Unit 9: Analyzing Business Transactions: Service Type of Business

Lesson 9.5
Accounting Cycle for Service-Type Businesses:
Adjusting
Contents
Introduction 1

Learning Objectives 2

Quick Look 3

Learn the Basics 5

Adjusting Entries 6
Basis of Adjusting Entries 6
Types of Adjusting Entries 7
Non-cash Expenses 7
Accruals 12
Deferrals 17
Alternative Method of Recording Deferrals 24
Preparing an Adjusted Trial Balance 33

Case Study 35

Keep in Mind 36

Try This 38

Practice Your Skills 39

Challenge Yourself 41

Photo Credits 44

Bibliography 44
Unit 9: Analyzing Business Transactions: Service Type of Business

Lesson 9.5

Accounting Cycle for Service-Type

Businesses: Adjusting

Introduction

Did you know that not all revenues and expenses of a business come from cash
transactions? This means that a company may recognize revenue even if its client did not
pay in cash, and a business may recognize an expense even if the business has not paid it
yet.

Recognizing revenue and expenses in the proper accounting period will assist the business
in understanding its actual financial situation. It shows the company the outstanding
receivables its customers owe and the financial obligations that the business must meet.
Hence, a business can measure its business activities, and it can adequately analyze, plan,
and implement actions to achieve its strategic goals and objectives. Furthermore, suppose

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 1

Unit 9: Analyzing Business Transactions: Service Type of Business

the business cannot accurately reflect its financial situation. In that case, other entities such
as banks may refuse to lend money to the company because the latter cannot determine
whether the business can repay loans.

To recognize revenue and expense in the accounting period in which they are earned and
incurred, businesses use the accrual method of accounting and prepare adjusting entries.

Learning Objectives DepEd Competency

Prepares adjusting entries

In this lesson, you should be able to do the
(ABM_FABM11-IVa-d -33).
following:
● Identify the purpose of adjusting entries.

● Prepare adjusting entries for non-cash

expenses and accruals.
● Differentiate the process of adjusting
entries for deferrals using the balance
sheet method and income statement
method.

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Unit 9: Analyzing Business Transactions: Service Type of Business

Quick Look

Preparing Adjusting Entries

Cath is an accountant of Daniel Consulting, and she is tasked to prepare the company’s
financial statements for the year 20x2. She has journalized the transactions, posted them to
the ledger and prepared an unadjusted trial balance. She is currently analyzing the
company’s accounts that require adjusting entries. She discovered that on November 2, the
former accountant recorded a debit of ₱54,000 to the administrative expenses account for
availing auditing services from AM Accounting Office from November 20x2 to April 20x3.

Questions to Ponder
1. What is the journal entry made by the former accountant to recognize the
administrative expense worth ₱54,000 on November 2?

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Unit 9: Analyzing Business Transactions: Service Type of Business

2. What adjusting entry should Cath record to update the administrative expense
account at the end of the year?

3. Assuming that no other adjustments are made to the administrative expense

account, how much should the Prepaid Expense and Administrative Expense be in
the Balance Sheet and Income Statement?

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 4

Unit 9: Analyzing Business Transactions: Service Type of Business

Learn the Basics

Large corporations use an accrual method of accounting to record revenue and expenses.
In this method, a business recognizes revenue when the service is rendered to their clients,
regardless of when the business received the cash payment; and it recognizes expenses
when incurred, regardless of when the business paid in cash.

On the contrary, small businesses use the cash basis of accounting. In this method, the
business recognizes revenue when the customer pays in cash, while the business recognizes
expense when the business pays for it. Generally, small businesses record cash at the start
of the day, and count it again at the end of the day. The difference represents the business’
income.

Table 1. Accrual vs Cash method of Accounting

Recognizes revenue when Recognizes expenses when

Accrual Method service is rendered expenses is incurred

Cash Method cash is received expenses is paid

Essential Question

Why should small businesses use the accrual accounting method to record
revenue and expenses?

In the previous lesson, you learned how to prepare a Trial Balance. It is also known as
Unadjusted Trial Balance because the balances are not yet updated to reflect adjustments to
the accounts, such as accruals and deferrals. To recognize the accruals and deferrals, an
accountant prepares adjusting entries. Adjusting entries are necessary for the preparation of
an Adjusted Trial Balance. An Adjusted Trial Balance has updated account balances,
meaning the adjustments of the accounts are reflected in the balances. The account balances
in the Adjusted Trial Balance are then used to prepare the financial statements.

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 5

Unit 9: Analyzing Business Transactions: Service Type of Business

Figure 1. Steps prior to the preparation of financial statements

Adjusting Entries
Adjusting entries are journal entries used to update a business’s account balances before
the preparation of financial statements. An accountant prepares adjusting entries because
some accounts affect more than one accounting period. By adjusting the account balances,
there will be no overstatement or understatement of balance sheet and income statement
accounts.

Basis of Adjusting Entries

The preparation of adjusting entries adheres to the revenue recognition, expense
recognition, and matching principles. The revenue recognition principle states that a
company should recognize revenue when earned and realized, regardless of when cash is
received. Whether a client has paid for the services of a business or not, the company must
record an income in its accounting books as long as it has rendered the services. On the
other hand, the expense recognition principle states that whether the company has paid
for expenses or not, it should record the expense in the accounting books as long as the
expenses have been incurred. And according to the matching principle, expenses should
match their related revenues in the same accounting period.

