Notes on Adjusting the Accounts and Accruals (Study Guide)

Accrual Accounting Basics

• Accrual Basis defined

  • The effects of transactions and other events are recognized when they occur, not when cash is received or paid.
  • Cash flow timing is relatively immaterial for recognizing revenues and expenses.
  • Purpose: inform users about past cash transactions, future cash obligations, and resources that will convert to cash in the future.

• Practical illustration of accrual vs. cash basis

  • Sea Wind Resort example: payment of ₱7,000 on April 8, 2012 for a one-day stay on May 13, 2012.
  • Accrual basis: revenue is recognized when service is rendered (May 13).
  • Cash basis would recognize revenue on April 8.

• Why accrual basis is preferred

  • Generally accepted accounting principles require accrual basis.
  • It provides a better measure of the results of transactions because revenues and related expenses are matched to the period in which they are earned and incurred.

Periodic Timing and Reporting

• Periodicity Concept

  • Division of a business’s economic life into artificial time periods (months, quarters, years).
  • The most basic period is one year.
  • Liquidation concept: a firm’s value is realized through reporting and closing processes, but accounting information should be communicated early enough to aid decision-making.

• Accounting Periods and Types

  • Fiscal year: any twelve consecutive months.
  • Calendar year: ends December 31.
  • Natural business year: ends when business activities are at their lowest point in the annual cycle.
  • Interim period: less than a year.

• Interaction with revenue/expense recognition

  • Periodicity interacts with revenue and expense recognition to justify accrual basis reporting.

Revenue and Expense Recognition Principles

• Core idea

  • To measure performance, allocate certain income and expense transactions over multiple periods via adjustments.
  • The adjustment process relies on recognition principles.

• Revenue recognition (PAS No. 18)

  • Revenue is recognized when it is probable that economic benefits will flow to the enterprise and can be measured reliably.

• Expense recognition (Matching principle)

  • Expenses are recognized when a decrease in future economic benefits related to a decrease in an asset or an increase in a liability has occurred and can be measured reliably.
  • Purpose: identify all expenses incurred during the period and match them with revenues earned in that period.

Three Broad Applications of the Expense Recognition Principles

• Direct Association
  • Expenses recognized in income statement by directly associating their cost with the earnings of specific items of income.
  • Examples: Sales commissions, cost of goods sold.
• Systematic and Rational Association
  • When benefits arise over several periods and direct association with income is indirect, allocate expenses over the periods as benefits accrue.
  • Examples: Property and equipment depreciation, allocation of prepaid rent and insurance.
• Immediate Recognition
  • Recognize expenses immediately when the expenditure yields no future benefits.
  • Examples: Officer salaries, most selling costs, and amounts paid to settle lawsuits.

The Need for Adjustment

• Adjusting entries adjust balances at period end to reflect correct balances for financial reporting.
• Without adjustments, statements may not fairly show solvency (balance sheet) or profitability (income statement).

Deferrals and Accruals (General Concept)

• Adjusting entries apply accrual accounting to transactions spanning more than one period.
• Two general types of adjustments at period end.
• Each adjusting entry affects both a balance sheet (asset or liability) and an income statement (income or expense).

Deferrals

• Deferral definition
  • Postponement of recognizing an expense that has already been paid but not yet incurred, or revenue already collected but not yet earned.
  • Involves an asset balance sheet account; the adjusting entry decreases the asset and increases the related income statement account.
• Deferral cases
  • Allocating assets to expense to reflect expenses incurred during the period (examples: prepaid insurance, supplies, depreciation).
  • Allocating revenues received in advance to revenue to reflect revenues earned during the period (example: subscriptions).

Accruals

• Accrual definition
  • Recognition of an expense already incurred but paid, or revenue earned but uncollected.
  • The adjusting entry increases both a balance sheet and an income statement account.
• Accruals cases
  • Accruing expenses to reflect expenses incurred during the period that are unpaid and unrecorded.
  • Accruing revenues to reflect revenues earned during the period that are uncollected and unrecorded.

Adjustments for Deferrals

• Allocating assets to expenses (Prepaid expenses)
  • Prepaid expenses are assets, not expenses.
  • At period end, the portion that has expired becomes an expense.
  • Expiration occurs with the passage of time or through use/consumption.

Balance Sheet and Income Statement Effects (Prepaids)

• Prepaid Insurance, Supplies – assets turn into expenses as time passes or goods/services are consumed.

