Accounting 1
Basic Financial Accounting & Reporting
Learning Objectives:
After studying this chapter, you should be able to:
1. Define accounting and explain its role in business.
2. Describe the fundamental business model and find how it is applied to the various
types of businesses.
3. Distinguish between the different forms and activities of business organization.
4. Explain the fundamental accounting concepts and principles.
5. Define the elements of Financial statements
6. Understand what is meant by the accounting equation and prove the validity of the
“mirror image” concept.
7. Explain how the double –entry system follows the rules of the accounting equation.
8. Summarize the rules of debit and credit as applied to balance sheet and income
statement accounts.
9. Analyze and state the effects of business transactions on an entity’s assets, liabilities
and owner’s equity and record these effects in accounting equation form using the
financial transaction worksheet and the T-accounts.
Chapter 1
DEFINITIONS OF ACCOUNTING
Accounting is a service activity. Its function is to provide quantitative information, primarily
financial in nature, about economic entities that is intended to be useful in making economic
decisions.
Accounting is an information system that measures, processes and communicates financial
information about economic entity.
Accounting is the process of identifying, measuring and communicating economic
information to permit informed judgments and decisions by users of the information.
Accounting is the art of recording, classifying and summarizing in a significant manner and in
terms of money, transactions and events which are, in part at least, of a financial character,
and interpreting the results thereof.
TYPES OF BUSINESS
SERVICES- An entities or individual that provides services to the public. Examples are software
developer, accounting and legal, colleges and universities, barbershop, salon and other
services.
TRADING – An entities or individual that buys and sells the products (buying and selling).
Examples are supermarket, department store and others.
MANUFACTURING – An entities that convert materials into finished products. Examples are
furniture’s production, noodles production, shoes manufacturing, garment factories and food
processing.
FORMS OF BUSINESS ORGANIZATIONS
Sole proprietorship. This business organization has a single owner called the proprietor who
generally is also the manager. Sole proprietorships tend to be small service type (e.g.
physicians, lawyers, and accountants) businesses and retail establishments. The owner
receives all profits, absorbs all losses and is solely responsible for all debts of the business.
Partnership. A partnership is a business owned and operated by two or more persons who
bind themselves to contribute money, property, or industry to a common fund, with the
intention of dividing the profits among themselves. Each partner is personally liable for any
debt incurred by the partnership.
Corporation. A corporation is a business owned by its stockholders. It is an artificial being
created by operation of law, having the rights of succession and the powers, attributes and
properties expressly authorized by law or incident to its existence. The stockholders are not
personally liable for the corporation’s debts.
FUNDAMENTAL CONCEPTS
Several fundamental concepts underlie the accounting process.
transactions, accountants should consider the following:
In recording business
Entity Concept. The most basic concept in accounting is the entity concept. An accounting
entity is an organization or a section of an organization that stands apart from other
organizations and individuals as a separate economic unit. Simply put, the transactions of
different entities should not be accounted for together. Each entity should be evaluated
separately.
Periodicity Concept. An entity’s life can be meaningfully subdivided into equal time periods
for reporting purposes. It will be aimless to wait for the actual last day of operations to
perfectly measure the entity’s profit. This concept allows the users to obtain timely information
to serve as a basis on making decisions about future activities. For the purpose of reporting
to outsiders, one year is the usual accounting period.
Stable Monetary Unit Concept. The Philippine peso is a reasonable unit of measure and that
its purchasing power is relatively stable. It allows accountants to add and subtract peso
amounts as though each peso has the same purchasing power as any other peso at any
time. This is the basis for ignoring the effects of inflation in the accounting records.
Going Concern Concept. Financial statements are normally prepared on the assumption
that the reporting entity is a going concern and will continue in operation for the foreseeable
future. Hence, it is assumed that the entity has neither the intention nor the need to enter
liquidation or to cease trading. This assumption underlies the depreciation of assets over their
useful lives.
ELEMENTS OF FINANCIAL STATEMENTS
The elements of financial statements defined in the March 2018 Conceptual Framework for
financial reporting (2018 Conceptual Framework) are:


Assets, liabilities and equity – relate to a reporting entity’s financial position; and
Income and expenses – relate to a reporting entity’s financial performance.
Financial Position
Asset
Asset is a present economic resource controlled by the entity as a result of past events. An
economic resource is a right that has the potential to produce economic benefits. There are
three aspects to these definitions: “right”; potential to produce economic benefits”; and
“control”.
Liability
A liability is a present obligation of the entity to transfer an economic resource as a result of
past events. For a liability to exists, three criteria must all be satisfied.
a. the entity has an obligation;
b. the obligation is to transfer an economic resource; and
c. the obligation is a present obligation that exists as a result of past events.
Example:
a. Obligations to pay cash.
b. Obligations to deliver goods or provide services.
c. Obligations to exchange economic resources with another party on unfavorable
terms.
d. Obligations to transfer an economic resource if a specified uncertain future event
occurs.
e. Obligations to issue a financial instrument if that financial instrument will oblige the
entity to transfer an economic resource.
A present obligation exists as a result of past events only if:
a. the entity already obtained economic benefits or taken an action; and
b. as a consequence, the entity will or may have to transfer an economic resource that
it would not otherwise have had to transfer.
Equity
Equity is the residual interest in the assets of the enterprise after deducting all its liabilities. In
other words, they are claims against the entity that do not meet the definition of a liability.
Equity may pertain to any of the following depending on the form of business organization:
 In a sole proprietorship, there is only one owner’s equity account because there is only
one owner.
 In a partnership, an owner’s equity account exists for each partner.

In a corporation, owners’ equity or stockholders’ equity consist of share capital,
retained earnings and reserves representing appropriations of retained earnings
among others.
Financial Performance
Income is increases in assets, or decreases in liabilities, that result in increases in equity, other
than those relating to contributions from holders of equity claims.
Expenses. Are decreases in assets, or increases in liabilities, that result in decrease in equity,
other than those relating to distributions to holders of equity claims.
THE ACCOUNT
The basic summary device of accounting is the account. A separate account is maintained
for each element that appears in the balance sheet (assets, liabilities and equity) and in the
income statement (income and expenses). Thus, an account may be defined as a detailed
record of the increases, decreases and balance of each element that appears in an entity’s
financial statements. The simplest form of the account is known as the “T” account because
of its similarity to the letter “T”. The account has three parts as follows.
Account Title
Debit
Credit
side
side
Left
Right
side
Side
THE ACCOUNTING EQUATION
Financial statements tell us how a business is performing. They are the final products of the
accounting process. But how do we arrive at the items and amounts that make up the
financial statements? The most basic tool of accounting is the accounting equation. This
equation presents the resources controlled by the enterprise, the present obligations of the
enterprise and the residual interest in the assets. It states that assets must always equal
liabilities and owner’s equity. The basic accounting model is:
Assets = Liabilities + Owner’s Equity
Note that the assets are on the left side of the equation opposite the liabilities and owner’s
equity. This explains why increases and decreases in assets are recorded in the opposite
manner (“mirror image”) as liabilities and owner’s equity are recorded. The equation also
explains why liabilities and owner’s equity follow the same rules of debit and credit.
DEBITS AND CREDITS – THE DOUBLE –ENTRY BOOKKEEPING SYSTEM
Accounting is based on a double –entry bookkeeping system which means that the dual
effects of a business transaction is recorded. A debit side entry must have a corresponding
credit side entry. For every transaction, there must be one or more accounts debited and
one or more accounts credited. Each transaction affects at least two accounts. The total
debits for a transaction must always equal the total credits.
An account is debited when an amount is entered on the left side of the account and
credited when an amount is entered on the right side. The abbreviations for debit and credit
are DR. and CR respectively.
The account type determines how increases or decreases in it are recorded. Increases in
assets are recorded as debits while decreases in assets are recorded as credits. Conversely,
increases in liabilities and owner’s equity are recorded by credits and decreases are entered
as debits.
The rules of debit and credit for income and expense accounts are based on the relationship
of these accounts to owner’s equity. Income increases owner’s and expense decreases
owner’s equity. Hence, increases in income are recorded as credits and decreases as debits.
Increases in expenses are recorded as debits and decreases as credit. These are the rules of
debit and credit. The following summarizes the rules
NORMAL BALANCE OF AN ACCOUNT
The normal balance of any account refers to the side of the account- debit or credit-where
increases are recorded. Assets owner’s withdrawal and expense accounts normally have
debit balances; liability, owner’s equity and income accounts normally have credit balances.
This result occurs because increases in an account are usually greater than or equal to
decreases.
