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CHAPTER 11 BUSINESS TRANSACTIONS AND THEIR ANALYSIS AS APPLIED TO THE ACCOUNTING CYCLE OF A SERVICE
BUSINESS
Step 5 Adjusting Entries
At the end of the accounting period, some accounts in the general ledger would require updating. The journal entries
that bring the accounts up to date are called adjusting entries. One purpose of adjusting entries is for income and
expenses to be reported in the correct period. Adjusting entries ensure that both the revenue recognition and
matching principles are followed. Prior to your lecture, recall the previous discussion on accounting principles and
concepts, specifically the matching principle.
Revenue Recognition – accounting standards require that revenue is recognized when it is earned and the amount
can be measured reliably.
To illustrate: • Assume that you are preparing the financial statements for Feb 2016. Matapang Computer Repairs
rendered services amounting to PHP25,000 for the repair of the computer units of Mr. Tamad on Feb 26, 2016.
However, the payment for these services of Matapang will be made on Mar 15, 2016.
Question: When should you recognize the PHP25,000 as revenue or income, in February or March? Applying the
revenue recognition principle, it should be reported as revenue for February 2016.
• Assume that you are preparing the financial statements for February 2016. On February 28, 2016, Matapang
Repairs received payment from Mr. Tamad amounting to PHP25,000. This payment is for the repair of the computer
units of Mr. Tamad on March 5, 2016.
Question: when should you recognize the PHP25,000 as revenue or income, in February or March? Applying the
revenue recognition principle, it should be reported as revenue in March 2016. Take note that since the service will
be rendered in March, the revenue should also be earned in March.
What about February 2016? The amount is recorded as a liability because Matapang Repairs has the obligation to
render this service in the future.
Matching Principle - this principle directs a business to report an expense on its income statement within the same
period as its related income.
To illustrate: • Assume that you are preparing the financial statements for February 2016. The business gives a
commission of 10% service income to its employees. The commission is paid the following month. On February 2016,
the total service income for the month is PHP100,000. Thus, the employees are entitled to a commission of
PHP10,000. This amount will be paid on March 12, 2016.
Question: when should the commission expense be recorded in the book of accounts of the business, in March or in
February? Applying the matching principle, the answer is in February.
Adjusting entries are made at the end of each accounting period. Adjusting entries make it possible to report correct
amounts on the statement of financial position and on the income statement. All adjusting entries affect at least one
income statement account and one statement of financial position account. Thus, an adjusting entry will always
involve an income or an expense account and an asset or a liability account.
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There are five basic sources of adjusting entries:
1. Depreciation expense
2. Deferred expenses or prepaid expenses
3. Deferred Income or unearned income
4. Accrued expenses or accrued liabilities
5. Accrued income or accrued assets
#1 Depreciation. Depreciation is a method of allocating the cost of an asset to an expense over the accounting
periods that make up the asset’s useful life.
Examples of assets subject to depreciation are: Store, Office, Building, and Transportation equipment.
These types of assets lose their ability to provide useful service as time passes. Depreciation can also be referred to as
the decrease in the usefulness of these types of assets. Take note that Land is not subject to depreciation because the
value of land mostly increases as time passes.
Exercise on Adjusting entries to record Depreciation
Recall that Matapang acquired office equipment on February 15, 2016 for his repair shop business. The cost of the
equipment is PHP25,000. It was estimated to have a useful life of five years. It is estimated that after five years, the
office equipment can be sold at a scrap value of PHP1,000. The company uses the straight line method of
depreciation.
Depreciation is a means of allocating the cost of an asset to an expense over the accounting period that will benefit
the use of the asset. In the exercise above, the equipment will be used by Matapang for five years. Proper accounting
procedures dictates that the cost of PHP25,000 should be spread over five years. There are several methods or
formulas to compute the amount of depreciation. The simplest is the straight line method. The formula is Annual
Depreciation : ( Acquisition Cost – Salvage or Residual Value) / Useful Life.
