Lecture 11- Business Transactions and Their Analysis as Applied to the Accounting Cycle of a Service Firm(Part

11)

Introductrion

In Chapter 10, analyzing business transactions, journalizing, posting to the ledger accounts, and the preparation of
the trial balance were discussed. Analyzing, journalizing and posting are done all year-round. Collectively , these
steps constitute what is called the recording phase of the accounting process. The summarizing phase starts with
the preparation of the trial balance, where the ending balances of the ledgers are taken and summarized in a
tabular presentation, together with the proper debit and credit balances.

This chapter will utilize the example used in Chapter 10, Matalino Dormitory. The result of the processes
discussed in the said chapter is the UDJUSTED TRIAL BALANCE which is as follows:

Adjusting Entries

The trial balance , which was prepared from the information found in the ledgers, reflects the effect of the various
transactions entered into by the entity throughout the accounting period. However , some of the amounts are not
final amounts that would be seen in the financial statements. This is due to the presence of accounts in which
there are expired and unexpired portions. Expired amount are those in which no economic benefits are expected.

In the accounting process of a service firm, there are six (6) classifications of adjusting entries: depreciation, bad
debts, prepaid expenses, accrued expenses, deferred revenues, accrued revenues.

Adjusting entries are prepared at the end of an accounting period to unrecorded revenue that has been earned
and unrecorded revenues expenses that have been incurred during the accounting period.

Each adjusting entry has the following characteristics:

1. Each entry is recorded at the end of an accounting period

2. Each entry has at least one balance sheet account (e.g. asset or liability) and at least one income
statement account (e.g, revenue or expense ); and
3. Each entry has no cash account in either the debit or the credit side.

Depreciation

Depreciation is applied to components of property, plant and equipment or PPE. These are assets held by
an entity and expected to benefit more than one accounting period. In other words, these are assets held for long
–term purposes. Depreciation is done to allocate the cost, less residual value of the PPE over its useful life. In
theory , an entity is benefited through increased revenues when its uses its PPE. Although there is no real outflow
of resources by the entity, an expense is still recorded in order to match depreciation expense in the same period
that the revenue is generated. In business, “when there is gain, there is no pain” . In this case , gain is represented
by revenue and pain is represented by depreciation expense. The entry to record depreciation is:

Dr. Depreciation XXX

Cr. Accumulated depreciation XXX

Depreciation expense is an income statement account while accumulated Depreciation is a balance

sheet . Accumulated Depreciation is a deduction from a PPE account. The difference between PPE account and its
related Accumulated Depreciation Account is called Accumulated Depreciation Account is P 50,000, the book value
of the building is P200,000.

The basic formula in computing depreciation is as follows:

Depreciation Expense = Cost of the PPE – Estimated Residual Value

Estimated Useful Life

In the Matalino Dormitory example, there are several depreciable assets , namely, building, furniture and
fixtures, and computer. Although land is an asset that benefits an entity for the long-term, it is not a depreciable
asset because its estimated useful life cannot be determined. For instance, the building is expected to be used for
a period of 20 years, and the residual value is expected to be P500,000. The residual value is the amount that is
expected to be recovered from the asset at the end of its useful life through sale, rather than through continuing
use.

To determine the amount of depreciation to be recorded, the residual value is deducted from the cost of
the building, which is P12,500,000, and the resulting figure,P12,000,000,is simply divided by the useful life in years,
which is 20, we get P600,000. Hence , the entry for depreciation should be:

Dr. Depreciation Expense 600,000

Cr. Accumulated Depreciation-building 600,000

This method of depreciation is called the straight-line method. This adjusting entry affects the accounting
equation in the accumulated depreciation will bring down the book value of the building . Equity will go down
because an expense is recorded-Depreciation Expense.