Adjusting entries recognizes the amount of income that the company has earned even if it is
not yet paid for by the client and the amount of expenses incurred even if the business does
not yet pay it during the reporting period. Moreover, recording adjusting entries involves
recognizing an income or an expense with a corresponding asset or liability account.
Therefore, an adjusting entry affects both the Statement of Financial Position and the
Statement of Comprehensive Income accounts.

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Unit 9: Analyzing Business Transactions: Service Type of Business

Types of Adjusting Entries

Business transactions usually have a timing difference in recognizing income or expense and
cash flows in accrual accounting. The recognition of income may not be the same as the time
of receipt of cash, and the recognition of expense may not be the same period when the
company pays it. There are three types of adjusting entries made at the end of the
company's accounting period: non-cash expenses, accruals, and deferrals.

Non-cash Expenses
Non-cash expenses are expenses incurred by the business even if no cash payment is made.
These could be those initially recorded as assets when acquired, which are allocated over
time to recognize the relevant portion to be expensed. An example is depreciation expense
which pertain to the allocation of the acquisition cost of a property, plant, or equipment over
its useful life.

Depreciation refers to the decrease in the value of a fixed asset, e.g. building, vehicle,
furniture, equipment, machinery, and the like as they become worn and torn because of
usage and passage of time.

Closer Look

How much is it worth now?

Lara bought a laptop worth ₱50,000 for the business during the current
year. In the future, the worth of the laptop will be less than what Lara
paid for because time has passed and Lara already used the laptop.

The amount of depreciation of a depreciable asset is recorded as Depreciation Expense. It

is an expense account, even if it doesn’t involve cash payment. Because of the matching
principle, the business must recognize depreciation as an expense because income is
generated when an asset is used. Therefore, the increase in expense will be recorded as
debit.

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Unit 9: Analyzing Business Transactions: Service Type of Business

Moreover, the amount of depreciation expense is not deducted directly from its related
asset account. Instead, the amount will be recorded to Accumulated Depreciation, a
contra-asset account. The asset's original cost less accumulated depreciation are disclosed
in the Statement of Financial Position. The accumulated depreciation decreases the asset
therefore, it will be recorded as a credit.

General Journal Page 1

Date Account Title and Description Ref Debit Credit

Dec 20x2

31 Depreciation Expense xx

Accumulated Depreciation xx

To record depreciation for the

period.

Figure 2. Pro-forma adjusting entry for Depreciation Expense

There are several ways to compute the depreciation of an asset. One of the most common
and simplest methods is the straight-line method. The formula to calculate the annual
depreciation using the straight-line method is:

Cost refers to the acquisition cost of a fixed asset plus any directly attributable cost incurred
by the company to make it ready for use. Examples of directly attributable costs are freight
and installation cost. There are costs that are outright charged to expenses when incurred.
Costs that are not directly attributable to an asset to make it ready for use, such as
vandalism, installation error, and fines for not obtaining permits, are not included in the
fixed asset cost.

The value of an asset once it is sold to third parties at the end of its useful life refers to
Salvage Value. It is also known as scrap value or residual value. On the other hand, the

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Unit 9: Analyzing Business Transactions: Service Type of Business

difference between the cost of the fixed assets and the salvage value refers to Depreciable
Cost. The depreciable cost is allocated to depreciation expense every accounting period
throughout the fixed asset's life. If the fixed asset does not have a salvage value at the end
of its estimated useful life, then its cost is to be depreciated throughout its life. On the other
hand, Estimated Useful Life is the number of years a fixed asset can be used in the
business.

Book value is the difference between the asset's cost and the accumulated depreciation.
The book value of the fixed asset is the net amount presented on the Statement of Financial
Position. Moreover, the book value of an asset is not necessarily the price at which the fixed
asset could be sold. Since depreciation of fixed assets is not directly related to its fair value
or market value, i.e, price upon which the seller and buyer agrees upon; an asset can be
sold higher or lower than its book value.

Closer Look

KBMS’ Annual Depreciation

Liza is an accountant of Kirie Business Management Services (KBMS). She
is tasked to prepare the adjusting entries at the end of the calendar year.

Kirie Business Management Services

Unadjusted Trial Balance
December 31, 20x2

Account Name Ref Debit Credit

Cash ₱21,000
Accounts Receivable 41,600
Supplies 0
Prepaid Insurance 20,000
Equipment 290,000
Accumulated Depreciation ₱93,000
Accounts Payable 15,200
Unearned Consultation Fees 37,000
Salaries Payable 0
Taxes Payable 40,800

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Unit 9: Analyzing Business Transactions: Service Type of Business

Notes Payable 40,000

Interest Payable 0
Kirie, Capital 143,700
Kirie, Drawing 5,000
Consultation Fees 56,300
Depreciation Expense 0
Administrative Expense 10,000
Advertising Expense 12,000
Rent Expense 20,000
Supplies Expense 6,400
Insurance Expense 0
Interest Expense 0
Total ₱426, 000 ₱426, 000

Figure 3. KBMS’ unadjusted trial balance.

A copy of the unadjusted trial balance of the business was given to Liza.
Liza determined that the equipment is estimated to have a useful life of
ten years without any salvage value. Liza is asked to compute the annual
depreciation & book value and to give the adjusting entry at year-end.