Applying this formula to the exercise: Annual Depreciation = (25,000-1,000) / 5 = PHP4,800
If the accounting period being reported by Matapang is for the month ending February 29, 2016, the adjusting entry
to record this DEPRECIATION in the books of Matapang is:
2/29/16
Depreciation Expense
200
Accumulated Depreciation-Office Eqpt
200
The depreciation expense of PHP200 was derived by computing the monthly depreciation of PHP400 (Annual
Depreciation of PHP4,800/12 months) and multiplying the PHP400 by one-half since the equipment was acquired in
the middle of February.
#2 Deferred Expenses or Prepaid Expenses.
These are items that have been initially recorded as assets but are expected to become expenses over time or
through the operations of the business.
Exercise - Adjusting entries to record deferred expenses or prepaid expenses
Recall that on February 19, 2016 Matapang purchased PHP5,000 worth of office supplies on account. By the end of
the month, PHP2,000 worth of these supplies are still unused. The February 19, 2016 entry to record the purchase on
the account of office supplies was already posted to the general ledger and included in the balances, as shown in the
unadjusted trial balance above. The entry was shown only for illustration purposes.
2/19/16 Supplies Expense 5,000
Accounts Payable 5,000
To record the purchased of office supplies on account
2/29/16
Supplies
2,000
Supplies Expense
2,000
To set-up the value of unused supplies
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#3 Deferred Income or Unearned Income. These are items that have been initially recorded as liabilities but are
expected to become income over time or through the operations of the business.
Exercise – Adjusting entries to record deferred or unearned income
On February 15, 2016 Matapang entered into a contract with Makisig to maintain the computers of Makisig for two
months starting on February 15, 2016 up to April 15, 2016. On the same date, Makisig paid the total contract amount
of PHP40,000 in full. The entries to record and adjust the books are: In the February 29, 2016 entry above, as of end
of February 2016, Matapang has already earned the service revenue for the first 15 days, thus an adjusting entry is
recorded.
2/15/16
Cash
40,000
Unearned Service Revenue 40,000
To record receipt of full payment for the two-month service contract with Makisig
2/29/16
Unearned Service Revenue 10,000
Service Revenue 10,000
To record service income earned from Feb 15-29, 2016; P40,000 x (1/2 month /2 months)
#4 Accrued Expenses or Accrued Liabilities. These are items of expenses that have been incurred but have not been
recorded and paid.
Exercise – Adjusting entries to record Accrued expenses or accrued liabilities On February 29, 2016, Matapang
received the electric bill for the month of February amounting to PHP3,800. Matapang will pay this bill on March
2016. The electric bill represents the cost of electricity used (or incurred) for February. Although the said bill is still
unpaid and thus was not recorded, the matching principle and accrual basis of accounting dictates that the same
should be recorded in February. Otherwise, your expense will be understated and thus the company will be reporting
an overstated income (or an erroneous income). Needless to say, erroneous information may lead to wrong
decisions. The entry to record the accrual of this expense is:
2/29/16
Utilities Expense 3,800
Utilities Payable 3,800
To accrue the cost of electricity incurred for the month of February.
#5 Accrued Income or Accrued Assets These are income items that have been earned but have not been recorded
and paid by the customer. In short, these are receivables of the business.
Exercise – Adjusting entries to record accrued income or accrued assets On February 28, 2016, Matapang repaired
the computer of Pedro for PHP15,000. Pedro was on an outof-town trip so he could not pay Matapang . He told
Matapang that he will pay for their services on March 1, 2016. Matapang has already earned the PHP15,000 but was
not paid as of the end of February 2016. Therefore, an income should be properly recognized in February 2016 for
this transaction.
The entry to record this is:
2/29/16
Accounts Receivable 15,000
Service Income
15,000
To accrue the cost of electricity incurred for the month of February.