Bad Debts

The concept of bad debts is an application of the conservatism principle of accounting, which when
applied to the accounts receivable of a firm. In the ordinary course of a business, it is just but normal to encounter
customers who later on, would not able to pay their dues to the business entity. The most common method of
estimating bad debts is by multiplying the amount of accounts receivable by a certain percentage, which is
determined through years of experience of the entry in business. The resulting figure is the required balance of
the allowance for doubtful accounts. The pro-forma entry for a bad debts adjusting entry is:

Dr. Bad Debts Expense XXX

Cr. Allowance for Doubtful accounts XXX

Bad Debts is an income statement account while Allowance for Doubtful Accounts is a balance sheet
account. Allowance for Doubtful Accounts is a deduction from Accounts Receivable. The difference between
account receivable and the Allowance for Doubtful Accounts is called the Net Realizable Value of the Accounts
Receivable. For example, if the account Receivable Account has a balance of P450,000 and the allowance for
Doubtful Accounts has a balance of P45,000, the Net Realizable Value of the Accounts Receivable is P 405,000.

For instance, there is a P1,000,000 accounts receivable at the end of the year, and it is determined that
5% of these receivables could be uncollectible. P1,000,000 times5% is equal to P50,000. Hence , the adjusting
entry is:

Dr. Bad Debts Expense 50,000

Cr. Allowance for Doubtful Accounts 50,000

This adjusting entry affects the accounting equation in the following manner: Assets will go down
because the Credit Allowance for Doubtful Accounts will bring down the Net Realizable Value Accounts Receivable.
Equity will go down because an expense is recorded-Depreciation Expense.

When later on ,a receivable is proved to be uncollectible, it is simply off. For example, P20,000 is deemed
uncollectible, the entry is simply:

Dr. Allowance for Doubtful Accounts 20,000

Cr. Accounts Receivable 20,000

Take note that the amount written off is just the amount that has been established as uncollectible. This
journal entry does not affect the amount of total assets because it reduces the amount of an asset account and its
contra-asset account. After making the entry, the balance of the Allowance for Doubtful Accounts is P30,000. This
amount is compared to the estimated Bad Debts Amount from the accounts receivable in the subsequent period to
determine the Bad Debts Expense to be recorded.

In the next accounting, for instance, the ending balance of accounts receivable is P1,500,000. If the
estimated doubtful accounts of 5%is still valid, these figures are just multiplied to get P75,000. Again, take note
that this is the required balance of the allowance account, not necessarily the amount to be recorded as bad debts
expense. Since there is already an existing P30,000 balance, only the deficiency of P45,000 is recorded as Bad
Debts Expense. The entry should be :

Dr. Bad Debts Expense 45,000

Cr Allowance for Doubtful Accounts 45,000

Notice that by making this adjusting entry, the new balance of the allowance account is now P75,000

Prepaid Expenses

As the name suggests, these expenses are paid even before they are incurred. The outlay of cash
precedes the actual consumption of the economic events . Prepaid expenses are usually periodic expenses which
are paid at the beginning of a certain period of time for convenience of both the payor and the payee. Most
prepaid expenses are expenses incurred every month, and instead of being bothered to go to the payee every
month to tender payment, the payor just pays the whole amount at the start of the period.

When cash is paid, the account cash account is credited to indicate the outflow of cash, while a prepaid
account is debited for the same amount. The pro-forma entry is as follows:

Dr. Prepaid Expense XXX

Cr. Cash XXX

When the prepaid expense has already expired, the following is the pro-forma adjusting entry:

Dr. Expense XXX

Cr. Prepaid Expense XXX

In the Matalino Dormitory example, there is a P6,000 balance in the prepaid insurance account. This
amount is insurance premium paid in July 1, for the next 6 months, or until December 31. Since period covered by
such prepaid expense has already lapsed, the balance should already be zero . Hence, we make the following
adjusting entry:

Dr. Insurance Expense 6,000

Cr. Prepaid Insurance 6,000

The adjusting entry affects the accounting equation in the f will go following manner: Assets will go down
because the credit to Prepaid Insurance will bring down the value of the Prepaid Insurance Account. Equity will go
down because an expense is recorded – Insurance Expense.
Accrued Expense

In prepaid expense, cash is disbursed before the incurrence of the actual expense. In accrued expense,
incurrence comes before the actual disbursement of cash. A perfect example of accrued expense is utilities, like
electricity and water. The actual bill for utilities comes after the month end, or any other period for that matter.
An expense should be recorded, although there is no actual outlay of cash. The pro-forma entry to record an
accrued expense is simply as follows:

Dr. Expense XXX

Cr. Accrued Expense Payable XXX

Again, following the Matalino Dormitory example, the total electricity, water, and telephone bills total
P32,983.20. In that case, the adjusting entry should be:

Dr. Utilities Expense 32,983.20

Cr. Utilities Payable 32,983.20

This adjusting entry affects the accounting in the following manner: Liability will go up because of the
credit to Utilities Payable. Equity will go down because an expense is recorded - Utilities
expense.