Given:
Cost = ₱290,000
Salvage Value = ₱0
Estimated Useful Life = 10 years

𝐶𝑜𝑠𝑡 − 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒

𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒

₱290,000 − ₱0
𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 10

𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = ₱29, 000

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 10

Unit 9: Analyzing Business Transactions: Service Type of Business

The adjusting entry would be:

Kirie Business Management Services

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

Dec 31 Depreciation Expense 29,000

Accumulated Depreciation 29,000

To record depreciation for the period.

Figure 4. Adjusting entry for equipment of Kirie Business Management

Services

After calculating the depreciation for the accounting period, Liza can
compute the book value of the equipment. The solution would be:

𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 = 𝐶𝑜𝑠𝑡 − 𝐴𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛

𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 = ₱290, 000 − ₱122, 000

𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 = ₱168, 000

In computing the book value of a fixed asset, the amount of accumulated

depreciation represents the cumulative balance of depreciation
recognized throughout the years. Since the equipment is the only fixed
asset of KBMS, the 93,000 accumulated depreciation presented in the
trial balance pertains to the equipment. And so, the total accumulated
depreciation that should be considered when computing its book value
should be 122,000 (93,000 depreciation from previous periods + 29,000
depreciation from the current period).

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Unit 9: Analyzing Business Transactions: Service Type of Business

Analysis: The depreciation worth ₱29,000 increased the expense,

decreasing the owner’s equity, and decreased the asset of the business.
Therefore, the adjusting entry will require a debit to Depreciation
Expense to recognize the increase in expense; and a credit to
Accumulated Depreciation to recognize the decrease in Assets.

Check Your Progress

Marie Company purchased office equipment on July 1, 20x2, for ₱250,000. It

has an estimated life of 8 years with a salvage value worth ₱20,000. What is
the adjusting entry on December 31, 20x2?

Accruals
Accruals refer to revenue earned by the business but will be collected at a future date or
expenses already incurred but payable on a future date. There are two types of accruals:
Accrued Revenues and Accrued Expenses.

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Unit 9: Analyzing Business Transactions: Service Type of Business

Accrued Revenues are unrecorded revenues that the company has earned but remain
uncollected. Some examples of accrued revenue are the accrual of interest from notes
receivable and accrual of revenue (i.e., service revenue and professional fees). Since the
revenues are uncollected, they increase the company's assets; and since the revenues are
already earned, they increase the income, increasing the owner's equity. The increase in the
asset will be recorded as a debit to a receivable account, while the increase in income will be
recorded as a credit to an income account.

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

Dec 31 Receivable xx

Revenue xx

To record accrued revenue for the period

Figure 5. Pro-forma adjusting entry for Accrued Revenues.

Closer Look

KBMS’ Accrued Revenue

Kirie Business Management Services (KBMS) entered into a contract with
Enrique Cafe to perform consulting services worth ₱4,000 per quarter, to
be paid 60 days after Kirie Business Management Services files its
quarterly VAT reports. KBMS filed its 3rd Quarter VAT reports on
December 28. The adjusting entry would be as follows:

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Unit 9: Analyzing Business Transactions: Service Type of Business

Kirie Business Management Services

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

Dec 31 Accounts Receivable 4,000

Consulting Fees 4,000

To record accrual of services

performed to Enrique Company.

Figure 6. Adjusting entry for KBMS accrued revenue as of December 31.

Analysis: The accrued revenue worth ₱4,000 increased the asset and
income, increasing the owner’s equity of the business. Therefore, the
adjusting entry will include a debit to Accounts Receivable to recognize
the increase in asset; and a credit to Consulting Fees to recognize the
increase in income.

Accrued Expenses are expenses that have been incurred by the business but are yet to be
recorded and yet to be paid. Some examples of accrued expenses are accrual of interest
from notes payables, accrual of wages, rent, and other expenses to be paid in the next
accounting period. Since the business has incurred the expenses, they increase the
company’s expense, decreasing the owner’s equity; and since the expenses are not yet paid,
they increase liability. The increase in expense will be recorded as a debit to an expense
account, while the increase in liability will be recorded as a credit to a liability account.

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 14

Unit 9: Analyzing Business Transactions: Service Type of Business

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

Dec31 Expense xx

Payable xx

To record accrued expense for the

period.

Figure 7. Pro-forma adjusting entry for Accrued Expenses.

Closer Look

KBMS’ Accrued Interest

Kirie Business Management Services (KBMS) borrowed ₱40,000 in notes
payable from Honest Bank on April 1 of the current year, with an interest
rate of 5% and it is payable after three years. The interest is paid every
March 31, until the loan’s maturity date. Liza is asked to compute the
interest and give the adjusting entry at year-end.

Given:
Principal = ₱40,000
Rate = 5%
9
Time= 12

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑅𝑎𝑡𝑒 × 𝑇𝑖𝑚𝑒

9
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = ₱40, 000 × 0. 05 × 12

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = ₱1, 500

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 15

Unit 9: Analyzing Business Transactions: Service Type of Business

The adjusting entry would be:

Kirie Business Management Services

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

Dec 31 Interest Expense 1,500

Interest Payable 1,500

To record accrued interest on notes

payable.