Increases
Recoded by
Normal
Balance
Account
Debit
Credit
Debit
Credit
Assets
X
X
liabilities
X
X
Owner’s equity
Owner’s capital
X
X
Withdrawals
X
X
Income
X
X
expenses
X
X
ACCOUNTING EVENTS AND TRANSACTIONS
An accounting event is an economic occurrence that causes changes in an enterprise’s
assets, liabilities, and/or equity. Events may be internal actions, such as the use of equipment
for the production of goods or services. It can also be an external event, such as the purchase
of raw materials from a supplier. A transaction is a particular kind of event that involves the
transfer of something of value between two entities. Examples of transactions include
acquiring assets from owner, borrowing funds from creditors, and purchasing or selling goods
and services.
TYPES AND EFFECTS OF TRANSACTIONS
It will be beneficial in the long-term to be able to understand a classification approach that
emphasizes the effects of accounting events rather the recording procedures involved. This
approach is quite pioneering. Although business entities engage in numerous transactions,
all transactions can be classified into one of four types, namely:
1. Source of Assets (SA). An asset account increases and a corresponding claims
(liabilities or owner’s equity) accounts increases. Examples: (1) Purchase of
supplies on account; (2) sold goods on cash on delivery basis.
2. Exchange of Assets (EA). One asset account increases and another asset
account decreases. Example: acquired equipment for cash.
3. Use of assets (UA). An asset account decreases and a corresponding claims
(liabilities or equity) account decreases. Example: (1) Settled accounts
payable; (2) paid salaries of employees.
4. Exchange of claims (EC). One claims (liabilities or owner’s equity) account
increases and another claims (liabilities or owner’s equity) account decreases.
Example: received utilities bill but did not pay.
Every accountable event has a dual but self-balancing effect on the accounting equation.
Recognizing these events will not in any manner affect the equality of the basic accounting
model. The four types of transactions above may be further expanded into nine types of
effects as follows:
1. Increase in Assets = Increase in Liabilities (SA)
2. Increase in Assets = Increase in Owner’s equity (SA)
3. Increase in in one = Decrease in another Asset (EA)
4. Decrease in Assets = Decrease in Liabilities (UA)
5. Decrease in Assets = Decrease in Owner’s Equity (UA)
6. Increase in Liabilities = Decrease in Owner’s equity (EC)
7. Increase in Owner’s equity = decrease in Liabilities (EC)
8. Increase in one Liability = Decrease in another liabilities (EC)
9. Increase in one Owner’s equity = Decrease in another Owner’s equity (EC)
STATEMENT OF FINANCIAL POSITION
ASSETS
Assets are should be classified only into two: current assets and non-current assets. Per revised
Philippine Standards (PAS) no. 1, an entity shall classify assets as current when:
a. It expects to realize the asset, or intends to sell or consume it, in its normal operating
cycle;
b. It holds the asset primarily for the purpose of trading;
c. It expects to realize the asset within twelve months after the reporting period; or
d. The asset is cash or a cash equivalents (as defined in PAS no. 7 ) unless the asset is
restricted from being exchanged or used to settle a liability for at least twelve
months after the reporting period.
All other assets should classified as non-current assets. Operating cycle is the time between
the acquisition of assets for processing and their realization in cash or cash equivalents. When
the entity’s normal operating cycle is not clearly identifiable, it is assumed to be twelve
months.
Current assets
Cash. Cash is any medium of exchange that a bank will accept for deposit at face value it
includes coins, currency, checks, money orders, bank deposits and drafts.
Cash equivalents. Per PAS no.7, these are short –term, highly liquid investments that are
readily convertible to known amounts of cash and which are subject to an insignificant risk of
changes in value.
Notes receivable. A note receivable is a written pledge that the customer will pay the
business a fixed amount of money on a certain date.
Accounts receivable. These are claims against customers arising from sale of services or
goods on credit. This type of receivable offers less security than a promissory note.
Inventories. Per PAS no. 2, these are assets which are (a) held for sale in the ordinary course
of business; (b) in the process of production for such sale; or (c) in the form of materials or
supplies to be consumed in the production process or in the rendering of services.
Prepaid expenses. These are expenses paid for by the business in advance. It is an asset
because the business avoids having to pay cash in the future for a specific expense. These
include insurance and rent. These prepaid items represent future economic benefits- assets
– until the time these start to contribute to the earning process; these, then, become
expenses.
Non –current assets
Property, Plant, and Equipment. Per PAS no. 16, these are tangible assets that are held by an
enterprise for use in the production or supply of goods or services, or for rental to others, or for
administrative purposes and which are expected to be used during more than 1 period.
Included are such items as land, building, machinery and equipment, furniture and fixtures,
motor vehicles and equipment.
Accumulated depreciation. It is a contra assets account that contains the sum of the
periodic depreciation charges. The balance in this account is deducted from the cost of the
related assets- equipment or buildings – to obtain book value.
Intangible Assets. Per PAS no. 38. These are identifiable, nonmonetary assets without physical
substance held for use in the production or supply of goods or services, for rentals to others,
or for administrative purposes. These include goodwill, patents, copyrights, licenses,
franchises, trademarks, brand names, secret processes, subscription list, and non-competition
agreements.
Liabilities
Per revised Philippine Accounting Standards (PAS) no. 1, an entity shall classify a liability as
current when:
a. it expects to settle the liability in its normal operating cycle;
b. it holds the liability primarily for the purpose of trading;
c. the liability is due to be settled within twelve months after the reporting period; or
d. the entity does not have an unconditional right to defer settlement of the liability
for at least twelve months after the reporting period.
All other liabilities should be classified as non-current liabilities.
Current Liabilities
Accounts payable. This account represents the reverse relationship of the accounts
receivable. By accepting the goods or services, the buyer agrees to pay for them in the near
future.
Notes payable. A note payable is like a note receivable but in a reverse sense. In the case
of a note payable, the business entry is the maker of the note; that is, the business entity is the
party who promises to pay the other party a specified amount of money on a specified future
date.
Accrued Liabilities. Amounts owed to others for unpaid expenses. This account includes
salaries payable, utilities payable, interest payable and taxes payable.
Unearned Revenues. When the business entity receives payment before providing its
customers with goods or services, the amounts received are recorded in the unearned
revenue account (liability method). When the goods or services are provided to the
customer, the unearned revenue is reduced and income is recognized.
Current portion of long-term debt. These are portions of mortgage notes, bonds and other
long-term indebtedness which are to be paid within one year from the balance sheet date.
Non –current liabilities
Mortgage Payable. This account records long-term debt of the business entity for which the
business entity has pledged certain assets as security to the creditor. In the event that the
debt payments are not made, the creditor can foreclose or cause the mortgaged asset to
be sold to enable the entity to settle the claim.
Bonds Payable. Business organization often obtain substantial sums of money from lenders to
finance the acquisition of equipment and other needed assets. They obtain these funds by
issuing bonds. The bond is a contract between the issuer and the lender specifying the terms
of repayment and the interest to be charged.
Owner’s Equity
Capital (from the Latin capitalis, meaning “property”). This account is used to record the
original and additional investments of the owner of the business entity. It is increased by the
amount of profit earned during the year or is decreased by a loss. Cash or other assets that
the owner may withdraw from the business ultimately reduce it. This account title bears the
name of the owner.
Withdrawals. When the owner of a business entity withdraws cash or other assets, such are
recorded in the drawing or withdrawal account rather than directly reducing the owner’s
equity account.
Income Summary. It is a temporary account used at the end of the accounting period to
close income and expenses. This account shows the profit or loss for the period before closing
to the capital accounts.
INCOME STATEMENT
Income
Service Income. Revenues earned by performing services for a customer or client; for
example, accounting services by a CPA firm, laundry shop.
Sales. Revenues earned as a result of sale of merchandise; for example, sale of building
materials by a construction supplies firm.
Expenses
Cost of sales. The cost incurred to purchase or to produce the products sold to customers
during the period; also called cost of goods sold.
Salaries or wages expense. Includes all payments as a result of an employer-employee
relationship such as salaries or wages, 13th month pay, cost of living allowances and other
related benefits.
Telecommunications, electricity, fuel and water expenses. Expenses related to use of
telecommunications facilities, consumption of electricity, fuel and water.
Rent expense. Expense for space, equipment or other asset rentals.
Supplies expense. Expense of using supplies (e.g. office supplies) in the conduct of daily
business.
Insurance expense. Portion of premiums paid on insurance coverage (e.g. on motor
vehicle, health, life, fire, typhoon or flood) which has expired.
Depreciation expense. The portion of the cost of a tangible asset ( e.g. buildings and
equipment) allocated or charged as expense during an accounting period.
Uncollectible account expense. The amount of receivables estimated to be doubtful of
collection and charged as expense during an accounting period.
Interest expense. An expense related to use of borrowed funds.
