ST.

THOMAS ACADEMY
Poblacion 3, City of Sto. Tomas, Batangas
School Year 2021-2022

Technology and Livelihood Education 10 – Basic Accounting

Module 7: Proper Valuation of Accounts: Adjusting the Books

Overview
In previous discussions you learned a straight forward rule that net income or net loss is simply the difference
between total revenues earned minus total expenses incurred by an entity over a period of time. You also
learned in previous modules the rules in recording income and expense transactions of the company. But
do you know that it is not really that simple? Many times, companies will find it difficult to determine in what
year they should report some of the revenues they earned and the expenses incurred. In short, measuring
net income or net loss requires proper timing.

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.

Purposes 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 modules on adjusting entries are subdivided into the following:
1. Accrual of income and expenses;
2. Recognition of depreciation expense and bad debts expense; and
3. Deferrals of income and expense (splitting of ‘mixed accounts’).

Learning Objective
At the end of this module, you shall be able to enumerate and describe the different adjusting entries.

Content

Scenario
Mr. Ulysses, owner of Thor General Merchandise successfully understood recording and posting the
business transactions of his company. He even understood now how posting to the general ledger grouped
all transactions in the general journal per account to obtain their individual balances. He appreciates the trial
balance preparation since it lists down all the accounts with their respective balances in a summarized form
on a specific date that you no longer need to flip the pages of the ledger if you want to know the balance of
a certain account.

But while he was trying to track the different entries recorded and posted in the general journal and
the general ledger, he noticed that the account Office Supplies does not decrease even though the shop is
using these supplies. He also noted that there is no Depreciation Expense recorded even though the shop

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uses the furniture and fixtures. But looking at the chart of accounts that his accountant friend prepared for
the shop, there were Office Supplies Expense and Depreciation Expense accounts.

Before we begin, let’s try to reflect and answer the question:

How can we prepare fairly valued

financial statements at the end of
every accounting period?

Adjusting the books is the fifth step and is fairly crucial in the preparation of accurate or fairly valued financial
statements. It is a common practice for an entity to recognize expense before payment, recognize income
before receipt, and pay for an expense before it is incurred, or received payment before it is earned. This
means that accounting records are maintained using the accrual basis. To accrue means to recognize. These
being the case, adjusting entries are necessary to present the fair valuation of every account in the financial
statements at the end of every reporting period.

TIMING ISSUES
Fiscal and Calendar Years
Both small and large companies prepare financial statements periodically in order to assess their financial
condition and results of operations. Accounting time periods are generally a month, a quarter, or a year.
Monthly and quarterly time periods are called interim periods. Most large companies must prepare both
quarterly and annual financial statements.
An accounting time period that is one year in length is a fiscal year. A fiscal year usually begins with the first
day of a month and ends twelve months later on the last day of a month. Most businesses use the calendar
year (January 1 to December 31) as their accounting period. Some do not. Sometimes a company’s year-
end will vary from year to year.

The need for proper timing is the reason why accountants thought of a convenient assumption of dividing
the economic life of a business into artificial time periods knows as reporting or accounting period. This is
the basic accounting concept of “periodicity” or “time period”. The time period assumption is important in
accomplishing the fifth step of the accounting cycle which is “adjusting the books”.

To understand step 5, let us begin by understanding first the meaning of adjusting entries.

ADJUSTING ENTRIES DEFINED

Adjusting entries are entries required at the end of each accounting period to recognize on an accrual basis
revenues and expenses for the period and to report proper amounts for assets, liabilities and owner’s equity
accounts (Principles of Accounting by Skousen, Langenderfer, and Albrecht, 1981). To adjust the book
implies that the entity recognizes expenses, income, depreciation and bad debts accounts at the end of the
accounting period to update the books because of events that has transpired throughout the period. One
common characteristic of adjusting entries is that they affect at least one real account (asset, liability, or
equity account) and one nominal account (revenue or expense account) (Fundamentals of Intermediate
Accounting by Kieso, Fargher, Wise, Weygant and Warfield, 2008).

Real, Nominal and Mixed Accounts

Accounts are classified into the following:

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 1. Real Accounts (Permanent Accounts) – are accounts that are not closed at the end of the accounting
period. Theses are extended to the next accounting period. Real accounts include all balance sheet
accounts, except the “Owner’s Drawing” account.
2. Nominal Accounts (Temporary Accounts) – are accounts that are closed at the end of the accounting
period. Nominal accounts include all income statement accounts, drawing account and clearing
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” account which stores
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 to
the “Owner’s Capital” account before the financial statements are prepared.
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
component is presented in the income statement while the real account component is presented in the
balance sheet.

ACCRUAL- VS. CASH-BASIS ACCOUNTING

What you will learn in this module is accrual-basis accounting. Under the accrual basis, companies record
transactions that change a company’s financial statements in the periods in which the events occur. For
example, using the accrual basis to determine net income means companies recognize revenues when
earned (rather than when they receive cash). It also means recognizing expenses when incurred (rather than
when paid).