Figure 8. Adjusting entry for accrued interest of Kirie Business

Management Services
Analysis: The accrued interest worth ₱1,500 increased the expense,
decreasing the owner’s equity, and increased the liability of the business.
Therefore, the adjusting entry will require a debit to Interest Expense to
recognize the increase in expense; and a credit to Interest Payable to
recognize the increase in liability.

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 16

Unit 9: Analyzing Business Transactions: Service Type of Business

Check Your Progress

Passion Pharmaceutical Company provides RT-PCR tests that cost ₱3,000

per test. At year end, the company discovered that five people were given
RT-PCR tests but they remained unbilled. What is the adjusting entry at
year-end?

Deferrals
Deferrals involve advance payments made by the company for future expenses or advance
payments of a company’s client for future services. There are two ways to record the
deferrals: The Balance Sheet method and the Income Statement method. The
succeeding discussion will focus on the Balance Sheet method.

When a business pays expenses in advance, this refers to Prepayments. Prepayments are
also known as Deferred Expenses or Prepaid Expenses. Insurance, administrative, and

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Unit 9: Analyzing Business Transactions: Service Type of Business

rent payments are typical examples of these. Prepayments are considered assets, but they
become an expense when they are already consumed or have expired.

Closer Look

Prepaid Load
Prepaid Load is an example of a prepayment. For instance, Lara paid for
prepaid phone credits worth ₱300. As long as Lara has not called or
texted anyone, the phone credits worth ₱300 are considered a
prepayment, an asset. But, once Lara consumes part of her phone credits
(she texted or called somebody), the worth of consumption will be
considered an expense.

When a prepayment has been consumed or has expired, an adjusting entry has to be made
in the accounting records so that there will be no overstatement of assets and no
understatement of expenses. Since prepayments, when used, become an expense, it will
increase expenses, decreasing the owner’s equity. At the same time, the used portion of the
prepayment will be a decrease to its related asset account. Therefore, the decrease in
owner’s equity will be recorded as a debit to an expense account, while the decrease in the
asset will be recorded as a credit to a prepaid expense account.

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

Dec 31 Expense xx

Prepaid Expense xx

To record the recognition of expense

from prepaid expense

Figure 9. Pro-forma adjusting entry for Prepayments under the balance sheet method

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Unit 9: Analyzing Business Transactions: Service Type of Business

Closer Look

KBMS’ Prepaid Expense - Balance Sheet Method

On June 1, 20x2, Kirie Business Management Services (KBMS) acquired 16
months worth of prepaid insurance for ₱20,000. Liza, KBMS’ accountant,
recorded the transaction as follows:

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

June 1 Prepaid Insurance 20,000

Cash 20,000

To record payment of insurance for 16

months.

Figure 10. Entry to record the prepayment under the balance sheet
method

At the end of the accounting period, Liza should prepare an adjusting

entry to record the cost of insurance that expired during the year. The
expired portion of the prepayment will be recorded as an expense. The
expired insurance is ₱8,750, and its adjusting entry would be as follows:

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Unit 9: Analyzing Business Transactions: Service Type of Business

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

Dec 31 Insurance Expense 8,750

Prepaid Insurance 8,750

To record expired insurance from

June 1 to December 31

Figure 11. Adjusting entry for KBMS’ prepayment under the balance sheet
method

Analysis: The expired portion of the insurance worth ₱8,750 increased the
expense, decreasing the owner’s equity, and decreased the asset of the
business. Therefore, the adjusting entry will require a debit to Insurance
Expense to recognize the increase in expense; and a credit to Prepaid
Insurance to recognize the decrease in asset.

Computation:
₱20, 000 ÷ 16 × 7 = 8, 750. The cost of prepaid insurance, ₱20,000, was
divided into 16 months to get the cost of insurance per month. The
quotient is then multiplied to 7 because there are seven months from
June 1 to December 31.

On the other hand, when clients make advance payments to the business for contracts
involving future services, this refers to Deferred Revenue or Unearned Revenue. Deferred
Revenues are considered liabilities because the business has an obligation to render the
service that was paid for in advance.

Once the services have been rendered, the accountant should record a portion or all of the
liability account to the revenue account for having provided services to the client at the end
of the accounting period. Since the business has rendered the services, its effect on the

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Unit 9: Analyzing Business Transactions: Service Type of Business

accounting equation would be a decrease in liability and increase in revenue, increasing

owner’s equity. The decrease in liability would require a debit to an Unearned Revenue
account, while the decrease in owner’s equity would require a credit to a revenue account.

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

Dec 31 Unearned Revenue xx

Revenue xx

To record the revenue as a result of

rendering service to the clients.

Figure 12. Pro-forma adjusting entry for Deferred Revenue under the Balance Sheet Method

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 21

Unit 9: Analyzing Business Transactions: Service Type of Business

Closer Look

KBMS’ Unearned Revenue - Balance Sheet Method

Kirie Business Management Services (KBMS) entered into a contract worth
₱92,500 to prepare financial statements for its clients for the period
October 1 20x2 to September 30, 20x3. The contract also states that KBMS’
client should put down a 40% down payment for the services.

KBMS would record the transaction as follows:

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

Oct 1 Cash 37,000

Unearned Consulting Fees 37,000

To record the receipt of an advance

payment from the client.

Figure 13. Recording the advance payment from the clients under the
balance sheet method.