Step 6 - Worksheet This step is simply about plotting the items in the unadjusted trial balance on the worksheet. In a
manual accounting system, a worksheet is a large columnar sheet of paper specifically designed to conveniently
arrange all the accounting information required at the end of a period. The worksheet is used to check whether
ledger accounts are balanced and adjusted. The satisfactory completion of a worksheet provides assurance that all
the details of the end-of-period accounting procedures were properly brought together. The worksheet serves as the
source in the preparation of financial statements and other closing and adjusting entries.
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Step 7 - Preparation of the Financial Statements.
Using the information from the worksheet, the financial statements are prepared.
The following are the financial statements to be prepared:
1. Statement of Financial Position (SFP) - Also known as the balance sheet. This statement includes the amounts of
the company’s total assets, liabilities and owner’s equity which in totality provides the financial position of the
company on a specific date.
2. Statement of Comprehensive Income (SCI) – Also known as the income statement. Contains the results of the
company’s operations for a specific period of time. This can be prepared on a monthly, quarterly or yearly basis.
3. Statement of Changes in Equity (SCE) - This statement is prepared prior to preparation of the Statement of
Financial Position in order to obtain the ending balance of the equity to be used in the SFP. All changes, whether
increases or decreases to the owner’s interest on the company during the period, are reported here.
4. Cash Flow Statement - Provides an analysis of inflows and/or outflows of cash from/to operating, investing and
financing activities. The income statement is prepared first so that net income can then be recorded in the statement
of changes in equity. The statement of changes in equity is then prepared to determine the ending balance of equity
or capital account. Once the ending balance is determined, the statement of financial position is prepared. The cash
flow statement is prepared last.
Step 8 - Journalize the Closing Journal Entries The income, expense, withdrawal (equity) accounts are called
temporary accounts or nominal accounts. They are called temporary because they accumulate the transactions of
only one accounting period.
At the end of this accounting period, the changes in owner’s equity accumulated in these temporary accounts are
transferred into the owner’s capital account.
This process serves two purposes:
(1) to update the balance of the owner’s capital; and
(2) it returns the balance of the temporary accounts to zero, so that they are ready to measure the income, expenses
and drawings of the next accounting period again.
The owner’s capital account and other statement of financial position accounts are referred to as permanent or real
accounts because their balances continue to exist beyond the current accounting period.
Closing the books is the process of transferring the balances of the temporary accounts to the owner’s permanent
capital account.
The closing journal entries should consist of the following:
• All of the nominal revenue accounts should be closed to the income summary account by a Debit to revenue
and a Credit to income summary.
• All of the nominal expense accounts should be closed to the income summary by a Credit to expense and a
Debit to income summary.
• The balance in the income summary account should now reflect the net income for the accounting period.
The next journal entry should close the income summary account to the equity or capital account. If there is a net
profit this entry will be a Debit to income summary and a Credit to owner’s capital account.
• Once the closing journal entries have been entered into the general journal, the information should be
posted to the general ledger. When this is accomplished, all of the nominal accounts in the general ledger should
have zero balances. To double check on this, we should prepare another trial balance based on the new balances in
the general ledger. If we have any nominal accounts with positive balances, a mistake was made along the way and
will need to be corrected before proceeding to the next accounting period.
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CHAPTER 12 Accounting Cycle of a Merchandising Business
A merchandising company is an enterprise that buys and sells goods to earn a profit.
Merchandise (or merchandise inventory) refers to goods that are held for sale to customers in the
normal course of business. This includes goods held for resale. For example:
• Candies, canned goods, noodles sold at a grocery stores
• Juice, biscuits sold in a grocery store
• Medicines sold in a pharmacy
If a grocery store decided to sell an old computer used in the office, this would not be merchandise
because grocery stores do not normally sell computers and the store is simply selling off old office
equipment. But a computer would be merchandise for a computer store who resells computer units.
Merchandise for one firm may be a fixed asset (or property and equipment) for another.
In another example, a pharmacy decided to sell a table used in their display area. This table is not
merchandise of a pharmacy. However, to a retail furniture store a table is merchandise because the
business of a furniture store involves the buying and selling of tables.