Illustrative Case: Prepaid Rent

• May 1: Paid ₱8,000 for two months’ rent in advance.
• Expiration of one month’s rent example:
  • Assets decrease; Owner’s Equity decreases.
  • Rule: Decreases in assets are recorded by credits; Decreases in owner’s equity are recorded by debits.
• Journal entry (for one month):
  • Dr Rent Expense (OE:E) ₱4,000; Cr Prepaid Rent (A) ₱4,000

Illustrative Case: Prepaid Insurance

• One-year comprehensive coverage for ₱14,400; Expiration of one month.
• Entry example: Dr Insurance Expense (OE:E) ₱1,200; Cr Prepaid Insurance (A) ₱1,200

Illustrative Case: Supplies

• May 8: Purchased supplies ₱18,000; end of month supplies on hand ₱15,000; used ₱3,000.
• Entry: Dr Supplies Expenses (OE:E) ₱3,000; Cr Supplies (A) ₱3,000

Depreciation of Property and Equipment

• Concept
  • Long-lived assets generate income; cost must be allocated over their estimated useful life.
• Key factors for depreciation (per period):
  • Asset cost: amount paid to acquire the asset.
  • Estimated salvage value: resale value at end of useful life.
  • Estimated useful life: number of periods the asset will be used.
• Depreciation method: Straight-line method (example formulas below).
• Straight-line depreciation formula:
  • Depreciation Expense for the time period = $ext{Depreciation Expense} = \frac{ ext{Asset Cost} - ext{Salvage Value}}{ ext{Estimated Useful Life}}$

Depreciation Examples

• Service Vehicle: cost ₱420,000; 7 years; salvage ₱84,000.
• Office Equipment: cost ₱60,000; 5 years; salvage ₱0.
• For a one-month period they recorded:
  • Service Vehicle: Depreciation Expense ₱4,000; Accumulated Depreciation – Service Vehicle ₱4,000
  • Office Equipment: Depreciation Expense ₱1,000; Accumulated Depreciation – Office Equipment ₱1,000
• Calculation notes
  • Service Vehicle annual depreciation =
  • Monthly depreciation = ₱4,000 (i.e., ₱48,000 per year ÷ 12 months).
  • Office Equipment monthly depreciation = ₱1,000 (i.e., ₱60,000 ÷ 60 months).

Allocating Revenues Received in Advance to Revenues (Unearned Revenues)

• Situation
  • Cash received for services/goods before services are performed or goods delivered.
  • Liability: unearned revenues.
• Balance sheet presentation
  • Liabilities (Unearned Revenues) reduce as revenues are earned (recognize income).
• Example: May 15, ₱10,000 advance for referrals.
  • Initially recorded as a liability; portion recognized as revenue when earned.
• Adjusting entry when ₱4,000 of the revenue has been earned by month-end:
  • Dr Unearned Revenues ₱4,000; Cr Referral Revenues (OE:I) ₱4,000
• Effects on accounts after posting (illustrative):
  • Liabilities decrease; Owner’s equity increases by the revenue amount recognized.
• Journal entry summary:
  • Dr Unearned Referral Revenues ₱4,000; Cr Referral Revenues ₱4,000

Adjustments for Accruals

• Accrued Expenses
  • Expenses incurred but not yet paid; cash payments occur later.
  • Examples: salaries, interest, utilities, taxes.
• Accrued Revenues
  • Revenues earned but not yet billed or collected; require accrual adjusting entries.

Accrued Salaries

• May payroll and end-of-month adjustments
  • May 13 and May 27 payrolls; three days (May 29-31) remain unpaid.
  • Salary rate: ₱7,800 per month or ₱300 per day (₱7,800/26 days).
• Adjustment needed for 3 days of service:
  • Entries: Dr Salaries Expenses ₱1,800; Cr Salaries Payable ₱1,800

Accrued Interest

• Example: May 2, borrowed ₱210,000 at 20% per annum.
• Monthly interest accrual: ₱210,000 × 0.20 / 12 = ₱3,500.
• Entry: Dr Interest Expense ₱3,500; Cr Interest Payable ₱3,500

Accrued Revenues

• Services performed but not billed or collected by period end.
• Accounting entry when revenue is earned but not yet recorded:
  • Dr Accounts Receivable ₱5,300; Cr Consulting Revenues ₱5,300

Accrual for Uncollectible Accounts

• Concept
  • Estimating uncollectible accounts to match income and expenses in the period.
  • Use a contra-asset (Allowance for Uncollectible Accounts) with a credit balance.
• Example: Credit sales ₱1,100,000; expected uncollectible rate 1%
  • Uncollectible Accounts Expense ₱11,000; Allowance for Uncollectible Accounts ₱11,000
• Write-offs when specific accounts are uncollectible
  • Dr Allowance for Uncollectible Accounts ₱1,500; Cr Accounts Receivable ₱1,500

Omitting Adjustments: Consequences

• If adjustments are omitted, FS misstate financial position and performance.
• One period’s inaccuracies can carry into later periods.
• Illustrative case (Santa Rita Manpower Services):
  • December 31, 2012: Accrued interest of ₱8,000 not recorded.
  • Correct entry would be Dr Interest Expense ₱8,000; Cr Interest Payable ₱8,000
  • Consequences: 2012 income statement understates or overstates profits; balance sheet effects on equity and liabilities.
• If interest is later settled in 2013 without prior accrual, 2013 profits may be misstated too (overstated or understated by ₱8,000 depending on timing).
• Overall effect described: two erroneous income statements and one erroneous balance sheet; net effect depends on the actual profit figure intended for each year.

