Study Objectives
After studying this lesson, you should be able to:
Achievement of Objective (Put a Check mark) 1 Recall the concept of unearned income and prepare
adjusting entry using the Liability method 2 Prepare adjusting entry using the Income method
Unearned income
To recall, unearned income is a liability that is received in advance but not yet earned.
Unearned income is the opposite of prepaid expense. If one party has recorded a prepaid item, then the other party has to record an unearned item.
Companies have two options or methods in recording unearned items. They may use the Liability method or Income method.
Objective 1 Liability Method
If the company chooses to use the liability method, then upon receiving the unearned item the pro-forma entry will be:
Date Particulars Debit Credit
Xxxx
xxx xx Cash xxx
Unearned _____ income Xxx
Receipt of unearned item in advance
It is possible that in this recorded unearned income there may be earned portion. To adjust the recorded unearned income, the pro-forma entry will be:
Date Particulars Debit Credit
Xxxx
Dec 31 Unearned _____ income xxx
_____ income xxx
Recognition of earned portion of the recorded unearned income
Confidentiality Requirement
Example:
On October 1, 2009, the company received from the tenant the advance rent payment of P 100,000 representing 10-month rent.
Date Particulars Debit Credit
2009
Oct 01 Cash 100,000
Unearned rent income 100,000
Receipt of unearned item in advance
Adjusting entry
Date Particulars Debit Credit
2009
Dec 31 Unearned rent income 30,000
Rent income 30,000
100,000 / 10 = 10,000 x 3
Recognition of earned portion of the recorded unearned rent
If the unearned income account is not adjusted at year-end, then the financial statements will be misstated showing overstated liabilities and understated income.
If the adjusted Unearned rent income of P 70,000 is fully earned in the following year, then the entire P 70,000 will be transformed to Rent income also in the following year.
Objective 2 Income Method
On the other hand, if the company chooses to use the Income method, then the pro-forma entry to record the unearned item is:
Date Particulars Debit Credit
xxxx
xxx xx Cash xxx
_____ income xxx
Receipt of unearned item in advance
It is possible that in this recorded income there may be unearned portion. To adjust the recorded income, the pro-forma entry will be:
Date Particulars Debit Credit
xxxx
Dec 31 _____ income xxx
Unearned _____ income xxx
Recognition of unearned portion of the recorded income
Example:
Assume the same example in liability method but this time the company will use the income method.
Date Particulars Debit Credit
2009
Oct 01 Cash 100,000
Rent income 100,000
Receipt of unearned item in advance
Adjusting entry
Date Particulars Debit Credit
2009
Dec 31 Rent income 70,000
Unearned rent income 70,000
100,000 / 10 = 10,000 x 7
Recognition of unearned portion of the recorded income
If the income account is not adjusted at year-end, then the financial statements will be misstated showing understated liabilities and overstated income.
Notice that whether the company uses the liability method or income method, the financial statements will show same amounts for liabilities and income. In the above example, both methods will show Unearned rent income adjusted balance of P 70,000 and Rent income adjusted balance of P 30,000.
Confidentiality Requirement Further Readings
Kieso, D., Kimmel, P. and Weygandt, J. (2008). Accounting Principles, 8th edition. New Jersey: John Wiley and Sons, Inc. pages 100 – 103, 117 – 118
Kimwell, Mercedes (2009). Fundamentals of Accounting, 2nd edition. Manila: GIC Enterprises & Co., Inc.
Valencia, E., and Roxas, G. (2009). Basic Accounting, 3rd edition. Baguio City: Valencia Educational Supply.
Cabrera, M.E.B, Ledesma, E.F., and Lupisan M.C.Y. (2007). Fundamentals of Accounting Vol. 1. Manila: GIC Enterprises & Co., Inc.
Chalmers, K., Fyfe, M., Kieso, D., Kimmel, P., Mitrione, L., and Weygandt, J. (2007). Principles of Financial Accounting. John Wiley and Sons Australia, Ltd.
LESSON 13 DEPRECIATION
Study Objectives
After studying this lesson, you should be able to:
Achievement of Objective (Put a Check mark) 1 Understand the concept of depreciation and its kinds
2 Enumerate the factors of depreciation and compute depreciation using the straight line method
Objective 1
Concept of depreciation
Property, plant and equipment, except land, normally are usable for a number of years after which they have relatively little value either for service or for sale. The difference between the original cost of a property and any remaining value when it is retired or worn out is an expense that should be distributed to the periods during which the asset is used (Valix, 2000).
Depreciation accounting
- Is a system of accounting which aims to distribute the cost of the depreciable fixed asset less salvage value, if any, over the estimated useful life of the asset in a systematic and rational manner. It is a process of allocation, not of valuation (Valix, 2000).
- The objective of depreciation accounting is to have each period benefitting from the use of the asset bear an equitable share of the asset cost (Valix, 2000).
Depreciation
- Is the portion of the cost of the asset charged as expense during an accounting period (Valix, 2000).