Unearned Revenue

In this particular type of adjusting entry, the first of two adjusting entries related to revenue, cash is
received first before services are rendered. This arrangement could be stipulated by certain companies, more
especially when enforcing cash collection is quite hard. When cash is received the following entry is made:

Dr. Cash XXX

Cr. Unearned Revenue XXX

As the period covered by the cash received expires, or the required services have already been rendered,
such revenue is deemed earned, rather than unearned. This is because the company has already provided the
economic benefits that are expected from it by the payor

As the period covered by the cash received expires, or the required services have already been rendered,
such revenue is deemed earned, rather than unearned. This is because the company has already provided the
economic benefits that are expected from it by the payor. When such revenue is earned, an adjustment of this
form should be made;

Dr. Unearned Revenue XXX

Cr. Revenue XXX

Notice that in the trial balance of Matalino Dormitory, there is a 30,000 credit balance in the Unearned
Rent Revenue account. Such amount is an advance payment made at the beginning of the year, to be applied to
the December. Although this rent payment is for the last month of the year, it has been agreed upon by the tenant
and the Matalino Dormitory that such payment be paid at the beginning of the year. In order to properly reflect
the amount of revenue earned during the year. In order to properly reflect the amount of revenue earned during
the year, the following adjusting entry should be made:

Dr. Unearned rent Revenue 30,000

Cr Rent Revenue 30,000

This adjusting entry affects the accounting equation in the following manner: Liability will go up because
a revenue is recorded - Rent Revenue
Accrued Revenue

Just like in the case of expenses, there is also an opposite of unearned revenue, and that is accrued
revenue. Instead of receiving rent in advance, rent is received after services are completely rendered. This is
usually the case when rendering of services is subject to certain conditions that would make it necessary to finish
rendering the services before payment is payment. Simply, the adjusting entry should be:

Dr. Receivable XXX

Cr. Revenue XXX

For instance, is a certain dormer in Matalino Dormitory failed to pay rent during a certain month, an
adjusting entry should still be made even though cash is yet to be received. The entry should be as follows:

Dr. Rent Receivable 30,000

Cr. Rent Revenue 30,000

This adjusting entry affects the accounting equation in the following manner: Assets will go up because of
the debit to Rent Receivable. Equity will go up because a revenue is recorded- Rent Revenue.

Adjusted Trial Balance

After all the adjusting entries are made, the adjusted trial balance can now be prepared. This is done by
updating the balances of the items from the adjusted trial balance, and if applicable, add items that came only
after the preparation of the adjusting entries. The adjusted trial balance is simply the unadjusted trial balance plus
the effects of the adjusting entries.

ACCOUNT NAME DEBIT CREDIT

Cash 1,079,291.56 -
Office Supplies 4,119.75 -
Accumulated Depreciation-Building - 625,000.00
Accumulated Depreciation -Furniture & - 20,000.00
Fixtures
Accumulated Depreciation - Computers 1,845.00
Building 12,500,000.00 -
Furniture & Fixtures 400,000.00 -
Computers 36,000.00
Refundable Customer Deposits - 30,000.00
Salaries and wages Payable - 15,875.00
Utilities Payable - 32,983.20
Notes Payable - 5,250,000.00
Owner’s Capital - 8,994,270.00
Owner’s Drawing 10,000.00 -
Salaries and Wages Expense 15,875.00 -
Depreciation Expense 646,845.00
Office Supplies Expense 5,000.00
Utilities Expense 376,941.89
Insurance Expense 12,000.00
Rent Revenue 360,000.00

Financial Statements

In financial reporting, there are several financial statements which serve different purposes. Some of
which are: income statement, balance sheet, statement of cash flows, statement of changes in equity, among
others. For the purposes of this chapter, the income statement and the balance sheet would be illustrated using
the Matalino Dormitory example.