ACCOUNTING FOR BUSINESS TRANSACTIONS
Accountants observe many events that they identify and measure in financial terms. A
business transaction is the occurrence of an event or a condition that affects financial
position and can be reliably recorded.
Financial Transaction Worksheet
Every financial transaction can be analyzed or expressed in terms of its effects on the
accounting equation. The financial transactions will be analyzed by means of a financial
transaction worksheet which is a form used to analyze increases and decreases in the assets,
liabilities or owner’s equity of a business entity.
Illustration. Galicano Del Mundo decided to establish a sole proprietorship business and
named it as Del mundo Graphics Design. Del Mundo is a graphic designer who has extensive
experience in drawing, layout, typography, lettering, diagramming, and photography. He
possesses the talent to visually communicate to a target audience with the right combination
of words, images and ideas.
Del Mundo Graphics Design can do the layout and production design of newspapers,
magazines, corporate reports, journals and other publications. The entity can create
promotional displays; marketing brochures for services and product; packaging design for
products; and distinctive logos for businesses. He also enters into agreements with clients for
the progressive development and maintenance of their web sites. His initial revenue stream
comes from web designing.
The owner, Galicano Del Mundo, makes the business decisions. The assets of the company
belong to Del Mundo and all obligations of the business are his responsibility. Any income
that the entity earns belongs solely to Del Mundo.
When a specific asset, liability or owner’s equity item is created by a financial transaction, it
is listed in the financial transaction worksheet using the appropriate accounts. The worksheet
that follows shows the first transaction of the Del Mundo Graphics Design. The dates are
enclosed in parentheses.
During March 2019, the first month of operations, various financial transactions took place.
These transactions are described and analyzed as follows.
Mar. 1
Del Mundo started his new business by depositing P350,000 in a bank account
in the name of Del Mundo Graphics Design at BPI Poblacion Branch.
Del Mundo Graphics Design
Financial transaction worksheet
Month of March 2019
Assets
=
liabilities
+
Owner’s Equity
Cash
Del Mundo, Capital
(1) P350,000
=
P350,000
=======
========
The financial transaction is analyzed as follows:
 An entity separate and distinct from Del Mundo’s personal financial affairs is created.
 An economic resource – cash of P350,000 is invested in the business entity. The source
of this asset is the contribution made by the owner, which represents owner’s equity.
The owner’s equity account is Del Mundo, Capital.
 The dual nature of the transaction is that cash is invested and owner’s equity created.
The effects on the accounting equation are as follows: Increase in asset – cash from
zero to P350,000 and increase in owner’s equity from zero to P350,000.

Mar. 5
At this point, the entity has no liabilities, and assets equal owner’s equity.
Computer equipment costing P145,000 is acquired on cash. The effect of the
transaction on the basic equation is:
Assets
= liabilities
+
Owner’s Equity
Cash
+
Computer Equip.
Del Mundo, Capital
Bal. P350,000
P145,000
P350,000
(5) (145,000)
Bal. P205,000 + P145,000
=
P350,000
========
========
=======
This transaction did not change the total assets but it did change the
composition of the assets – it decreased one asset – cash and increased
another asset – computer equipment by P145,000. Note that the sums of the
balances on both sides of the equation are equal. This equality must always
exist.
Mar. 9
Computer supplies in the amount of P25,000 are purchased on account.
Assets
=
Liabilities
+ Owner’s Equity
Cash +Computer
+ Computer
accounts
+ Del Mundo,
Supplies
equipment =
payable
Capital
P205,000
+
P145,000
=
+ P350,000
25,000
=
25,000
P205,000 + 25,000 +
P145,000
=
25,000
+ P350,000
P375,000
=
P25,000
+P350,000
========
=======
========
Assets don’t have to be purchased in cash. It can also be purchased on credit.
Acquiring the computer supplies with a promise to pay the amount due later is
called buying on account. This transaction increases both the assets and the
liabilities of the business. The asset affected is computer supplies and the
liability created is an accounts payable.
Mar. 11
Del Mundo Graphics Design collected P88,000 in cash for designing interactive
web sites for two exporters based inside the Ortigas Ecozone.
Assets
=
Liabilities
+
Owner’s Equity
Cash + Computer + Computer =
Accounts
Del Mundo,
Supplies + equipment =
payable
Capital
Bal. P205,000+ P25,000 + P145,000 =
P25,000
P350,000
(11) 88,000
88,000
Bal. P293,000 + P25,000 + P145,000 =
P25,000
+
P438,000
P463,000 =
P463,000
========
========
The entity earned service income by designing web sites for clients. Del Mundo
rendered his professional services and collected revenues in cash. The effect
on the accounting equation is an increase in the asset – cash and an increase
in owner’s equity. Income increases owner’s equity. This transaction caused
the business to grow, as shown by the increase in total assets from P375,000 to
P463,000.
Mar. 16
Del Mundo paid P18,000 to Ceradoy Bills Express, a one – stop bills payment
service company, for the semi-monthly utilities.
Assets
=
Liabilities
+
Owner’s Equity
Cash + computer + computer =
accounts
+
Del Mundo,
Supplies equipment
payable
capital
Bal. P293,000 P25,000 P145,000 =
P25,000
+
P438,000
(16) (18,000)
(18,000)
P275,000 + P25,000 + P145,000 =
P25,000
+
P420,000
P445,000 =
P445,000
========
========
Expenses are recorded when they are incurred. Expenses can be paid in cash
when they occur, or they can be paid later. The payment for utilities is an
expense for the month of March. It represented an outflow of resources and a
reduction of owner’s equity. Expenses have the opposite effect of income,
they cause the business to shrink as shown by the smaller amount of total assets
of P445,000.
Mar. 17
The entity has service agreements with several Netpreneurs to maintain and
update their web sites weekly. Del Mundo billed these clients P35,000 for
services already rendered during the month.
Assets
=
liabilities + Owner Equity
Cash + Accounts + Computer + Computer = Accounts + Del Mundo,
Receivables supplies
equipment
Payable
capital
Bal. P275,000
P25,000
P145,000
P25,000
P420,000
(17)
P35,000
=
P35,000
P275,000 + P35,000+P25,000 + P145,000
= P25,000
+ P455,000
P480,000 = P480,000
========
=======
The entity has performed services to clients so income should already be
recognized Del Mundo is entitled to receive payment for these but the clients
did not pay immediately. Performing the services creates an economic
resource, the client’s promise to pay the amount which is called accounts
receivable. This transaction resulted to an increase in asset- accounts
receivable and an increase in owner’s equity of P35,000.
Mar. 19
Del Mundo made a partial payment of P17,000 for the March 9 purchase on
account.
Assets
=
L
+
OE
Cash + accounts + computer + computer accounts + Del MUndo,
Receivable supplies equipment
Payable
capital
Bal. P275,000 P35,000
P25,000 P145,000
= P25,000
P455,000
(19) (17,000)
(17,000
P258,000 +P35,000 + P25,000 + P145,000
= P 8,000
+ P455,000
P463,000
= P463,000
=========
========
This transaction is a payment on account. The effect on the accounting
equation is a decrease in the asset-cash and a decrease in the liabilityaccounts payable. The payment of cash on account has no effect on the
asset – computer supplies because the payment does not increase or
decrease the supplies available to the business.
Mar. 20
Checks totaling P25,000 were received from clients for billing dated March 17.
A
=
l
+
OE
Cash + accounts + computer + computer = accounts + Del Mundo,
Receivable supplies
equipment payable
capital
Bal. P258,000 P35,000
P25,000
P145,000 = P8,000
P455,000
(20) 25,000 (25,000)
P283,000 +P10,000 + P25,000 + P145,000 = P8,000
+ P455,000
P463,000
= P463,000
========
========
Last March 17, Del Mundo billed clients for services already rendered. On
March 20, the entity was able to collect P25,000 from them. The asset-cash is
increased by P25,000. The business should not record service income on March
20 since it has already recorded the income last March 17. Total assets are
unchanged. The business merely reduced one asset – accounts receivable
and increased another –cash.
Mar. 21
Del Mundo withdrew P20,000 from the business for his personal use.
A
=
L
+
OE
Cash + accounts + computer + computer = Accounts + Del Mundo,
Receivables supplies equipment = Payable + capital
Bal. P283,000 P10,000
P25,000
P145,000
P8,000
P455,000
(21) (20,000)
=
(20,000)
P263,000 + P10,000 + P25,000 + P145,000
= P8,000
+ P435,000
P443,000
= P443,000
========= = ========
Withdrawal of cash or other assets for personal use is the by which the owner
of the entity receives advance distribution of the profits. On March 1, Del
Mundo invested P350,000; both cash and owner’s equity increased. The
transaction was an investment by the owner and not an income-generating
activity. Del Mundo simply transferred funds from his personal account to the
business. A cash withdrawal is exactly the opposite. The P20,000 cash
withdrawal transaction resulted to a reduction in both cash and owner’s
equity.