A merchandiser’s primary source of revenue is sales revenue or sales.
Expenses for a merchandising company are divided into two categories:
1. Cost of goods sold (COGS) – the total cost of merchandise sold during the period; and
2. Operating expenses (OP) - expenses incurred in the process of earning sales revenue that are
deducted from gross profit in the income statement. Examples are sales salaries and insurance gross profit in
the income statement. Examples are sales salaries and insurance expenses.
Gross profit (GP) is equal to Sales Revenue less the Cost of Goods Sold.
Income measurement process for a merchandiser follows as:
Sales - COGS = Gross Profit - Operating Exp. = Net Income (Loss)
The Operating Cycles for a merchandiser:
Merchandising Company operating cycle (cash to cash) involves:
1. buy merchandise inventory
2. sell inventory
3. obtain Accounts Receivable
4. receive cash
JOURNALIZING THE TRANSACTIONS IN A MERCHANDISING BUSINESS
Prior to the discussion on the journal entries, recall the first step in the accounting cycle discussed in
previous chapters (specifically Chapter 10) on financial and non-financial transactions.
Step 1, transactions are identified and measured. At this stage, the documents used by the business
are analyzed to see whether these transactions have financial impact or effect. Recall the rule that only
financial transactions are recorded and that the amount can be measured. These two conditions must
exist in order for a particular transaction to be recognized or recorded. As defined, financial
transactions are those activities that change the value of an asset, liability or equity.
Step 2 is the Preparation of Journal Entries (Journalization)
A merchandising company may use special and general journals to record its transactions.
SPECIAL JOURNALS
Some businesses encounter voluminous quantities of similar and recurring transactions, which may create
congestion if these transactions are recorded repeatedly in a single day or monthly in the general journal.
The use of special journals will eliminate this problem.
The following are the commonly used special journals:
1. Cash Receipts Journal –used to record all cash that had been received
2. Cash Disbursements Journal –used to record all transactions involving cash payments
3. Sales Journal (Sales on Account Journal) –used to record all sales on credit (on account)
4. Purchase Journal (Purchase on Account Journal) –used to record all purchases of inventory on credit (or
on account)
INVENTORY SYSTEMS
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Maintaining inventory items is a unique set-up in a merchandising business. There are two methods of
accounting for inventory, namely:
Perpetual Inventory System and Periodic Inventory System.
Merchandising entities may use either of the following inventory systems:
1. Perpetual System — Detailed records of the cost of each item are maintained, and the cost of each item
sold is determined from records
when the sale occurs. For example, a car dealership has separate inventory records for each vehicle.
• Record purchase of Inventory.
• Record revenue and record cost of goods sold when the item is sold.
• At the end of the period, no entry is needed except to adjust inventory for losses, etc.
2. Periodic System — Cost of goods sold is determined only at the end of an accounting period. This system
involves:
• Record purchase of Inventory.
• Record revenue only when the item is sold.
• At the end of the period, you must compute cost of goods sold (COGS):
1. Determine the cost of goods on hand at the beginning of the accounting period
(Beginning Inventory = BI),
2. Add it to the cost of goods purchased (COGP),
3. Subtract the cost of goods on hand at the end of the accounting period
4. (Ending Inventory = EI) illustrated as:
BI + COGP = Cost of goods available for sale - EI = COGS
Additional Considerations:
• Perpetual systems have traditionally been used by companies that sell merchandise with high unit values
such as automobiles, furniture, and major home appliances. With the use of computers and scanners, many
companies now use the perpetual inventory system.
• The perpetual inventory system is named because the accounting records continuously — perpetually —
show the quantity and cost of the
inventory that should be on hand at any time. The periodic system only periodically updates the cost of
inventory on hand.
• A perpetual inventory system provides better control over inventories than a periodic inventory, since the
records always show the quantity that should be on hand. Then, any shortages from the actual quantity
and what the records show can be investigated immediately.
