ADJUSTMENTS

Managers, investors and the other interested parties use the financial statements to judge the financial position and
operating results of the business. It is therefore important that the financial statements be properly and fairly presented.
Ledger balances should show accurately the revenues earned, expenses incurred, assets owned, liabilities owed and
owner’s equity of the business. During the accounting period some ledger accounts may not reflect accurate amounts
because of the following reasons:
1. Some events are not journalized daily because it is too time consuming. e.g., consumption of supplies, salaries
and wages of employees
2. Some costs are not journalized during the accounting period because they expire with the passage of time rather
than through recurring daily transactions. Examples are equipment deterioration, rent and insurance.
3. Some items may be unrecorded. E.g., utility service bill
4. Some income and expenses included in the books do not belong to current accounting period.
5. Some liabilities are already earned or some recorded income but are still unearned.

In short, adjusting entries are needed to ensure that the income recognition and matching principles are followed.
Adjusting entries are required every time financial statements are prepared.
• The starting point is an analysis of each account in the trial balance to determine whether it is complete and up-to-
date.
• The analysis requires a thorough understanding of the business’s operations and the interrelationship of accounts

Types of adjusting entries:

1. Accrued expenses – expenses incurred but not yet paid. e.g., interest expense, utilities, salaries, goods purchased
Dr. Expense, Cr. Liability
2. Accrued income – representing income earned but not yet collected, e,g, interest income, sales revenue,
Dr. Accounts Receivable, Cr. Income
3. Prepaid expenses – represents advance payment for service or expense still to be incurred or used up in the
future. At the end of the year, the unexpired portion of the expense should be separated from the expired or
expense portion.

At the time of payment:

Dr. Prepaid expenses
Cr. Cash

Adjustment:
Dr. Expense
Cr. Prepaid expenses

4. Unearned income – cash received in advance for income/sales still to be earned or delivered, or service to be
rendered in the future. At the end of the year, the portion collected by the company for income not yet earned
should be separately recognized from the earned portion. The unearned portion represents a payable for the
company which should be presented as current liability in the balance sheet.

At the time of collection/receipt:

Dr. Cash; Cr. Liability

Adjustment
Dr. Liabilities; Cr. Income or Sales

5. Other adjustments
Amortization of discount on notes payable -
e.g. A note of P500,000 is discounted at 8% for two years. The amount of discount for 2 years is P500,000 x 8%
x 2 years or P80,000.00

5.1 Issuance of Note

Cash P420,000.00
 Discount on Notes payable 80,000.00
Notes payable P500,000.00

Amortization of discount:
At the end of 1st year:

Interest expense 40,000.00

Discount on notes payable 40,000.00

At the end of 2nd year:

Interest expense 40,000.00
Discount on notes payable 40,000.00

Depreciation-straight line method

Dr. Depreciation; Cr. Accumulated Depreciation

Doubtful accounts (allowance method) – estimating uncollectible accounts at the end of each period. This
provides better matching on the income statement and ensures that receivables are stated at their net realizable
value on the balance sheet date. Net realizable value is the net amount expected to be received in cash

Estimation of Doubtful accounts : Balance Sheet approach – what percentage of receivables will result in losses
from uncollectible accounts. Ageing of accounts receivable – customer balances are classified by the length of
time they have been unpaid; the expected bad debt losses are determined by analyzing the ages of accounts
receivable.

Adjustment:

Bad debts expense xxx

Allowance for bad debts xxx

Write off of accounts receivable – recognition of bad debts when they are judged as uncollectible.
Adjustment:
Bad debts written off xxx
Accounts receivable xxx

Recovery and subsequent collection of accounts previously written-off.

Journal entry:
Cash xxx
Miscellaneous income xxx

Merchandise inventory (periodic inventory method)

Recall that under the periodic method of accounting for merchandise, the account title Purchases is used when
merchandise is purchased and the account title Sales is used when the merchandise is sold. The merchandise
given to the customer called the cost of sales is not recorded at the point of sales but is determined at the end of
the year based on the physical count of the stock on hand. The inventory count representing the cost of the
merchandise not sold is to be deducted from the goods available for sale to arrive at the cost of the merchandise
sold.

The goods available for sale is the sum of the beginning merchandise inventory and the purchases made during
the year. The beginning inventory represents the ending inventory at the preceding period brought forward (as
presented in the balance sheet)

Journal entry to record ending inventory:

Merchandise inventory xxx
Income and expense summary xxx