An alternative to the accrual basis is the cash basis. Under cash-basis accounting, companies record
revenue when they receive cash. They record an expense when they pay out cash. The cash basis seems
appealing due to its simplicity, but it often produces misleading financial statements. It fails to record revenue
that a company has earned but for which it has not received the cash. Also, it does not match expenses with
earned revenues. Cash-basis accounting is not in accordance with generally accepted accounting
principles (GAAP). Individuals and some small companies do use cash-basis accounting. The cash basis is
justified for small businesses because they often have few receivables and payables. Medium and large
companies use accrual-basis accounting.

RECOGNIZING REVENUES AND EXPENSES

It can be difficult to determine the amount of revenues and expenses to report in a given accounting period.
Two principles help in this task: the revenue recognition principle and the matching principle.

REVENUE RECOGNITION PRINCIPLE

The revenue recognition principle dictates that companies recognize revenue in the accounting period in
which it is earned. In a service enterprise, revenue is considered to be earned at the time the service is
performed. To illustrate, assume that Dave’s Dry Cleaning cleans clothing on June 30 but customers do not
claim and pay for their clothes until the first week of July. Under the revenue recognition principle, Dave’s
earns revenue in June when it performed the service, rather than in July when it received the cash. At June
30, Dave’s would report a receivable on its balance sheet and revenue in its income statement for the service
performed.

MATCHING PRINCIPLE
Accountants follow a simple rule in recognizing expenses: “Let the expenses follow the revenues.” That is,
expense recognition is tied to revenue recognition. In the dry-cleaning example, this principle means that
Dave’s should report the salary expense incurred in performing the June 30 cleaning service in the income
statement for the same period in which it recognizes the service revenue. The critical issue in expense
recognition is when the expense makes its contribution to revenue. This may or may not be the same period

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in which the expense is paid. If Dave’s does not pay the salary incurred on June 30 until July, it would report
salaries payable on its June 30 balance sheet. This practice of expense recognition is referred to as the
matching principle. It dictates that efforts (expenses) be matched with accomplishments (revenues).

THE BASICS OF ADJUSTING ENTRIES

In order for revenues and expenses to be reported in the correct period, companies make adjusting entries
at the end of the accounting period. Adjusting entries ensure that the revenue recognition and matching
principles are followed. Adjusting entries make it possible to report correct amounts on the balance sheet
and on the income statement. The trial balance—the first summarization of the transaction data—may not
contain up-to-date and complete data. This is true for several reasons:

1. Some events are not recorded daily because it is not efficient to do so. For example, companies do
not record the daily use of supplies or the earning of wages by employees.
2. Some costs are not recorded during the accounting period because they expire with the passage of
time rather than as a result of daily transactions. Examples are rent, insurance, and charges related
to the use of equipment.
3. Some items may be unrecorded. An example is a utility bill that the company will not receive until the
next accounting period.

A company must make adjusting entries every time it prepares financial statements. It analyzes each account
in the trial balance to determine whether it is complete and up-to-date. For example, the company may need
to make inventory counts of supplies. It may also need to prepare supporting schedules of insurance policies,
rental agreements, and other contractual commitments. Because the adjusting and closing process can be
time-consuming, companies often prepare adjusting entries after the balance sheet date, but date them as
of the balance sheet date.

ADJUSTING ENTRIES versus CORRECTING ENTRIES

A lot of people substitute adjusting entries with correcting entries. This however is a mistake for the two are
very different in their nature and function. A correcting entry is done when there was an error in the journal
entry made, e.g., error of transposition or transplacement in the amounts of the journal entry. Such being the
case, correcting entries are input to CORRECT the wrong amounts. In adjusting entries, there are no errors
that need to be corrected but certain adjustments have to be affected because certain account balances
need to be updated in order to reflect fair values for the assets, liabilities, expenses, income, and capital in
the financial statements.

TYPES OF ADJUSTING ENTRIES

1. Deferrals:
a. Prepaid Expenses – expenses paid in cash and recorded as assets before they are used or
consumed.
b. Unearned Revenues – cash received and recorded as liabilities before revenue is earned.
2. Accruals:
a. Accrued Revenues – revenues earned but not yet received in cash or recorded.
b. Accrued Expenses – expenses incurred but not yet paid in cash or recorded.

References
Ballada, W.B. (2011). Basic Accounting Made Easy (16th ed.). Quezon City, Philippines: Dane Publishing
House Inc.

Manalo, M. V. (2016). Learning to Succeed in Business with Accounting Volume 1. Quezon City, Philippines:
Phoenix Publishing House Inc.

Florento, J.G. (2016). Fundamentals of Accountancy, Business, and Management 1 (1st ed.). Sampaloc,
Manila, Philippines: REX Bookstore.

Rabo, J. S., et al. (2016). Fundamentals of Accountancy, Business, and Management 1. Quezon City,
Philippines: Vibal Group, Inc.

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