Mar. 27
Warlito Blance Publishing submitted a bill to Del Mundo for P8,000 worth of
newspaper advertisements for this month. Del Mundo will pay this bill next
month.
A
=
L
+
OE
Cash + accounts + Computer + computer = Accounts + Del Mundo,
Receivable supplies
equipment = payable
capital
Bal. P263,000 P10,000 P25,000
P145,000
= P8,000
P435,000
(27)
= P8,000
(P8,000)
P263,000 + P10,000 + P25,000 + P145,000
= P16,000
+ P427,000
P443,000
=
P443,000
========
========
Warlito Blance rendered services on account. Del Mundo Graphics Design has
incurred an expense in the amount of P8,000 by availing of Warlito Blance’s
services. There was no payment during the month. This advertising expense
resulted to a decrease in owner’s equity and an increase in the liability –
accounts payable.
Mar. 31
Del Mundo paid his assistant designer salaries of P15,000 for the month.
A
=
L
+
OE
Cash + accounts + computer + computer = accounts
Del Mundo,
Receivables supplies
equipment payable
capital
Bal. P263,000 P10,000 P25,000
P145,000
= P16,000
P427,000
(31) (15,000)
=
(15,000)
P248,000 + P10,000 + P25,000 + P145,000 = P16,000
+ P412,000
P428,000
=
P428,000
========
========
This transaction resulted to a reduction in owner’s equity as well as a reduction
in cash. By providing his services to Del Mundo for the month, the assistant
designer has created for the business an expense – salaries expense.
Multiple Choice
1. If assets total P700,000 and liabilities total P400,000, how much are the net
assets?
a. P300,000
b. P400,000
c. P700,000
d. P1,100,000
2. What are increases in resources that a firm earns by providing goods or services
to its customers?
a. Assets
b. Income
c. Expenses
d. Liabilities
3. If assets increase by P100,000 and Liabilities decrease by P30,000, owner’s
equity must
a. remained unchanged
b. increase by P130,000
c. decrease by P70,000
d. decrease by P130,000
4. Which of the following is true?
a. The debit is on the right side of an asset account.
b. The debit is on the left side of an asset account.
c. The credit is on the left side of a liabilities account.
d. The debit is on the right side of an expense account.
5. Which of the following accounts has a normal debit balance?
a. Accounts payable
b. Notes payable
c. Consulting revenues
d. Advertising expense
6. Which of the following accounts is increased by a credit?
a. Accounts receivable
b. Sales
c. Withdrawals
d. Advertising
7. Which of the following is true?
a. A debit will increase a liability account.
b. A credit will increase an asset account.
c. A credit will increase a revenue account.
d. A debit will decrease an expense account.
8. In applying the rules of debits and credits, which of the following statements is
correct?
a. The word “ debit “ means to increase, and the word “credit” means to
decrease.
b. Assets, expense and capital accounts are debited for increases.
c. Liability, revenue and capital accounts are debited for increases.
d. Asset, expense and withdrawals are debited for increases.
9. The entity purchases P10,000 fixtures for entity use on credit. Which of the
following will be affected?
1. Assets
2. Liabilities
3. Capital
a. (1) and (2) only
b. (1) and (3) only
c. (2) and (3) only
d. (1), (2) and (3)
10. Suppose a debtor repays his debt of P50,000 by transferring the money into the
bank account of the business. The effect of the transaction on the accounting
equation would be:
a. Both assets and liabilities increase by P50,000.
b. Both assets and liabilities decrease by P50,000.
c. Only assets decrease by P50,000.
d. Assets and liabilities remain unchanged.
11. Under the double-entry system, what is the value of X if assets, current liabilities,
non-current liabilities and capital are X, P40,000, P60,000 and P350,000
respectively?
a. P250,000
b. P350,000
c. P370,000
d. P450,000
12. Which of the following is correct under the double-entry system?
a. Asset amount must be equal to liability amount.
b. The change in asset must be compensated by a change in liability.
c. The change in a debit- side entry must be compensated by a change in
credit – side entry
d. A decrease in non-current asset means a credit entry in assets account.
Quiz
1
Chapter 2: Recording Business Transactions
Learning Objectives:
After studying this chapter, you should be able to:
1. List and explain in brief the sequential steps in the accounting cycle.
2. Identify the general journal as the book of original entry.
3. Detail the standard contents of the general journal.
4. Outline the steps in analyzing transactions and state the role of
source documents.
5. Analyze the impact of transactions on the elements and the specific
accounts.
6. Apply the rules of debits and credits in analyzing business
transactions.
7. Journalize transactions in proper form.
8. Describe a general ledger and understand what purpose it serves.
9. Post entries from the general journal to the general ledger.
10. Distinguish between permanent and temporary accounts.
11. Develop a chart of account.
12. Prepare and explain the use of a trial balance.
TRANSACTION ANALYSIS (STEP 1)
The analysis of transactions should follow these four basic steps:
1. Identify the transaction from source documents.
2. Indicate the accounts – either assets, liabilities, equity, income or expenses – affected
by the transaction.
3. Ascertain whether each account is increased or decreased by the transaction.
4. Using the rules of debit and credit, determine whether to debit or credit the account
to record its increase or decrease.
SOURCE DOCUMENTS
Transactions and events are the starting points in the accounting cycle. By relying on source
documents, transaction s and events can be analyzed as to how they will affect performance
and financial position. Source documents identify and describe transactions and events
entering the accounting process. These original written evidences contain information about
the nature and the amounts of the transactions. These are the bases for the journal entries;
some of the more common source documents are sales invoices, cash register tapes, official
receipts, bank deposit slips, bank statements, checks, purchase orders, time cards and
statements of account.
ACCOUNTING CYCLE
The accounting cycle refers to a series of sequential steps or procedures performed to
accomplish the accounting process. The steps in the cycle and their aims follow:
Step 1
Identification of Events to be recorded
Aim: To gather information about transactions or events generally through the
source documents.
Step 2
Step 3
Step 4
Step 5
Step 6
Step 7
Step 8
Step 9
Step 10
Transactions are recorded in the Journal
Aim: To record the economic impact of transactions on the firm in a journal,
which is a form that facilitates transfer to the accounts.
Journal Entries are Posted to the Ledger
Aim: To transfer the information from the journal to the ledger for classification.
Preparation of a Trial Balance
Aim: To provide a listing to verify the equality of debits and credits in the ledger.
Preparation of the Worksheet including Adjusting Entries
Aim: To aid in the preparation of financial statements.
Preparation of the Financial Statements
Aim: To provide useful information to decision –makers.
Adjusting journal Entries are Journalized and Posted
Aim: To record the accruals, expiration of deferrals, estimations and other
events from the worksheets.
Closing Journal Entries are Journalized and Posted
Aim: To close temporary accounts and transfer profit to owner’s equity.
Preparation of a Post-Closing Trial balance
Aim: To check the equality of debits and after the closing entries.
Reversing Journal Entries are Journalized and Posted
Aim: To simplify the recording of certain regular transactions in the next
accounting period.
This cycle is repeated each accounting period. The first three steps in the accounting cycle
are accomplished during the period. The fourth to the ninth steps generally occur at the end
of the period. The last step is optional and occurs at the beginning of the next period.
THE JOURNAL
The journal is a chronological record of the entity’s transactions. A journal entry shows all the
effects of a business transaction in terms of debits and credits. Each transaction is initially
recorded in a journal rather than directly in the ledger. A journal is called the book of original
entry. The nature and volume of transactions of the business determine the number and type
of journals needed. The general journal is the simplest journal.
Format
The standard contents of the general journal are as follows:
1. Date. The year and month are not rewritten for every entry unless the year or month
changes or a new page is needed.
2. Account titles and explanation. The account to be debited is entered at the extreme
left of the first line while the account to be credited is entered slightly indented on the
next line. A brief description of the transaction is usually made on the line below the
credit. Generally, skip a line after each entry.
3. P. R. (posting reference). This will be used when the entries are posted, that is, until the
amounts are transferred to the related ledger accounts. The posting process will be
described later.
4. Debit. The debit amount for each account is entered in this column.
5. Credit. The credit amount for each account is entered in this column.
Assume that Maria Concepcion Jennifer Perez-Manalo established her own wedding
consultancy with an initial investment of P250,000 on May 1
The journal entry is shown below
Date
2019
May 1
Journal
Account titles and explanation
Cash
Perez-Manalo, capital
To record initial investment
P. R.
Debit
page 1
Credit
250,000
250,000
Simple and Compound Entry
In a simple entry, only two accounts are affected – one account is debited and the other
account credited. An example of this is the entry to record the initial investment of PerezManalo. However, some transactions require the use of more than two accounts. When
three or more accounts are required in a journal entry, the entry is referred to as a compound
entry.