Analysis: Receiving cash for a contract worth ₱37,000 to render services will
increase the asset and increase the liability of the business. Therefore, the
entry will require a debit to Cash to recognize the increase in asset; and a
credit to Unearned Consulting Fees to recognize the increase in liability.

At the end of the accounting period, Liza found out that Kirie Business
Management Services (KBMS) performed consulting fees worth ₱30,000.

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Unit 9: Analyzing Business Transactions: Service Type of Business

Liza would record the transaction as follows:

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

Dec 31 Unearned Consulting Fees 30,000

Consulting Fees 30,000

To record consulting fees earned from

the client.

Figure 14. Adjusting entry for KBMS’ unearned revenue under the balance
sheet method

Analysis: The rendered portion of the unearned consulting fees worth

₱30,000 decreased the liability and increased the revenue, increasing the
owner’s equity of the business. Therefore, the adjusting entry will require a
debit to Unearned Consulting Fees to recognize the decrease in liability;
and a credit to Consulting Fees to recognize the increase in revenue.

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 23

Unit 9: Analyzing Business Transactions: Service Type of Business

Check Your Progress

On October 1, 20x2, YLA Accounting Office received one year worth of

accounting fees for ₱180,000. What is the adjusting entry on December 31,
20x2.

Keep in mind that transactions are initially recorded as prepayments and unearned revenue
under the Balance Sheet method. Thus, the expired or used portion of the prepayment, and
the rendered portion of the services are recorded as adjusting entries.

Alternative Method of Recording Deferrals

The Income Statement method is an alternative way to record prepayments and deferred
revenue. In recording prepayments under the Income Statement method, transactions are
initially recorded as expenses rather than prepaid expenses. Note that the amount paid to
purchase the prepayment will be recorded as a debit to an Expense account.

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Unit 9: Analyzing Business Transactions: Service Type of Business

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

Expense xx

Cash xx

To record cash payment of insurance for

n months

Figure 15. Recording prepayments under the income statement method.

Consequently, the accountant will record the advance payment for future expenses for the
adjusting entry. At the end of the accounting period, the accountant will compute the unused
portion of the insurance and will record it as a debit to a Prepaid Expense account.

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

Dec 31 Prepaid Expense xx

Expense xx

To record the prepaid expense for the

next period

Figure 16. Pro-forma adjusting entry for Prepayments under the income statement method

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 25

Unit 9: Analyzing Business Transactions: Service Type of Business

Closer Look

KBMS’ Prepaid Insurance - Income Statement Method

The previous accountant of Kirie Business Management Services (KBMS)
used the Income Statement method to record the advance payment of
insurance for 16 months worth ₱20,000 on June 1. The entry would be as
follows:

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

June 1 Insurance Expense 20,000

Cash 20,000

To record cash payment of insurance

for 16 months

Figure 17. Entry to record the acquisition of insurance under the income
statement method

The adjusting entry to reflect the amount of the remaining Prepaid

Insurance of KBMS would be as follows:

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

Dec 31 Prepaid Insurance 11,250

Insurance Expense 11,250

To record prepaid insurance from Jan 1

to Sept 30 of the next period

Figure 18. Adjusting entry to KBMS’ prepaid insurance under the income
statement method

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 26

Unit 9: Analyzing Business Transactions: Service Type of Business

Computation:
₱20, 000 − ₱8, 750 = 11, 250. To compute the amount of the remaining
Prepaid Insurance, we get the cost of insurance prior to adjustment
(₱20,000) and deduct the expired portion of the insurance (₱8,750).

₱20, 000 ÷ 16 × 7 = ₱8, 750. To compute the expired portion of

prepaid insurance, the cost of prepaid insurance (₱20,000) was divided
into 16 months to get the cost of insurance per month. The quotient is
then multiplied to 7 because there are seven months from June 1 to
December 31.

Analysis: The remaining portion of the Prepaid Insurance worth ₱11,250

increased the asset, and decreased the expense, increasing the owner’s
equity. Therefore, the adjusting entry will require a debit to Prepaid
Insurance to recognize the increase in asset; and a credit to Insurance
Expense to recognize the decrease in expense.

Keep in mind that the amount debited to the prepaid expense account represents the
prepaid expense in the following accounting period.

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 27

Unit 9: Analyzing Business Transactions: Service Type of Business

Closer Look

KBMS’ Supplies - Income Statement Method

The supplies expense account of Kirie Business Management Services
showed a balance of ₱6,400. Prior to adjustments, Liza found out that the
supplies were reduced to ₱2,000 at the end of the accounting period. Liza
made the following adjusting entry to match the ending balance of the
Supplies account:

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

Dec 31 Supplies 2,000

Supplies Expense 2,000

To record the remaining supplies for

the year.

Figure 19. Adjusting entry for KBMS’ supplies expense under the income
statement method

Analysis: The ending balance of supplies worth ₱2,000 increased the asset
and decreased the expense, increasing owner’s equity. Therefore, the
adjusting entry will require a debit to Supplies to recognize the increase in
asset and a credit to Supplies Expense to recognize the decrease in
expense.

In practice, both the Balance Sheet method and the Income Statement method of recording
prepayments are acceptable because the ending balance of each account will be the same
regardless of the method used by the accountant.