Illustrative T-Account Demonstrations (summary)

• Example 1: Supplies
  • Beginning balance: 0
  • Cash paid for supplies: plug figure to reconcile ending balance with Supplies expense
  • Ending balance and expense recognized reflect accrual/expense recognition for supplies used
• Example 2: Prepaid Insurance
  • Beginning balance: ₱48,000; Insurance expense for period: ₱12,000; Ending balance: ₱79,000 (illustrative)
  • Demonstrates cash payments and how prepaid asset balances adjust over time with expense recognition

Summary of Adjusting Entries (types and effects)

• Prepaid Expenses (Asset Method)
  • Asset overstated; Expense understated; Result: Expense understated, Assets overstated
• Unearned Revenues (Liability Method)
  • Liabilities overstated; Income understated; Revenues understated, Unearned Revenues decreases as revenue is earned
• Accrued Expenses (Payable)
  • Liabilities understated; Expenses understated; Payable increases; Expenses increase
• Accrued Revenues (Receivable)
  • Assets understated; Revenues understated; Receivable increases; Revenues increase

Alternative Methods of Recording Deferrals

• Prepaid Expenses (Policy choices)
  • Oct 1, 2012: 3-year insurance policy for ₱36,000; can be recorded as asset (Prepaid Insurance) or expense (Insurance Expense) initially.
• Initial entry options
  • Asset option: Dr Prepaid Insurance ₱36,000; Cr Cash ₱36,000
  • Expense option: Dr Insurance Expense ₱36,000; Cr Cash ₱36,000
• If initial entry was asset and adjustment is required
  • Adjusting entry (if asset first): Dr Insurance Expense ₱3,000; Cr Prepaid Insurance ₱3,000
  • Or if initial was expense and adjustment is required: Dr Prepaid Insurance ₱33,000; Cr Insurance Expense ₱33,000
• Ledger effects after posting are the same regardless of the initial debit/credit choice.

Unearned Revenues (Alternative method example)

• July 1, 2012: Received ₱48,000 for 2 years’ rent in advance.
• Two initial recording options
  • Liability method: Dr Cash ₱48,000; Cr Unearned Rent Revenue ₱48,000
  • Revenue method: Dr Cash ₱48,000; Cr Rent Revenue ₱48,000
• Adjusting entry required if initial recording was liability method
  • Dr Unearned Rent Revenue ₱12,000; Cr Rent Revenue ₱12,000
• If initial recording was revenue method, adjusting entry would instead move revenue from unearned to earned as time passes:
  • Dr Rent Revenues ₱36,000; Cr Unearned Rent Revenues ₱36,000
• Ledger effects after posting are the same regardless of initial method: Unearned Rent Revenues decreases and Rent Revenues increases as period ends.

Key Formulas and Concepts to Memorize

• Revenue recognition: recognize when probable economic benefits will flow and can be measured reliably.
  • Related concept: accruals ensure revenue is recorded when earned, not when cash is received.
• Expense recognition (matching): recognize expenses in the period they relate to the revenues they helped generate.
• Depreciation (straight-line):
  • Depreciation Expense per period = $\frac{ ext{Cost} - ext{Salvage Value}}{ ext{Estimated Useful Life}}$
  • Example: monthly depreciation for a vehicle is cost-based and reduces both asset value (via accumulated depreciation) and equity via depreciation expense.
• Deferrals vs. accruals: deferrals shift timing of recognition (prepaid expenses, unearned revenues); accruals recognize expenses/revenues that have occurred but are not yet recorded or collected.

Note: Practical journal-entry formats used in examples

• Journal entries typically shown as Dr [Account] ₱[amount] ; Cr [Account] ₱[amount]
• Common account labels in these notes:
  • Assets: Prepaid Rent, Prepaid Insurance, Supplies, Accumulated Depreciation (contra-asset)
  • Liabilities: Unearned Revenues, Salaries Payable, Interest Payable
  • Equity and Income: Rent Expense, Insurance Expense, Supplies Expense, Salaries Expenses, Interest Expense, Consulting Revenues, Revenue items, Depreciation Expense
• The general rule: decreases in assets are credits; decreases in owner’s equity are debits; increases in liabilities are credits; increases in owner’s equity are credits for revenues and debits for expenses (to reflect net income effects).