TRANSACTIONS ARE JOURNALIZED (step 2)
After the transaction or event has been identified and measured, it is recorded in the journal.
The process of recording a transaction is called journalizing. The following are the transactions
for Wedding “R” Us during the month of May. The double – entry system will be used.
To understand the nature of the affected accounts, the letter A (for asset), L (liability) or OE
(owner’s Equity) is inserted after each entry. In addition, owner’s equity is further classified
into OE: I (income) and OE: E (expenses)
Note that the rule of double – entry system are observed in each transaction:
1. Two or more accounts are affected by each transaction.
2. The sum of the debits for every transaction equals the sum of the credits.
3. The equality of the accounting equation is always maintained.
Initial Investment (Source of Assets)
May 1
Maria Concepcion Jennifer Perez- Manalo is a social entrepreneur from the
South. She is into a lot of interesting causes. Her fine taste is preeminent such
that she is considered an authority in planning weddings. Upon the advice
and prodding of an esteemed colleague, Bendalyn Landicho, Perez-Manalo
decided to organize her wedding consultancy. She invested P250,000 into this
entity.
Analysis
Assets increased. Owner’s equity increased.
Entry
Increase in assets is recorded by a debit to cash. Increase in owner’s equity is
recorded by a credit to Perez-Manalo, capital
Debit
Credit
Cash (A)
250,000
Perez – Manalo, capital (OE)
250,000
Rent Paid in Advance (Exchange of Assets)
May 1
rented office space and paid two month’s rent in advance, P8,000.
Analysis
Assets increased. Assets decreased.
Entry
Increase in assets is recorded by a debit to prepaid rent. Decrease in assets is
recorded by a credit to cash.
Debit
Credit
Prepaid rent (A)
8,000
Cash (A)
8,000
Note Issued for Cash (Source of Assets)
May 2
Maria Concepcion Jennifer Perez-Manalo issued a promissory note for a
P210,000 loan from Metrobank. This availment will be used for the acquisition
of a service vehicle. The note carries a 20% interest per annum. The
arrangement with the bank is that both the interest and the principal are
payable in full in one year.
Analysis
assets increased. Liabilities increased.
Entry
Increase in assets is recorded by a debit to cash. Increase in liabilities is
recorded by a credit to notes payable.
Debit
Credit
Cash (A)
210,000
Notes payable (L)
210,000
May 2
Hired an office assistant and an account executive each with a P7,800 monthly
salary. Or, each is to receive P300 per day for the 26-day work month. No entry
is necessary at this point. They started work immediately.
Service Vehicle Acquired for Cash (exchange of assets)
May 4
Acquired service vehicle for P420,000.
Analysis
Assets increased. Assets decreased.
Entry
Increase in assets is recorded by a debit to service vehicle. Decrease in assets
is recorded by a credit to cash.
Service vehicle(A)
Cash (A)
Debit
420,000
Credit
420,000
Insurance Premiums Paid (exchange of assets)
May 4
Paid Prudential Guarantee and Assurance, Inc. P14,400 for a one-year
comprehensive insurance coverage on the service vehicle.
Analysis
An asset increased. Another assets decreased.
Entry
Increase in assets is recorded by a debit to prepaid insurance. Decrease in
assets is recorded by a credit to cash.
Debit
Credit
Prepaid Insurance (A)
14,400
Cash (A)
14,400
Office Equipment Acquired on Account (exchange and source of assets)
May 5
Acquired office equipment from fair and Square Emporium for P60,000; paying
P15,000 in cash and the balance next month. Note: A compound entry is
needed for this transaction.
Analysis
Assets increased. Assets decreased. Liabilities increased.
Entry
Increase in assets is recorded by a debit to office equipment. Decrease in
assets is recorded by a credit to cash. Increase in liabilities is recorded by a
credit to accounts payable.
Debit
Credit
Office Equipment (A)
60,000
Cash (A)
15,000
Accounts payable (L)
45,000
Supplies Purchased on Account (source of assets)
May 8
Purchased supplies on credit for P18,000 from San Jose merchandising.
Analysis
Assets increased. Liabilities increased.
Entry
Increase in assets is recorded by a debit to supplies. Increase in liabilities is
recorded by a credit to accounts payable.
Debit
Credit
Supplies (A)
18,000
Accounts payable (L)
18,000
Accounts Payable Partially Settled (use of assets)
May 9
Paid San Jose Merchandising P10,000 of the amount owed.
Analysis
Assets decreased. Liabilities decreased.
Entry
Decrease in liabilities is recorded by a debit to accounts payable. Decrease
in assets is recorded by a credit to cash.
Debit
Credit
Accounts payable (L)
10,000
Cash (A)
10,000
Revenue Earned and Cash Collected (source of assets)
May 10
Analysis
Entry
Coordinated and finalized simple bridal arrangements for three couples and
collected fees of P8,800 per couple. Services include prospecting and
selecting the church and reception location, couturier, caterer, car service,
flowers, souvenirs, and invitations.
Assets increased. Owner’s equity increased.
Increase in assets is recorded by a debit to cash. Increase in owner’s equity is
recorded by a credit to consulting revenues.
Debit
Credit
Cash (A)
26,400
Consulting revenues (OE:I)
26,400
Salaries Paid (use of Assets)
May 13
Paid salaries, P6,600. The entity pays salaries every two Saturdays
Analysis
Assets decreased. Owner’s equity decreased.
Entry
Decrease in owner’s equity is recorded by debit to salaries expense. Decrease
in assets is recorded by a credit to cash.
Debit
Credit
Salaries expense (OE:E)
6,600
Cash (A)
6,600
Unearned Revenues Collected (source of assets)
May 15
The entity is earning additional revenues by referring consulting clients to
friendly hotels, caterers, printers, and couturiers. Received P10,000 advance
fees for three clients referred.
Analysis
Assets increased. Liabilities increased.
Entry
Increase in assets is recorded by a debit to cash.
recorded by a credit to unearned referral revenues.
Increase in liabilities is
Debit
Cash (A)
Unearned referral revenues (L)
Credit
10,000
10,000
Revenues Earned on Account (source of assets)
May 19
Analysis
Entry
Coordinated and finalized elaborate bridal arrangements for three couples
and billed fees of P12,000 per couple. Additional services include documents
preparation, consultation with a feng shui expert as to the ideal wedding date
for prosperity and harmony, provision for limousine service and honeymoon
trip.
Assets increased. Owner’s equity increased.
Increase in assets is recorded by a debit to accounts receivable. Increase in
owner’s equity is recorded by a credit to consulting revenues.
Debit
Credit
Accounts receivable (A)
36,000
Consulting revenues (OE:I)
36,000
Withdrawal of Cash by Owner (use of assets)
May 25
Perez-Manalo withdrew P14,000 for personal expenses.
Analysis
Assets decreased. Owner’s equity decreased.
Entry
Decrease in owner’s equity is recorded by a debit to Perez-Manalo,
withdrawals. Decrease in assets is recorded by a credit to cash.
Debit
Credit
Perez-Manalo, withdrawals (OE)
14,000
Cash (A)
14,000
Salaries paid (use of assets)
May 27
Paid salaries, P7,200.
Analysis
Assets decreased. Owner’s equity decreased.
Entry
Decrease in owner’s equity is recorded by to salaries expense. Decrease is
assets is recorded by a credit to cash.
Debit
Credit
Salaries expense (OE:E)
7,200
Cash (A)
7,200
Expenses Incurred but Unpaid (exchange of claims)
May 30
Received the ICC-Bayan Tel telephone bill, P1,400.
Analysis
Liabilities increased. Owner’s equity decreased.
Entry
Decrease in owner’s equity is recorded by a Debit to utilities expense. Increase
in liabilities is recorded by a credit to utilities payable.
Debit
Credit
Utilities expense (OE:E)
1,400
Utilities payable (L)
1,400
Accounts Receivable Partially Collected ( exchange of assets)
May 30
Received P24,000 from two clients for services billed last May 19.
Analysis
An asset increased. Another asset decreased.
Entry
Increase in assets is recorded by a debit to cash. Decrease in assets is recorded
by a credit to accounts receivable.
Debit
Credit
Cash (A)
24,000
Accounts receivable
24,000
Expenses Incurred and Paid (use of assets)
May 31
Settled the electricity bill of P3,000 for the month.
Analysis
Assets decreased. Owner’s equity decreased.