Note: The periodic inventory system will be used in all illustrations of this chapter while the perpetual system
will be included in the “enrichment” portion of this guide.
PERIODIC INVENTORY SYSTEM
Recording purchases and related transactions under the Periodic Inventory System
PURCHASES OF MERCHANDISE: PERIODIC SYSTEM
1. When merchandise is purchased for resale to customers, the account, Purchases, is debited for the cost
of goods purchased.
2. Like sales, purchases may be made for cash or on account (credit).
3. The purchase is normally recorded by the purchaser when the goods are received from the seller.
• Each credit purchase should be supported by a purchase invoice.
• A purchase invoice received by the buyer is actually a sales invoice or a charge invoice prepared by the
supplier or vendor.
• Note that only purchases of merchandise are debited to the ‘Purchase’ account. Acquisition (purchases)
of other assets: supplies,
equipment, and similar items are debited to their respective accounts.
EXAMPLE:
Magaling Computer Store started its operations on January 2, 2016. The store is located in Sikat Mall in Bicol.
The owner invested PHP500,000 to start the business. On January 3, 2016, Magaling purchased 20 units of
computers on account for PHP10,000 each. Upon delivery of the units, the supplier, Delta, Inc., issued
Charge Invoice No. 145 to Magaling.
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PURCHASE RETURNS AND ALLOWANCES
• A purchaser may find the merchandise received to be unsatisfactory because the goods are:
• damaged or defective of inferior quality not in accord with the purchaser’s specifications
• The purchaser initiates the request for a reduction of the balance due through the issuance of a debit
memorandum. The debit memorandum is a document issued by a buyer to inform a seller that the seller’s
account has been debited because of unsatisfactory goods.
• A return of the merchandise (a deduction from the purchase price when unsatisfactory goods are kept) is
shown by the entry where
Accounts Payable is debited and Purchase Returns and Allowances is credited to show that the purchases
was reduced with a return or an allowance.
• The Purchase Returns and Allowances account is a “contra purchases” account when merchandise is
returned to a supplier.
EXAMPLE:
Out of the 20 computer units purchased last January 3, 2016, it was found after inspection on the same day
that one unit was damaged during shipment. Magaling issued a debit memorandum (DM 01) and informed
the supplier that it will return the one damaged item.
ACCOUNTING FOR FREIGHT COSTS
The sales agreement should indicate whether the seller or the buyer is to pay the cost of
transporting the goods to the buyer’s place of business. The two most common arrangements for
freight costs are FOB SHIPPING POINT AND FOB DESTINATION.
FOB Shipping Point:
• Goods placed free on board (FOB) the carrier by seller.
• Buyer pays freight costs.
• Freight-In is debited if buyer pays freight.
• Cash is credited if the goods come on cash on delivery (COD), for example, and was paid
immediately. Accounts Payable would be credited if on account.
• Ownership over the goods is transferred to the buyer once it is out of the premises of the seller.
FOB Destination
• Goods placed free on board (FOB) at buyer’s business.
• Seller pays freight costs.
• Delivery Expense is debited if seller pays freight on outgoing merchandise to a buyer. This is an operating
expense to the seller.
• Ownership over the goods is transferred to the buyer once the goods are delivered and received by the
buyer.
Assume the supplier of Magaling is based in Manila. In order to bring the 20 computer units to Bicol, it will
cost PHP3,000 to deliver the goods.
If the terms is FOB Shipping Point, the entry to record, assuming Magaling paid the common carrier in cash
on January 4, 2016 is:
01-04-2016
Freight In
Php3,000
Cash
Php3,000
If the terms is FOB Destination, no entry is recorded in the books of Magaling. The PHP3,000 will be paid by
the seller, in this case Delta, Inc.
PURCHASE DISCOUNTS:
• Credit terms (specify the amount of cash discount and time period during which a discount is offered)
may permit the buyer to claim a cash discount for the prompt payment of a balance due. If the credit
terms show 2/10, n/30 means a 2% discount is given if paid within 10 days (called the discount period);
otherwise, the invoice is due in 30 days.