Kinds of depreciation (Valix, 2000) 1. Physical depreciation
a. Is related to the depreciable asset’s wear and tear and deterioration over a period. This also results to the ultimate retirement of the property or termination of the service of the asset.
b. Physical depreciation may be caused by: i. Wear and tear due to frequent use ii. Passage of time due to nonuse
iii. Action of the elements such as wind, sunshine, rain or dust iv. Accidents such as fire, flood, earthquake and other natural disaster
v. Diseases in animals and wooden buildings 2. Functional or economic depreciation
a. Arises from obsolescence or inadequacy of the asset to perform efficiently. i. Obsolescence may arise from the following:
Confidentiality Requirement
1. When there is no future demand for the product which the depreciable asset produces
2. When a new depreciable asset becomes available and the new asset can perform the same function for substantially less cost ii. Inadequacy arises when the asset is no longer useful to the firm because
of an increase in the volume of operations.
Objective 2
Factors of depreciation (Valix, 2000)
In order to properly compute the amount of depreciation to be charged as expense during an accounting period, three factors are necessary, namely:
1. Cost 2. Scrap value
a. Is the amount estimated to be recovered when the asset is retired from use. b. It is also known as Residual value or Salvage value.
c. From the practical standpoint, the scrap value is often considered as zero because the valuation is usually very small or not capable of estimation.
3. Estimated useful life
a. Is the expected service or economic life of the asset.
Straight line method of depreciation (Valix, 2000)
Under the straight line method, the annual depreciation charge is calculated by allocating the amount to be depreciated equally over the number of years of estimated useful life.
The formula for the computation of the annual depreciation following the straight line method is as follows:
Annual depreciation = Cost minus scrap
Life in years
Cost minus scrap value equals Depreciable cost. Depreciable cost multiplied by the Annual depreciation rate also gives the amount of annual depreciation.
The Annual depreciation rate is determined by dividing 100% by the life of the asset in years. For example, if the life of the asset is 5 years, then the depreciation rate is 20% (100% / 5).
The straight line method is based on the theory that periods benefited by the use of the asset should bear an equal or equitable share of the asset cost because the straight line approach considers depreciation as a function of time rather than as a function of usage.
Pro-forma Adjusting Entry
Date Particulars Debit Credit
xxxx
Dec 31 Depreciation expense xxx
Accumulated depreciation – <asset> xxx
Depreciation of fixed asset
Example:
Assume the following data for 2011 Equipment cost,
purchased on January 1, 2011
P 105,000
Scrap value P 5,000
Life in years 5 years
A depreciation table may appear as follows:
Year Depreciation Accumulated depreciation Net carrying value Acquisition cost 105,000 2011 20,000 20,000 85,000 2012 20,000 40,000 65,000 2013 20,000 60,000 45,000 2014 20,000 80,000 25,000 2015 20,000 100,000 5,000
Adjusting entry for 2011
Date Particulars Debit Credit
2011
Dec 31 Depreciation expense 20,000
Accumulated depreciation – Equipment 20,000
Depreciation of equipment for 2011 Note xx – Property, Plant and Equipment
Cost Accumulated
Depreciation
Net Carrying Value
Land P xxx,xxx P xxx,xxx
Transportation Equipment xxx,xxx P xxx,xxx xxx,xxx
Building xxx,xxx xxx,xxx xxx,xxx
Equipment 105,000 20,000 85,000
Furniture and Fixtures xxx,xxx xxx,xxx xxx,xxx
Total P xxx,xxx ========= P xxx,xxx ======== P xxx,xxx =========
Confidentiality Requirement
Adjusting entry for 2012
Date Particulars Debit Credit
2012
Dec 31 Depreciation expense 20,000
Accumulated depreciation – Equipment 20,000
Depreciation of equipment for 2012
Note xx – Property, Plant and Equipment
Cost Accumulated
Depreciation
Net Carrying Value
Land P xxx,xxx P xxx,xxx
Transportation Equipment xxx,xxx P xxx,xxx xxx,xxx
Building xxx,xxx xxx,xxx xxx,xxx
Equipment 105,000 40,000 65,000
Furniture and Fixtures xxx,xxx xxx,xxx xxx,xxx
Total P xxx,xxx ========= P xxx,xxx ======== P xxx,xxx =========
Further Readings
Kieso, D., Kimmel, P. and Weygandt, J. (2008). Accounting Principles, 8th edition. New Jersey: John Wiley and Sons, Inc. pages 422 – 431, 435 – 436
Kimwell, Mercedes (2009). Fundamentals of Accounting, 2nd edition. Manila: GIC Enterprises & Co., Inc.
Valencia, E., and Roxas, G. (2009). Basic Accounting, 3rd edition. Baguio City: Valencia Educational Supply.
Cabrera, M.E.B, Ledesma, E.F., and Lupisan M.C.Y. (2007). Fundamentals of Accounting Vol. 1. Manila: GIC Enterprises & Co., Inc.
Chalmers, K., Fyfe, M., Kieso, D., Kimmel, P., Mitrione, L., and Weygandt, J. (2007). Principles of Financial Accounting. John Wiley and Sons Australia, Ltd.
Confidentiality Requirement
LESSON 14