Entry
Decrease in owner’s equity is recorded by a debit to utilities expense.
Decrease in assets is recorded by a credit to cash.
Debit
Credit
Utilities expense (OE:E)
3,000
Cash (A)
3,000
THE LEDGER
A grouping of the entity’s accounts is referred to as ledger. Although some firms may use
various ledgers to accumulate certain detailed information, all firms have a general ledger.
A general ledger is the “reference book” of the accounting system and is used to classify and
summarize transactions, and to prepare data for basic financial statements
The accounts in the general ledger are classified into two general groups:
1. Balance sheet or permanent accounts (assets, liabilities and owner’s equity).
2. Income statement or temporary accounts (income and expenses). Temporary or
nominal accounts are used to gather information for a particular accounting period.
At the end of the period, the balances of these accounts are transferred to a
permanent owner’s equity account.
Each account has its own record in the ledger. Every account in the ledger maintains the
basic format of the T-account but offers more information (e.g. the account number at the
upper right corner and the journal reference column). Compared to a journal, a ledger
organizes information by account.
CHART OF ACCOUNTS
A listing of all the accounts and their account numbers in the ledger is known as the chart of
accounts. The chart is arranged in the financial statement order, that is, assets first, followed
by liabilities, owner’s equity, income and expenses. The accounts should be numbered in a
flexible manner to permit indexing and cross-referencing.
When analyzing transactions, the accountant refers to the chart of accounts to identify the
pertinent accounts to be increased or decreased. If an appropriate account title is not listed
in the chart, an additional account may be added. Presented below is the chart of accounts
for the illustration.
Wedding “R” Us
Chart of Accounts
110
120
130
140
150
160
165
170
175
210
220
230
240
250
260
310
320
330
Balance Sheets
Assets
Cash
Accounts Receivable
Supplies
Prepaid Rent
Prepaid Insurance
Service Vehicle
Accumulated Depreciation
Office Equipment
Accumulated Depreciation
Liabilities
Notes Payable
Accounts Payable
Salaries Payable
Utilities Payable
Interest Payable
Unearned Referral Revenues
Owner’s Equity
Perez-Manalo, Capital
Perez-Manalo, Withdrawals
Income Summary
410
420
Income Statement
Income
Consulting Revenues
Referral Revenues
510
520
530
540
550
560
570
580
590
Expenses
Salaries Expense
Supplies Expense
Rent Expense
Insurance Expense
Utilities Expense
Depreciation Expense-SV
Depreciation Expense –OE
Miscellaneous Expense
Interest Expense
POSTING (STEP 3)
Posting means transferring the amounts from the journal to the appropriate accounts in the
ledger. Debits in the journal are posted as debits in the ledger, and credits in the journal as
credits in the ledger. The steps are illustrated as follows:
1. Transfer the date of the transaction from the journal to the ledger.
2. Transfer the page number from the journal to the journal reference (J.R.) column of
the ledger.
3. Post the debit figure from the journal as a debit figure in the ledger and the credit
figure from the journal as a credit figure in the ledger.
4. Enter the account number in the posting reference column of the journal once the
figure has been posted to the ledger.
The Journal
Date
Account titles and explanation
P. R.
Debit
Credit
May 1
2019
Cash
Perez-Manalo, Capital
Initial Investment
110
310
250,000
250,000
The Ledger
Account: Cash
Date
2019
May 1
Explanation
Account: Perez-Manalo
Date
Explanation
2019
May 1
J. R.
Debit
J-1
250,000
J. R.
Debit
J-1
Account No. 110
Credit
Balance
250,000
account no. 310
Credit
Balance
250,000
250,000
LEDGER ACCOUNTS AFTER POSTING
At the end of an accounting period, the debit or credit balance of each account must be
determined to enable us to come up with a trial balance.
 Each account balance is determined by footing (adding) all the debits and credits.
 If the sum of an account’s debits is greater than the sum of its credits, that account
has a debit balance.
 If the sum of its credits is greater , that account has a credit balance.
TRIAL BALANCE (STEP 4)
The trial balance is a list of all accounts with their respective debit or credit balances. It is
prepared to verify the equality of debits and credits in the ledger at the end of each
accounting period or at any time the posting are updated.
The procedures in the preparation of a trial balance follow:
1. List the account titles in numerical order.
2. Obtain the account balance of each account from the ledger and enter the debit
balances in the debit column and the credit balances in the credit column.
3. Add the debit and credit columns.
4. Compare the totals.
The trial balance is a control device that helps minimize accounting errors. When the totals
are equal, the trial balance is in balance. This equality provides an interim proof of the
accuracy of the records but it does not signify the absence of errors. For example, if the
bookkeeper failed to record payment of rent, the trial balance columns are equal but in
reality, the accounts are incorrect since rent expense is understated and cash overstated.
The trial balance for the illustration follows:
Weddings “R” Us
Trial Balance
May 31, 2019
Cash
Accounts Receivable
Supplies
Prepaid Rent
Prepaid Insurance
Service Vehicle
Office Equipment
Notes Payable
Accounts Payable
Utilities Payable
Unearned Referral Revenues
Perez- Manalo, capital
Perez- Manalo, Withdrawals
Consulting Revenues
Salaries expense
Utilities expense
Total
Debit
P22,200
12,000
18,000
8,000
14,400
420,000
60,000
Credit
P210,000
53,000
1,400
10,000
250,000
14,000
62,400
13,800
4,400
-------------P586,800
=======
-------------P586,800
========
LOCATING ERRORS
An inequality in the totals of the debits and credits would automatically signal the presence
of an error. These errors include:
1. Error in posting a transaction to the ledger:
a. An erroneous amount was posted to the account.
b. A debit entry was posted as a credit or vice versa.
c. A debit or credit posting was omitted.
2. Error in determining the account balances:
a. A balance was incorrectly computed
b. A balance was entered in the wrong balance column.
3. Error in preparing the trial balance:
a. One of the columns of the trial balance was incorrectly added.
b. The amount of an account balance was incorrectly recorded on the trial
balance.
c. A debit balance was recorded on the trial balance as a credit or vice versa,
or a balance was omitted entirely.
What is the most efficient approach in locating an error? The following procedures when
done in sequence may save considerable time and effort in locating errors:
1. Prove the addition of the trial balance columns by adding these columns in the
opposite direction.
2. If the error does not lie in addition, determine the exact amount by which the trial
balance is out of balance. The amount of the discrepancy is often a clue to the
source of the error. If the discrepancy is divisible by 9, this suggests either a
transposition (reversing the order of numbers) error or a slide (moving of the decimal
point). For example, assume that the cash account balance is P21,750, but in copying
the balance into the trial balance the figures are transposed and written as P21, 570.
The resulting error amounted to P180 and is divisible by 9. Another common error is
the slide, or incorrect placement of the decimal point, as when P21,750.00 is copied
as P2,175.00. The resulting discrepancy in the trial balance will also be an amount
divisible by 9.
Assume that the office equipment account has a debit balance of P42,000 but it is
erroneously listed in the credit column of the trial balance. This will cause a
discrepancy of two times P42,000 or P84,000 in the trial balance totals. Since such
errors as recording a debit in a credit column are common, it is advisable, after
determining the discrepancy in the trial balance totals, to scan the columns for an
amount equal to exactly one-half of the discrepancy. It is also advisable to look over
the transactions for an item of the exact amount of the discrepancy. An error may
have been made by recording the debit side of the transaction and forgetting to
enter the credit side.
3. Compare the accounts and amounts in the trial balance with that in the ledger. Be
certain that no account is omitted.
4. Recompute the balance of each ledger account.
5. Trace all posting from the journal to the ledger accounts. As this is done, place a
check mark in the journal and in the ledger after each figure is verified. When the
operation is completed, look through the journal and the ledger for unchecked
amounts. In tracing postings, be alert not only for errors in amount but also for debits
entered as credits, or vice versa.
Note that even when a trial balance is in balance, the accounting records may still
contain errors. A balanced trial balance simply proves that, as recorded, debits equal
credits. The following errors are not detected by a trial balance.
1. Failure to record or post a transaction.
2. Recording the same transaction more than once.
3. Recording an entry but with the same erroneous debit and credit amounts.
4. Posting a part of a transaction correctly as debit or credit but to the wrong account.
Multiple Choice
1. Which of the following will cause a trial balance to be out of balance?
a. Mistakenly debiting an asset account instead of an expense account.
b. Posting P1,230 as P2,130 to both a debit and a credit account.
c. Posting the same transaction twice by mistake.
d. Posting only the debit part of a transaction.
2. A journal entry that contains more than just two accounts is called
a. A posted journal entry.
b. An adjusting journal entry.
c. An erroneous journal entry.
d. A compound journal entry.