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 28

Unit 9: Analyzing Business Transactions: Service Type of Business

Referring to the previous example of prepayment, On June 1, Kirie Business Management

Services (KBMS) acquired 16 months worth of prepaid insurance during the year for ₱20,000; we
can see through the comparison below (fig 20 and fig 21) that the ending balance for both
the prepaid expense and expense account are the same under the two methods.

Prepaid Insurance Insurance Expense

June 1 20,000 Dec 31 8,750 Dec 31 8,750

End Bal 11, 250 End Bal 8, 750

Fig. 20 Recording prepayments under the Balance Sheet method

Prepaid Insurance Insurance Expense

Dec 31 11,250 June 1 20,000 Dec 31 11,250

End Bal 11, 250 End Bal 8, 750

Figure 21. Recording prepayments under the Income Statement method

On the other hand, in recording deferred revenue under the Income Statement method,
transactions are initially recorded as income rather than as liabilities. Take note that the
amount received to render the services in the future will be recorded as a credit to a
Revenue account.

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

Cash xx

Revenue xx

To record cash receipt for services for n

months

Figure 22. Recording deferred revenue under the income statement method.

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 29

Unit 9: Analyzing Business Transactions: Service Type of Business

Consequently, the accountant will record the client's advance payment for future services for
the adjusting entry. At the end of the accounting period, the accountant will compute the
unearned portion of the revenue and will record it as a credit to an Unearned Revenue
account.

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

Dec 31 Revenue xx

Unearned Revenue xx

To record the unearned revenue for the

next period

Figure 23. Pro-forma adjusting entry for deferred revenue under the income statement
method

Closer Look

KBMS’ Unearned Revenue - Income Statement Method

Kirie Business Management Services (KBMS) entered into a contract worth
₱92,500 to prepare financial statements for its clients for the period
October 1 20x2 to September 30, 20x3. The contract also states that KBMS’
client should put down a 40% down payment for the services.

Let us assume that KBMS records the transaction initially at the income
statement method. KBMS would record the transactions as follows:

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 30

Unit 9: Analyzing Business Transactions: Service Type of Business

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

Oct 1 Cash 37,000

Consulting Fees 37,000

To record the receipt of an advance

payment from the client.

Figure 24. Recording the advance payment from the clients under the
income statement method.

Analysis: Receiving cash worth ₱37,000 as a downpayment for a contract to

render services will increase the asset and increase the revenue of the
business. Therefore, the entry will require a debit to Cash to recognize the
increase in asset; and a credit to Consulting Fees to recognize the increase
in the revenue.

At the end of the accounting period, Liza found out that Kirie Business
Management Services (KBMS) performed consulting fees worth ₱30,000.
KBMS would record the transaction as follows:

General Journal Page 1

Date Account Title and Description Ref Debit Credit

20x2

Dec 31 Consulting Fees 7,000

Unearned Consulting Fees 7,000

To record consulting fees still

unearned

Figure 25. Adjusting entry for KBMS’ unearned revenue under the income
statement method

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 31

Unit 9: Analyzing Business Transactions: Service Type of Business

Computation:
₱37, 000 − ₱30, 000 = ₱7, 000. To compute the remaining amount of
unearned revenue at the end of the accounting period, we get the
difference between the revenue recorded during the receipt of advance
payment (₱37,000) and the earned revenue (₱30,000).

Analysis: The remaining unearned revenue worth ₱7,000 decreased the

revenue, decreasing owner’s equity, and increased the liability. Therefore,
the adjusting entry will require a debit to Consulting Fees to recognize the
decrease in the revenue and credit the Unearned Consulting Fees to
recognize the remaining liability of the company.

Like in prepayments, both the Balance Sheet method and the Income Statement method of
recording deferred revenue are acceptable because the ending balance of each account will
be the same regardless of the method used by the accountant.

Referring to the previous example of deferred revenue, Kirie Business Management Services
(KBMS) entered into a contract worth ₱92,500 to prepare financial statements for its clients for
the period October 1, 20x2 to September 30, 20x3. The contract also states that KBMS’ client
should put down a 40% down payment for the services; we can see in (fig 26 and fig 27) that the
ending balance for both the unearned revenue and revenue account are the same.

Unearned Consulting Fees Consulting Fees

Dec 31 30,000 Oct 1 37,000 Dec 31 30,000

End Bal 7, 000 End Bal 30, 000

Figure 27. Recording deferred revenue under the Balance Sheet method

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 32

Unit 9: Analyzing Business Transactions: Service Type of Business

Unearned Consulting Fees Consulting Fees

Dec 31 7,000 Dec 31 7,000 Oct 1 37,000

End Bal 7, 000 End Bal 30, 000

Figure 27. Recording deferred revenue under the Income Statement method

Preparing an Adjusted Trial Balance

After recording the necessary adjustments, the accountant can now prepare an adjusted
trial balance. An Adjusted Trial Balance lists the updated general ledger balances, except
for the owner's capital account, following the adjustments made by the accountant. From
the adjusted trial balance, the accountant can prepare the financial statements.

If the totals in the adjusted trial balance's debit and credit columns do not equal, it indicates
that errors were made during the adjustment process. However, even if the adjusted trial
balance is equal, it does not automatically mean that no errors were committed. For
instance, if an accountant omits an adjusting entry, the adjusted trial balance will still be
equal.