• The buyer calls this discount a purchase discount.
• A purchase discount is normally based on the invoice cost less returns and allowances, if any.
EXAMPLE:
The credit terms for the purchase of 20 computer units (total cost PHP200,000) is 2/10, n/30. This means that if
Magaling pays on or before January 13, 2016, it is entitled to a 2% discount, otherwise Magaling will have to
pay the full amount on or before February 4, 2016 (30 days after purchase). On January 10, 2016, Magaling
paid the account in full with Delta.
Journal Entry:
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Jan. 10, 2016
Accounts Payable
Purchase Discount
Cash
200,000
4,000
196,000
Assuming that instead of paying on January 10, 2016, magaling paid on February 4, 2016, thus forfeiting the
2% discount, the entry to record is:
Feb 4, 2016
Accounts Payable
Cash
200,000
200,000
Recording of sales and related transactions under the Periodic Inventory System
SALES TRANSACTIONS: REVENUE ENTRIES FOR A MERCHANDISER
• Revenues are reported when earned in accordance with the revenue recognition principle, and in a
merchandising company, revenues are earned when the goods are transferred from seller to buyer.
• All sales should be supported by a document such as a cash register tape (to provide evidence of cash
sales) or cash receipt, or office receipt for cash sales, and charge invoice for credit sales, or sales on
account.
• One entry is made with each sale:
Debit — Accounts Receivable (if a credit sale) or Cash (if a cash sale) which increases assets for the sales
amount
Credit — Sales which increases revenues
• The sales account is credited only for sales of goods held for resale. Sales of assets not held for resale (such
as equipment, buildings, land, etc.) are credited directly to the asset account.
EXAMPLE
For the month of January, Magaling made the following sale:
1/10/2016 Official Receipt (OR) No. 001 Sold two units for cash to Marie Cruz for PHP36,000 (PHP18,000 per
unit), FOB Destination
1/15/2016 Charge Invoice (ChI) No. 001 Sold five units on account to Rafael Reyes for PHP97,500 (PHP19,500
per unit) with terms 3/10, n/30, FOB Shipping Point
• An entry is made when seller pays the freight to deliver goods to a customer or buyer. If the buyer
will pay for the freight, no entry is made.
• Debit — Delivery Expense and credit — Cash or Accounts Payable
SALES RETURNS AND ALLOWANCES:
• Sales Returns result when customers are dissatisfied with merchandise and are allowed to return the goods
to the seller for credit or a refund.
• Sales Allowances result when customers are dissatisfied, and the seller allows a deduction from the selling
price.
• To grant the return or allowance, the seller prepares a credit memorandum to inform the customer that a
credit has been made to the customer’s account receivable.
• Sales Returns and Allowances is a contra revenue account to the Sales account. A contra account is a
reduction to a particular account.
• A contra account is used, instead of debiting sales, to disclose the amount of sales returns and
allowances in the accounts.
• This information is important to management as excessive returns and allowances suggest inferior
merchandise, inefficiencies in filling orders, errors in billing customers, and mistakes in delivery or shipment of
goods.
• The normal balance of Sales Returns and Allowances is a debit.
• One entry is made with each sales return and allowance:
The entry to record the sales return or allowance:
• Debit — Sales Return and Allowances which decreases revenues for the amount of the sale
• Credit — Accounts Receivable (if a credit sale) or Cash (if a cash sale) which decreases assets
EXAMPLE:
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On January 16, 2016, Rafael Reyes returned one unit of the computers purchased last January 15, 2016
under Charge Invoice 001. The unit
returned was in good condition. However, Rafael Reyes returned the unit because it is one unit more than
what they need. The return was approved and accepted by Magaling. The price will be deducted from the
account of Rafael Reyes.
SALES DISCOUNTS
1. A sales discount is the offer of a cash discount to encourage customers to pay the balance at an earlier
date.