3. Posting refers to the process of transferring information from
a. A journal to the general ledger accounts.
b. General ledger accounts to journal.
c. Source of documents to a journal.
d. A journal to source document.
4. A business bought a photocopier for office use. The payment was recorded in the
photocopying expense account. State the type of error made.
a. Compensating error.
b. Error of commission.
c. Error of complete reversal
d. Error of principle
5. ______________ refers to the process of transferring the debit and credit amounts from
journals to ledger accounts.
a. Balancing off
b. Transferring
c. Posting
d. Closing
6. _____________ refers to the process of entering transactions into the books of original
entry.
a. Identifying
b. Classifying
c. Reporting
d. Recording
7. Which of the following items will not be included in a trial balance?
a. Opening inventory
b. Trade discounts
c. Accounts receivable
d. Accounts payable
8. The purpose of the ledger is to
a. Record chronologically the day’s transactions.
b. Keep a record of documentation to support each transaction.
c. Maintain a separate account for each balance sheet and income statement
accounts.
d. Make sure that all balance sheet and income statement accounts have
normal balances at all times.
9. Which of the following does not directly or indirectly affect the owner’s capital
account?
a. Paying an accounts payable
b. Withdrawals by the owner
c. Earning of revenues
d. Incurring of expenses
10. What function do general ledgers serve in the accounting process?
a. Summarizing
b. Recording
c. Classifying
d. Reporting
EVALUATION: Quiz
Chapter 3:
Adjusting the Accounts
Learning Objectives:
After studying this chapter, you should be able to:
1. Explain accrual accounting and state how it improves financial statements.
2. Explain the importance of periodic reporting and time period assumption.
3. Explain the recognition and derecognition process.
4. Identify the types of adjustments and their purposes.
5. Illustrate how accounting adjustments link to financial statements.
6. Use the same steps learned in analyzing transactions.
7. Prepare and explain the adjusting entries.
8. Interpret the effects of omitting adjustments on the financial statements.
9. Develop skills in preparing adjusting entries using t-accounts.
10. Summarize the adjustment process showing the type of adjustment, the effect of
omitting the adjusting entry on the financial statements and the adjusting entry.
11. Prepare an adjusted trial balance.
12. Explain the alternative methods of recording deferrals.
ACCRUAL BASIS
The financial statements, except for the cash flow statement, are prepared on the accrual
basis of accounting in order to meet their objectives. Under the accrual basis, the effects of
transactions and other events are recognized when they occur and not as cash is received
or paid. This means that the accountant records revenues as they are earned and expenses
as they are incurred. The timing of cash flows is relatively immaterial for determining when to
recognize revenues and expenses.
PERIODICITY CONCEPT
The only way to know how successfully a business has operated is to close its doors, sell all its
assets, pay the liabilities and return any excess cash to the owners. This process of going out
of business is called liquidation. This, however, is not a practical way of measuring business
performance.
Accounting information is valued when it is communicated early enough to be used for
economic decision-making. To provide timely information, accountants have divided the
economic life of a business into artificial time periods. This assumption is referred to as the
periodicity concept.
Accounting periods are generally a month, a quarter or a year. The most basic accounting
period is one year. Entities differ in their choice of the accounting year- fiscal, calendar or
natural. A fiscal year is a period of any twelve consecutive months. A calendar year is an
annual period ended December 31. A natural business year is a twelve-month period that
ends when business activities are at their lowest level of the annual cycle. A period of less
than a year is an interim period. Some even adopt an annual reporting period of 52 weeks.
Businesses need periodic reports to assess their financial condition and performance. The
periodicity concept ensures that accounting information is reported at regular intervals. It
interacts with the recognition and derecognition principles to underlie the use of accruals.
To measure profit in a fair manner, entities update the income and expense-accounts
immediately before the end of the period.
RECOGNITION AND DERECOGNITION
The initial recognition of assets or liabilities arising from transactions or other events may result
in the simultaneous recognition of both income and related expenses. For example, the sale
of goods for cash results in the recognition of both income (from the recognition of one assetthe cash) and an expense (from the derecognition of another asset- the goods sold). The
simultaneous recognition of income and related expenses is sometimes referred to as the
matching of costs with income.
Recognition is appropriate if it results in both relevant information about assets, liabilities,
equity income and expenses and a faithful representation of those items, because the aim is
to provide information that is useful to investors, lenders and other creditors.
Derecogntion is the removal of all or part of a recognized asset or liability from an entity’s
statement of financial position. Derecognition normally occurs when that item no longer
meets the definition of an asset or a liability.
a. For an asset, derecogntion normally occurs when the entity losses control of all
or part of the recognized asset; and
b. For a liability, derecognition normally occurs when the entity no longer has a
present obligation for all or part of the recognized liability.
THE NEED FOR ADJUSTMENTS
Accountants make adjusting entries to reflect in the accounts information on economic
activities that have occurred but have not yet been recorded. Adjusting entries assign
revenues to the period in which they are earned, and expenses to the period in which they
are incurred. These entries are needed to measure properly the profit for the period, and to
bring related asset and liability accounts to correct balances for the financial statements.
In short, adjustments are needed to ensure that the recognition and derecognition principles
are followed thus resulting to financial statements reporting the effects of all transactions at
the end of the period.
Adjusting entries involve charging account balances at the end of the period from what is
the current balance of the account to what is the correct balance for proper financial
reporting. Without adjusting entries, financial statements may not fairly show the solvency of
the entity in the balance sheet and the profitability in the income statement.
DEFERRALS AND ACCRUALS
Accountants use adjusting entries to apply accrual accounting to transactions that cover
more than one accounting period. There are two general types of adjustments made at the
end of the accounting period –deferrals and accruals.
Each adjusting entry affects a balance sheet account (an asset or a liability account) and
an income statement account (income or expense account).
Deferral is the postponement of the recognition of “an expense already paid but not yet
incurred, “ or of “ revenue already collected but not yet earned”. This adjustment deals with
an amount already recorded in a balance sheet account; the entry, in effect, decreases the
balance sheet account and increases an income statement account. Deferrals would be
needed in two cases:
1. Allocating assets to expense to reflect expenses incurred during the accounting
period (e.g. prepaid insurance, supplies and depreciation).
2. Allocating revenues received in advance to revenue to reflect revenues earned
during the accounting period (e.g. subscriptions).
Accrual is the recognition of “an expense already incurred but unpaid”, or “revenue earned
but uncollected”. This adjustment deals with an amount unrecorded in any account; the
entry, in effect, increase both a balance sheet and an income statement account. Accruals
would be required in two cases:
1. Accruing expenses to reflect expenses incurred during the accounting period that are
unpaid and unrecorded.
2. Accruing revenues to reflect revenues earned during the accounting period that are
uncollected and unrecorded.
The weddings “R” Us case is continued to illustrate the adjustment process. The letters A, L,
OE, OE:I and OE:E are still used to ensure a better understanding of the nature of the accounts
affected.
ADJUSTMENTS FOR DEFERRALS (step 5)
Allocating Assets to Expenses
Entities often make expenditures that benefit more than one period. These expenditures are
generally debited to an asset account. At the end of each accounting period, the estimated
amount that has expired during the period or that has benefited the period is transferred from
the asset account to an expense account. Two of the more important kinds of adjustments
are prepaid expenses, and depreciation of property and equipment.
Prepaid Expenses
Some expenses are customarily paid in advance. These expenditures (e.g. supplies, rent and
insurance) are called prepaid expenses. Prepaid expenses are assets, not expenses. At the
end of an accounting period, a portion or all of these prepayments may have expire. The
portion of an asset that has expired becomes an expense. Prepaid expenses expire either
with the passage of time or through use and consumption. The flow of costs from the balance
sheet to the income statement is illustrated below:
If adjustment for prepaid expenses are not made at the end of the period, both the balance
sheet and the income statement will be misstated. First, the assets of the entity will be
overstated; second, the expenses of the company will be understated. For this reason,
owner’s equity in the balance sheet and profit in the income statement will both be
overstated. Besides prepaid rent, Wedding “R” Us has prepaid expenses for supplies and
insurance, both accounts need adjusting entries.
Prepaid Rent (adjustment a). On May 1, Weddings “R” Us paid P8,000 for two months’ rent in
advance. This expenditure resulted to an asset consisting of the right to occupy the office for
two months. A portion of the asset expires and becomes an expense each day. By May 31,
one –half of the asset had expired, and should be treated as an expense.
The analysis of this economic event is shown below.
Transactions
Analysis
Entries
Expiration of one month’s rent.
assets decreased. Owner’s equity decreased.
Decreased in owner’s equity is recorded by a debit to rent expense.