To illustrate the adjusted trial balance, assume that Liza has completed preparing the
adjusting entries of Kirie for the period. She then prepares an adjusted trial balance in the
worksheet. The adjusted trial balance is presented below.

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 33

Unit 9: Analyzing Business Transactions: Service Type of Business

Kirie Business Management Services

December 31, 20x2

Trial Balance Adjustment Adjusted Trial Balance

Account Name Debit Credit Debit Credit Debit Credit

Cash 21,000 21,000
Accounts Receivable 41,600 4,000 45,600
Supplies 0 2,000 2,000
Prepaid Insurance 20,000 8,750 11,250
Equipment, Gross 290,000 290,000
Accumulated Depreciation 93,000 29,000 122,000
Accounts Payable 15,200 15,200
Unearned Consultation Fees 37,000 30,000 7,000
Taxes Payable 40,800 40,800
Notes Payable 40,000 40,000
Interest Payable 0 1,500 1,500
Kirie, Capital 143,700 143,700
Kirie, Drawing 5,000 5,000
30,000
Consultation Fees 56,300 4,000 90,300
Depreciation Expense 0 29,000 29,000
Administrative Expense 10,000 10,000
Advertising Expense 12,000 12,000
Rent Expense 20,000 20,000
Supplies Expense 6,400 2,000 4,400
Insurance Expense 0 8,750 8,750
Interest Expense 0 1,500 1,500

Total 426, 000 426, 000 75, 250 75, 250 460, 500 460, 500

Figure 28. KBMS adjusted trial balance

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 34

Unit 9: Analyzing Business Transactions: Service Type of Business

Case Study

The Fraud Scandal of the Waste Management Inc.

Founded in 1894, Waste Management Incorporation is an environmental
services company that manages waste. It is a public company, i.e., anyone
can purchase its shares, and it has an approximate revenue of $80
million. When Waste Management, Inc. acquired Service Corporation of
America in the 1980s, it became the leading waste management service in
the country. However, between 1992 and 1997, the company was
involved in fraudulent accounting schemes.

These schemes involved increasing its salvage value and prolonging the
estimated useful life of the company's long-term assets. Moreover, due to
the decrease in the value of its company, it purposefully deferred
recording its expenses. It recognized its expenses as assets to further
defer the recording of expenses.

In doing these schemes, the company recorded higher net income, and as
a result, it attracted many investors. A company with high profits is more
attractive to investors because it reflects profitability.

However, in the case of Waste Management Inc., the company is not

profitable because it declared false profits. Because of its fraudulent
schemes, the company reduced its operating expenses to roughly $490
million. When its irregular accounting schemes were made known to the
public, the stock price decreased by 33%, and its shareholders lost about
$6 billion in market value. The auditor of Waste Management Inc. was
fined $7 million, and the company was made liable to pay $457 million.

Adjusting entries makes the business reflect its proper financial condition,
but accountants should not prepare it to defraud others. Businesses
maintain integrity in their financial statements because many users rely

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 35

Unit 9: Analyzing Business Transactions: Service Type of Business

on it, such as suppliers, lenders, and even the company's stakeholders.

The actual condition of the business will help all parties to make their
decisions to achieve their goals and objectives.

The Waste Management, Inc. 1998 Fraud Scandal

“The Waste Management, Inc. 1998 Fraud Scandal.” Ellrich
Neal Smith Stohlman PA. Accessed February 8, 2022.
https://ensscpa.com/waste-management-inc-1998-fraud-scan
dal/.

Keep in Mind

● Recognition of revenue and income in the period in which they are earned and incurred
through the preparation of adjusting entries reflect the actual financial condition of the
business. Adjusting entries does not involve Cash.
● Generally adjusting entries are classified as: non-cash expenses, accruals, and
deferrals.
● There are two examples of accruals: accrued expenses and accrued revenue. Accrued
Expenses are expenses already incurred but not yet paid; while Accrued Revenues are
income already earned but not yet received.
● There are two examples of deferrals: Prepayments (Deferred Expenses) and Deferred
Revenue. Deferrals can be recorded using the Balance Sheet or the Income Statement
method. Prepayments are expenses already paid but not yet used; while Deferred
Revenue are income already received but not yet earned.
● After preparing the adjusting entries, the accountant can prepare the adjusted trial
balance and from there, prepare the financial statements.

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 36

Unit 9: Analyzing Business Transactions: Service Type of Business

Summary of Adjusting Entries

Comparison of accruals and deferrals

Incurred/Earned? Paid/Received?

Accrued Expenses Incurred Not Paid

Accrued Revenue Earned Not Received

Prepayments Not Incurred Paid

Deferred Revenue Not Earned Received

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 37

Unit 9: Analyzing Business Transactions: Service Type of Business

Try This

A. True or False. Write true if the statement is correct. Otherwise, write false.

________________ 1. Depreciation expense is a contra-asset account.

________________ 2. Unearned revenue requires an adjusting entry when the

company renders services to its clients. It is an example of
accrued revenue.

________________ 3. The accountant can prepare financial statements after

preparing the adjusted trial balance.

________________ 4. The journal entry to record an advance payment of a business

for its expenses will include a debit to accrued expense.

________________ 5. Matching Principle states that a business' revenue should be

recognized when earned and realized regardless of the cash
receipts.