2. An example of a discount term is commonly expressed as: 2/10, n/30, which means that the customer is
given 2% discount if payment is
made within 10 days. After 10 days there is no discount, and the balance is due in 30 days.
3. Sales Discounts is a contra revenue account with a normal debit balance.
EXAMPLE:
Assume that Magaling purchased on cash, five units of computers at PHP10,000 per unit from a supplier on
January 17, 2016. These units were subsequently sold to Jun Cruz on January 18, 2016 under Charge Invoice
(ChI) No. 002 amounting to PHP90,000 (PHP18,000 per unit)
with terms 2/10, n/30, FOB Shipping Point. On January 23, 2016, Cruz paid the said account in full
In a periodic inventory system, separate ledger accounts are maintained for various items composing the
cost of goods sold (Purchases, Purchase Returns & Allowances, Freight-In, Purchase Discounts). At the end of
the accounting period, a physical count of inventory is necessary to establish the ending balance of the
inventory.
Determining Cost of Goods Sold under Periodic Inventory System
The Cost of Goods Sold under the periodic inventory system is determined at the end of the period (monthly
or yearly) by a short computation,
Purchase Returns & Allowances, Freight-In, Purchase Discounts). At the end of the accounting period, a
physical count of inventory is necessary to establish the ending balance of the inventory.
Step 3 – Posting to the General Ledger. From the summary of transactions in the special journals and general
journals, the entries will now be posted in each general
Step 4 & 5– Prepare the unadjusted trial balance, and preparation of worksheet. The balances in the general
ledger for each account will be extended to the first two money columns of the worksheet.
Step 6 – Prepare adjusting entries. Recall in Chapter 11, the five basic sources of adjusting entries:
1. Depreciation expense
2. Deferred expenses or prepaid expenses
3. Deferred income or unearned Income
4. Accrued expenses or accrued liabilities
5. Accrued income or accrued assets
Step 7 - Preparation of Financial Statements. The first statement prepared is the income statement. All
income statement accounts are extended to the appropriate column. Using the periodic inventory system,
the beginning balance of merchandise inventory account is also extended to the debit side, while the result
of the physical count to determine the ending inventory is reflected on the credit side. The total debit and
total credit are determined and if credit balance is higher than the debit side, the difference is added to
the debit side. The difference is actually the income for the period. However, if the total debit side exceeds
the total credit side, the difference is added to the credit side and this is the net loss of the business. The
statement of financial position is then prepared. All assets, liabilities and equity accounts are extended. The
ending merchandise inventory is extended to the debit side.
Step 8 – Closing Entries. The closing journal entries consist of the following:
• All of the nominal revenue accounts should be closed to the income summary account by a Debit to
revenue and credit to income summary.
• All of the nominal expense and cost of goods sold accounts should be closed to the income summary by
a Credit to expense and a debit to income summary
• The Merchandise Inventory, Beginning is closed to Income summary account by a debit to Income
Summary and a credit to Merchandise Inventory.
• The Merchandise Inventory, Ending is set up in the books by a debit to Merchandise Inventory, Ending and
a credit to Income Summary. The amount that will be used is the result of the physical count.
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• The balance in the income summary account should now reflect the net income for the accounting
period. The next journal entry should close the income summary account to the equity or capital account. If
there is a net profit this entry will be a debit to income summary and a credit to owner’s capital account.
Once the closing journal entries have been entered into the general journal, the information should be
posted to the general ledger. When this is accomplished, all of the nominal accounts in the general ledger
should have zero balances. To double check on this, we prepare another trial balance based on the new
balances in the general ledger. If we have any nominal accounts with positive balances, a mistake was
made along the way and will need to be corrected before proceeding to the next accounting period.
Prepared by:
ZORINA Z. LUGO
ABM Teacher
REFERENCE:
Teaching Guide for Senior High School
FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 1
SPECIALIZED SUBJECT | ACADEMIC – ABM
The Commission on Higher Education
in collaboration with the Philippine Normal University