Income Statement

The first financial statement to be prepared is the income statement. The simplified presentation of the
income statement should follow the following format:

Name of Company
Income Statement
Period Ended December 31, 20__

Revenue XXX

Expenses XXX

Other Gains and Losses XXX

Net Income XXX

The income statement basically contains all the nominal accounts, except the drawing accounts and the
income summary account.

Matalino Dormitory’s income statement is as follows:

Matalino Dormitory
Income Statement
For the Year Ended December 31, 2015

Rent Revenue 360,000

Salaries & Wages Expenses (258,875.00)

Depreciation Expense (646,845.00)

Office supplies expense ( 5,000.00)

Utilities Expense (376,941.89)

Insurance Expense ( 12,000.00)

Net Income (939,661.89)

Balance Sheet

Also as the statement of financial position, the balance sheet provides the amounts for the various assets,
liabilities, and owner’s capital accounts.

The assets are presented first, followed by the liabilities and equity. To show that the accounting
equation is satisfied, the total assets and the total liabilities and owner’s capital should be highlighted to be equal
amount.

The following is the recommended format:

Name of Company
Balance Sheet
As of December 31, 20XX

Asset 1 Liability 1
Asset 2 Liability 2
Asset 3 Total Liabilities
Asset 4
Asset 5 Owner’s Capital
Total Assets Total liabilities & owner’s Capital

Owner’s Capital

Notice that in the last line of the heading of the balance sheet, the phrase “ for the period ended” is used.
This is because the income statement is the result of operations on an entity for a particular period. Meanwhile, in
the heading of the balance sheet, the phrase “ as of” is used because what is shown are the amounts of assets,
liabilities, and owner’s capital at a certain point in time.

Usually , the assets and liabilities are presented according to their liquidity. Cash, being the most liquid
asset, is presented first, followed by receivables, inventories, and PPE accounts. Basically, the shorter the time an
asset is expected to be converted into cash, the more liquid it is, and this is the reason why cash is presented first.
The same is followed in the presentation of liabilities. Those liabilities expected to be paid first are presented
before those that will be paid later
Closing Entries

From the adjusted trial balance, closing entries are to be made. By making closing entries, all nominal or
temporary accounts are closed out to the owner’s capital account, through the income summary account. Closing
entries reduce the balances of the temporary accounts to zero to prepare then for accumulating amounts for
another accounting period.

The following pro-forma journal entries should be made:

Dr. Revenues
Cr. Income Summary

To close revenue accounts

Dr. Income Summary

Cr. Expenses

To close expense account

Dr. Income Summary

Cr. Owner’s Capital

To close income summary account if there is a Net Income

OR

Dr. Owner’s Capital

Cr. Income Summary

To close Income summary account is there is a net income.

Dr. Owner’s Capital

Cr. Owner’s Drawings
To close the drawing’s

The first two entries effectively close out all income statements accounts to the income summary
account. After making the first two entries, the balance of the income summary account is either a credit or a
debit, and should be equal to the amount of the net income or loss, respectively. The third entry closes out the
income summary account to the owner’s capital if there is a net income.

The fourth entry closes out the income summary account to the owner’s capital if there is a net loss. The
fifth entry closes the owner’s drawing to the owner’s capital. It should be noted that although there is an outflow
of resources in owner’s drawings, it is not included in the income statement since it is purely a transaction with the
owner.

Closing Entries of Matalino Dormitory

Rent Revenue 360,000

Income Summary 360,000

To close the revenue account

Income summary 1,299,661.89

Salaries and Wages Expense 258,875.00

Depreciation Expense 646,845.00
Office Supplies Expense 5,000.00
Utilities Expense 376,941.89
Insurance Expense 12,000.00

To close expense account

Owner’s Capital 8,994,270.00

Income Summary Owner’s capital 8,994,270.00