________________ 6. Revenue Recognition Principle states that the company

expenses should be matched with its revenues in the same
accounting period.

________________ 7. An adjusting entry with a debit to Prepaid Rent indicates that

the transaction was initially recorded with a debit to Rent
Expense.

________________ 8. An adjusting entry with a debit to Interest Expense indicates

that the company incurred an expense but there is no journal
entry made to record the transaction.

________________ 9. Accruals are transactions that involve an advance payment.

________________ 10. No errors are committed if the totals in an adjusted trial

balance are equal.

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 38

Unit 9: Analyzing Business Transactions: Service Type of Business

B. Matching Type. Identify the adjusting entry described in the statement.

Column A Column B

_____________ 1. Advance payment of rent a. Accrued Revenue

_____________ 2. Unpaid wages b. Accrued Expense

_____________ 3. Depreciation of c. Prepaid Expense

machinery

_____________ 4. Rendered services d. Unearned Revenue

without an invoice

_____________ 5. Cash received in advance e. Depreciation Expense

from clients

Practice Your Skills

Prepare Adjusting Entries

Carla Avellina Dental Clinic prepares adjusting entries every December 31 under the balance
sheet method. Prepare the necessary adjusting entries for the transactions below.

1. On January 1 of the current year, Carla purchased dental equipment at a price of

₱100,000. It has an estimated life of five years and a salvage value of ₱10,000.
2. It signed a ₱40,000, 8%, two year-year notes payable on October 1 of the current
year. Interest is payable annually every September 30 until the maturity date.
3. On December 1, the company received ₱20,000 from one of its loyal customers in
full payment for the services provided in December and January.
4. Dental supplies at the beginning of the year amounted to ₱8,500. On December 31, it
amounted to ₱1,800.
5. The company is giving a dental service to Tomy Rod at an agreed rate of ₱2,000 per
check-up. On December 31, 6 days of unbilled dental services were provided.

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 39

Unit 9: Analyzing Business Transactions: Service Type of Business

Company Name

General Journal Page

Date Account Title and Description Ref Debit Credit

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 40

Unit 9: Analyzing Business Transactions: Service Type of Business

Challenge Yourself

KB Accounting Office offers various bookkeeping, accounting, and auditing services to its
client, Pretty Accounting Office. Rit, an intern of KB Accounting Office, was tasked to record
the adjusting entries to the general journal and create an adjusted trial balance for its client.
Below are the unadjusted trial balance and the related adjustments of Pretty Accounting
Office.

KB Accounting Office
December 31, 20x2

Trial Balance Adjustment

Account Name Debit Credit Debit Credit

Cash ₱84,000
Accounts Receivable 166,400 (f) ₱30,000
Office Supplies 0 (b) 4,500
Prepaid Advertising 80,000 (c) 15,000
Building, Gross 1,160,000
Accumulated Depreciation ₱372,000 (a) ₱46,400
Accounts Payable 60,800
Unearned Consultation Fees 0 (e) 55,000
Salaries Payable 0 (d) 66,000
Taxes Payable 163,200
Notes Payable 160,000
Pretty, Capital 574,800
Pretty, Drawings 20,000
Consultation Fees 373,200 (e) 55,000 (f) 30,000
Depreciation Expense 0 (a) 46,400
Administrative Expense 40,000
Advertising Expense 80,000 (c) 15,000
Salaries Expense 0 (d) 66,000
Office Supplies Expense 25,600 (b) 4,500
Insurance Expense 48,000
Total ₱1, 704, 000 ₱1, 704, 000 ₱216, 900 ₱216, 900

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 41

Unit 9: Analyzing Business Transactions: Service Type of Business

1. Give the adjusting entry with explanation and write it in the general journal below.

Company Name

General Journal Page

Date Account Title and Description Ref Debit Credit

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 42

Unit 9: Analyzing Business Transactions: Service Type of Business

2. Which adjusting entries are deferrals and recorded using the income statement
method? Write the letter of the adjusting entries in the space provided.

__________________________________________________________________________________________
__________________________________________________________________________________________
__________________________________________________________________________________________

3. Prepare an adjusted trial balance. Put your answers in the space provided.

Company Name
Adjusted Trial Balance
(Date)

Account Name Ref Debit Credit

Total

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 43

Unit 9: Analyzing Business Transactions: Service Type of Business

Photo Credits
Customer Paying with a Credit Card, by Yan Krukov is free for commercial use under the
Pexels license via Pexels.

Bibliography
Bragg, Steven. “Matching Principle Definition.” AccountingTools. AccountingTools, February
5, 2022. https://www.accountingtools.com/articles/2017/5/14/the-matching-principle.

Larson, Kermit D., John J. Wild, and Barbara Chiappetta. Fundamental Accounting Principles.
Boston: McGraw-Hill Irwin, 2002.

Stice, Earl K., Earl K. Stice, and James D. Stice. Financial Accounting Reporting & Analysis. New
Delhi: South Western, 2009.

Tuovila, Alicia. “Revenue Recognition as an Accounting Principle.” Investopedia.

Investopedia, February 8, 2022.
https://www.investopedia.com/terms/r/revenuerecognition.asp.

Williams, J. R., Haka, S. F., & Bettner, M. S. (2017). Financial accounting. McGraw-Hill
Higher Education

9.5. Accounting Cycle for Service-Type Businesses: Adjusting 44