90,000; or
(120,000 x 9mos./12mos.) = 90,000.
b. Unearned portion (unused) – pertains to the remaining 3 months covering January 1 to
March 31, 2020. This portion is computed as follows:
(10,000 rent per month x 3 months) = 30,000; or
(120,000 x 3mos./12 mos.) = 30,000

• Adjusting entries are needed to separate the real account and nominal account
components of a mixed account.
• The adjusting entries (AJE) on December 31, 2019 are as follows:

Liability method Income method

December 31, 2019 December 31, 2019
Unearned rent 90,000 Rent income 30,000
Rent income 90,000 Unearned rent 30,000
to recognize the earned portion of the to recognize the unearned portion of
1-year rent in advance the 1-year rent in advance

Both the liability and income methods are acceptable. Regardless of the method used, the
adjusted amounts of rent income and unearned rent to be presented in the financial statements
are the same.
Expenses
Prepayments of expenses may initially be recorded using either the (1) asset method or (2)
expense method.

1. Asset method – under this method cash disbursement 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 disbursement 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 recognize as asset while incurred portion remains as
expense.

Illustration 3.2:Asset method vs. Expense method

A business prepays one-year insurance for P120,000 on October 1, 2019.

The prepayment of insurance is recorded as follows:

Asset method Expense method
October 1, 2019 October 1, 2019
Prepayment insurance 120,000 Insurance expense 120,000
Cash 120,000 Cash 120,000
to record the prepayment of 1-year to record the prepayment of 1-year
insurance insurance

Observe that under the asset method, the prepayment of insurance is debited to an asset
account; while under the expense method, the prepayment is debited to an expense account.

The incurred portion relates to the income statement (nominal account) while the not yet
incurred portion relates to the balance sheet (real account). These portion are analysed as
follows:
a. Incurred portion (used up or expired) – pertains to the first 3 months of the 1-year
prepaid insurance covering the months of October 1 to December 31, 2019. This portion
is computed as follows:
(120,000 x 3mos./12mos) = 30,000

b. Not yet incurred portion (unused or unexpired) - pertains to the remaining 9 months of January 1
to September 20, 2020. This portion is computed as follows:
(120,000 x 9mos/12mos.) = 90,000

The adjusting entries on December 31, 2019 are as follows:

Asset method Expense method

December 31, 2019 December 31, 2019
Insurance expense 30,000 Prepaid insurance 90,000
Prepaid insurance 30,000 Insurance expense 90,000
to recognize the expired portion of the to recognize the unexpired portion of
1-year insurance the 1-year insurance

Both the asset and expense methods are acceptable. Regardless of the method used, the adjusted
amounts of insurance expense and prepaid insurance to be presented in the financial statements are the
same.
 ❖ Accruals and deferrals are opposites.
Accrual Deferral

➢ To recognize income that is already ➢ To postpone the income recognition of an

earned but not yet collected. advance collection. The advance
collection is treated as liability until
earned.

➢ To postpone the expense recognition of a

➢ To recognize expense that is already
prepayment. The prepayment is treated as
incurred but not yet paid. asset until incurred.
Activity Sheet
FUNDAMENTALS OF ACCOUNTING, BUSINESS AND MANAGEMENT
ACTIVITY
NAME: SCORE:
COURSE/YEAR/SECTION: DATE: