ACCO UNTIN G CYCLE

FO R A SERVICE
BUSINESS PART 3
LESSON 6
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 MOST ESSENTIAL LEARNING
COMPETENCIES
Prepares adjusting entries
Complete the accounting cycle

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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.
During the Step 2: Transactions are recorded in the journal.
accounting period
Step 3: Journal entries are posted to the ledger.
Step 4: Preparation of a trial balance.
Step 5: Preparation of the worksheet including adjusting entries.
At the end of the Step 6: Preparation of the financial statements.
accounting period
Step 7: Adjusting journal entries are journalized and posted.
Step 8: Closing journal entries are journalized and posted.
Step 9: Preparation of a post-closing trial balance.
At the start of the Step 10: Reversing journal entries are journalized and posted.
next period

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ACCRUAL BASIS

• The effects of transactions and other events are recognized when they occur and not as cash
is received or paid.
• Revenues are recorded as they are earned, and expenses as they are incurred.

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CASH BASIS

• The accountant does not record a transaction until cash is received or paid.
• Cash receipts are treated as revenues and cash payments as expenses.

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FOR EXAMPLE:

• A client paid the Sea Wind Resort in Boracay Island P7,000 on April 20, 2021 for one day super
deluxe accommodation on May 14, 2021.
– Under accrual basis of accounting, the receipt of P7,000 will be considered as revenues when the
business has rendered its service on May 14.
– If cash basis is used, the hotel will recognized revenues on April 20.
• Suppose a financial report is prepared at the end of April:
– Accrual basis: no revenue or expense will be reported
– Cash basis: revenues of P7,000 will be reported but the related expenses will be recorded when
incurred on May 14.

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PERIODICITY CONCEPT

• The only way to know how successfully a business has operated is to close its doors, sell all its
assets, pay the liabilities and return any excess cash to the owners. This process of going out of
business is called liquidation. This, however, is not a practical way of measuring business
performance.
• 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.

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PERIODICITY CONCEPT

• Fiscal year – period of any twelve consecutive months.

• Calendar year – annual period ending on December 31.
• Natural business year – twelve month period that ends when business activities are at their
lowest level of the annual cycle.
• Interim period – a period of less than a year.

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REVENUE AND EXPENSE RECOGNITION
PRINCIPLES
• Revenue is recognized when it is probable that economic benefits will flow to the enterprise
and these economic benefits can be measured reliably. Revenue is earned in the accounting
period when the services are rendered or the goods sold are delivered.
• Expense recognition principle is the basis for recording expenses. Expense is recognized when
it is probable that a decrease in future economic benefits related to a decrease in an asset or
an increase of a liability has arisen, and that the decrease in economic benefits can be
measured reliably.

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THE NEED FOR ADJUSTMENTS

• 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.

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DEFERRALS AND ACCRUALS

• There are two general types of adjustments made at the end of the accounting period –
deferrals and accruals
• 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”.
• Accrual is the recognition of “an expense already incurred but unpaid”, or “revenue earned but
uncollected”.

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DEFERRALS

• 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.
Deferrals would be needed in two cases:
– Allocating assets to expense to reflect expenses incurred during the accounting period (e.g. prepaid
insurance, supplies and depreciation).
– Allocating revenues received in advance to revenue to reflect revenues earned during the accounting
period ( e.g. subscriptions).

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ACCRUALS

• This adjustment deals with an amount unrecorded in any account; the entry, in effect, increases
both a balance sheet and an income statement account. Accruals would be required in two
cases:
– Accruing expenses to reflect expenses incurred during the accounting period that are unpaid and
unrecorded.
– Accruing revenues to reflect revenues earned during the accounting period that are uncollected and
unrecorded.

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ADJUSTMENTS FOR DEFERRALS

• Prepaid expenses – some expenses that are customarily paid in advance. Example: supplies,
rent, and insurance. Prepaid expenses are assets, not expenses. At the end of an accounting
period, a portion or all of these prepayments may have expired. The portion of an asset that
has expired becomes an expense. Prepaid expenses expire either with the passage of time or
through the use and consumption.

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A. 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:
• Transaction: Expiration of one month's rent.
• Analysis: Assets decreased. Owner's equity decreased
• Rules: Decreases in assets are recorded by credits. Decreases in owner's equity are recorded
by debits.
• Entries:
Debit (Dr) Credit (Cr)
Rent Expense (OE:E) 4,000
Prepaid Rent (A) 4,000

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B. 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.The adjustment is analyzed and recorded as shown below:
• Transaction: Expiration of one month's insurance.
• Analysis:Assets decreased. Owner's equity decreased.
• Rules: Decreases in assets are recorded by credits. Decreases in owner's equity are recorded
by debits.
• Entries:

Debit (Dr) Credit (Cr)

Insurance Expense (OE:E) 1,200
Prepaid Insurance (A) 1,200

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C. SUPPLIES
• On May 8, Weddings "R" Us purchased supplies, P18,000 During the month, the entity used supplies
in the process of performing services for clients. There is no need to account for these supplies
every day since the financial statements will not be prepared until the end of the month. At the end
of the accounting period, Diaz makes a careful physical inventory of the supplies. The inventory
count showed that supplies costing P15,000 are still on hand. This transaction is analyzed and
recorded as follows:
• Transaction: Consumption of supplies.
• Analysis:Assets decreased. Owner's equity decreased.
• Rules: Decreases in assets are recorded by credits. Decreases in owner's equity are recorded by
debits.
• Entries:
Debit (Dr) Credit (Cr)
Supplies Expense (OE:E) 3,000
Supplies (A) 3,000

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D. SERVICE VEHICLE
• 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. Substitution of the
pertinent amounts into the basic formula will yield depreciation for service vehicle for the month as
P4,000 [(P420,000 - P84,000)/84 months. These amounts represent the cost allocated to the month,
thus reducing the asset accounts and increasing the expense accounts. As a matter of company
policy, the period May 4 to 31 is considered a month.The analysis follows:
• Transaction: Recording depreciation expense.
• Analysis: Assets decreased. Owner's equity decreased
• Rules: Decreases in assets are recorded by credits. Decreases in owner's equity are recorded by
debits.
• Entries: Debit (Dr) Credit (Cr)
Depreciation Expense – 4,000
Service Vehicle (OE:E)
Accumulated 4,000
Depreciation Expense -
Service Vehicle (A)
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E. UNEARNED REFERRAL REVENUES
• On May 15. Weddings "R" Us received P10,000 as an advance payment for referrals made.
Assume that by the end of the month, one of the three couples referred has already taken
their marriage vows and as a result the amount of P4,000 pertaining to the referred event has
been realized.This transaction is analyzed as follows:
• Transaction: Recognition of income where cash is received in advance.
• Analysis: Liabilities decreased. Owner's equity increased
• Rules: Decreases in assets are recorded by credits. Decreases in owner's equity are recorded
by debits.
• Entries:
Debit (Dr) Credit (Cr)
Unearned Referral 4,000
Revenues (L)
Referral Revenues (OE:I) 4,000
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ADJUSTMENTS FOR ACCRUALS

• An entity often incurs expenses before paying for them. Cash payments are usually made at
regular intervals of time such as weekly, monthly, quarterly or annually. If the accounting period
ends on a date that does not coincide with the scheduled cash payment date, an adjusting
entry is needed to reflect the expense incurred since the last payment. This adjustment helps
the entity avoid the impractical preparation of hourly or daily journal entries just to accrue
expenses. Salaries, interest, utilities (e.g., electricity, telecommunications and water) and taxes
are examples of expenses that are Incurred before payment is made.

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F. 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 a 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
Sun Mon Tue Wed Thu Fri Sat
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

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F. ACCRUED SALARIES
• Transaction:Accrual of unrecorded expense.
• Analysis: Liabilities increased. Owner's equity decreased.
• Rules: Increases in liabilities are recorded by credits. Decreases in owner's equity are recorded
by debits.
• Entries:

Debit (Dr) Credit (Cr)

Salaries Expense (OE:E) 1,800
Salaries Payable (A) 1,800

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G. ACCRUED INTEREST
• On May 2, Diaz 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, Diaz 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.
• Transaction:Accrual of unrecorded expense.
• Analysis: Liabilities increased. Owner's equity decreased.
• Rules: Decreases in assets are recorded by credits. Decreases in owner's equity are recorded by
debits.
• Entries:
Debit (Dr) Credit (Cr)
Interest Expense (OE:E) 3,500
Interest Payable (A) 3,500

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H. 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.This should be recorded as shown below:
• Transaction:Accrual of unrecorded expense.
• Analysis: Assets increased. Owner's equity increased
• Rules: Increase in assets are recorded by debits. Increases in owner's equity are recorded by
credits.
• Entries:

Debit (Dr) Credit (Cr)

Accounts Receivable (A) 5,300
Consulting Revenues 5,300
(OE:I)
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