Decrease in assets is recorded by a credit to prepaid rent.
Debit
Credit
Rent expense (OE:E)
4,000
Prepaid Rent (A)
4,000
After adjustments, the prepaid rent account has a balance of P4,000
(May 1 prepayment of P8,000 less the P4,000 expired portion); the rent
expense account reflects the P4,000 expense for the month.
Prepaid Insurance (adl. b). Weddings “R” Us acquired a one-year comprehensive insurance
coverage on the service vehicle and paid P14,400 premiums. In a manner similar to prepaid
rent, prepaid insurance offers protection that expires daily. The adjustment is analyzed and
recorded as shown below:
Transaction
Analysis
Entries
Expiration of one month’s insurance.
Assets decreased. Owner’s equity decreased.
Decrease in owner’s equity is recorded by a debit to insurance
expense; decrease in assets as a credit to prepaid insurance.
Debit
Credit
Insurance expense (OE:E)
1,200
Prepaid insurance
1,200
The prepaid insurance account has a balance of P13,200 (May 4
prepayment of P14,400 less P1,200) and insurance expense reflects the
expired cost of P1,200 for the month. As a matter of company policy,
the period May 4 to 31 is considered a month.
Supplies (adjustment c). On May 8, Weddings “R” Us purchased supplies, P18,000. During the
month, the entity used supplies in the process of performing services for clients. There is no
need to account for these supplies every day since the financial statements will not be
prepared until the end of the month. At the end of the accounting period, Perez-Manalo
makes a careful physical inventory of the supplies. The inventory count showed that supplies
costing P15,000 are still on hand. This transaction is analyzed and recorded as follows:
Transaction
Analysis
Entry
Consumption of supplies.
Assets decreased. Owner’s equity decreased.
Decrease in owner’s equity is recorded by a debit to supplies expense.
Decrease in assets is recorded by a credit to supplies.
Debit
Credit
Supplies expense (OE:E)
3,000
Supplies (A)
3,000
The asset account supplies now reflect the adjusted amount of P15,000
(P18,000 less P3,000). In addition, the amount of supplies expensed
during the accounting period is reflected as P3,000.
Depreciation of Property and Equipment
When an entity acquires long-lived assets such as buildings, service vehicles, computers or
office furnitures, it is basically buying or preparing for the usefulness of that asset. These assets
help generate income for the entity. Therefore, a portion of the cost of the assets should be
reported as expense in each accounting period. Proper accounting requires the allocation
of the cost of the asset over its estimated useful life. The estimated amount allocated to any
one accounting period is called depreciation or depreciation expenses. Three factors are
involved in computing depreciation expense.
1. Asset cost is the amount an entity paid to acquire the depreciable asset.
2. Estimated salvage value is the amount that the asset can probably be sold for at the
end of its estimated useful life.
3. Estimated useful life is the estimated number of periods that an entity can make use
of the asset. Useful life is an estimate, not an exact measurement.
Accountants estimate periodic depreciation. They have developed a number of methods
for estimating depreciation. The simplest procedure is called the straight-line method. The
formula for determining the amount of depreciation expenses for each period using this
method is:
Asset cost
xx
Less: Estimated salvage value
xx
Depreciable cost
xx
Divided by: Estimated useful life
xx
Depreciation expense for each time period
xx
==
The asset account is not directly reduced when recording depreciation expense. Instead,
the reduction is recorded in a contrac account called accumulated depreciation. A contra
account is used to record reductions in a related account and its normal balance is opposite
that of the related account. Use of the contra account – accumulated depreciation – allows
the disclosure of the original cost of the related asset in the balance sheet. The balance of
the contra account is deducted from the cost to obtain the book value of the property and
equipment.
Service Vehicle and Office Equipment (adjs. D and e). Suppose that Weddings “R” Us
estimated that the service vehicle, which was bought on May 4, will last for seven years
(eighty-four months) and with a salvage value of P84,000. The office equipment that was
acquired on May 5 will have a useful life of five years (sixty months) and will be worthless at
that time. Substitution of the pertinent amounts into the basic formula will yield depreciation
for service vehicle and office equipment for the month as P4,000 (420,000-84,000)/84months
and P1,000 (P60,000/60 months), respectively. These amounts represent the cost allocated
to the month, thus reducing the asset accounts and increasing the expense accounts. As a
matter of company policy, the period May 4 to 31 is considered a month. The analysis follows;
Transaction
Analysis
Recording depreciation expense.
Assets decreased. Owner’s equity decreased.
Entries
Owner’s equity is decreased by debits to depreciation expense- service
vehicle and depreciation expense –office equipment. Assets are
decreased by credits to contra-asset accounts accumulated
depreciation – service vehicle and accumulated depreciation –office
equipment.
Debit
Credit
Depreciation expense –SV (OE:E)
4,000
Accumulated depreciation- SV(A)
4,000
Depreciation expense – OE (OE:E)
1,000
Accumulated depreciation-OE (A)
1,000
Allocating revenues Received in Advance to Revenues
There are times when an entity receives cash for services or goods even before service is
Rendered or goods are delivered. When such is received in advance, the entity has an
Obligation to perform services or deliver goods. The liability referred to is unearned revenues.
For example, publishing companies usually receive payments for magazine subscriptions in
Advance. These payments must be recorded in a liability account. If the company fails to
Deliver the magazines for the subscription period, subscribers are entitled to a refund. As the
Company delivers each issue of the magazine, it earns a part of the advance payments. This
Earned portion must be transferred from the unearned subscription revenues account to the
Subscription revenue account.
Unearned Referral Revenues (adj. f). On May 15, Weddings “R” Us received P10,000 as an
advance payment for referrals made. Assume that by the end of the
month, one of the three couples referred has already taken their
marriage vows and as a result the amount of P4,000 pertaining to the
referred event has been realized. This transaction is analyzed as follows:
Transaction
Analysis
Recognition of income where cash is received in advance.
Liabilities decreased. Owner’s equity increased.
Entry
Decrease in liabilities is recorded by a debit to unearned referral
revenues. Increase in owner’s equity is recorded by a credit to referral
revenues.
Debit
Credit
Unearned referral revenues (L)
4,000
Referral revenues (OE:I)
4,000
The liability account unearned referral revenues reflects the referral revenues still to be
earned, P6,000. The referral revenues account reflects the amount of
referrals already completed and considered as revenues during the
months, P4,000.
ADJUSTMENTS FOR ACCRUALS (step 5)
Accrued Expenses
An entity often incurs expenses before paying for them. Cash payments are usually made at
regular intervals of time such as weekly, monthly, quarterly or annually.
If the accounting period ends on a date that does not coincide with
the schedule cash payment date, an adjusting entry is needed to
reflect the expense incurred since the last payment. This adjustment
helps the entity avoid the impractical preparation of hourly or daily
journal entries just to accrue expenses. Salaries, interest, utilities (e.g. ,
electricity, telecommunications and water) and taxes are examples of
expenses that are incurred before payment is made.
Accrued Salaries (adj. g). Entities pay their employees at regular intervals. It can be weekly,
semi-monthly or monthly. Weekly payrolls are usually made on Fridays
(for a five-day workweek) or Saturdays (for a six-day workweek).
Weddings “R” Us pays salaries every two Saturdays. Assume that the
calendar for May appears as follows:
May
Su
M
T
W
Th
F
Sa
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
The office assistant and the account executive were paid salaries on May 13 and 27. At
month-end, the employees have worked for three days (May 29, 30 and
31) beyond the last pay period. The employees earned the salary for
these days, but it is not due to be paid until the regular payday in April.
The salary for these three days is rightfully an expense for May, and the
liabilities should reflect that the entity owes the employees salaries for
those days.
Each of the employee’s salary rate is P7,800 per month or P300 per day (P7,800/26 working
days). The expense to be accrued is P1,800 (P300 x 3 days x
employees). This accrued expense can be analyzed as shown:
Transaction
Analysis
Accrual of unrecorded expense.
Liabilities increased. Owner’s equity decreased.
Entries
decrease in owner’s equity is recorded by a debit to salaries expense.
Increase in liabilities is recorded by a credit to salaries payable.
Debit
Credit
Salaries Expense (OE:E)
1,800
Salaries payable (L)
1,800
The liability of P1,800 is now correctly reflected in the salaries payable account. The actual
expense incurred for salaries during the month is P15,600.
Accrued Interest (adj. h). On May, Perez-Manalo borrowed P210,000 from Metrobank. She
issued a promissory note that carried a 20% interest per annum. Both
the interest and principal will be payable in one year. The note issued
to the bank accrued interest at 20% annually. At the end of May, PerezManalo owed the bank P3,500 (see computation below) for interest in
addition to the P210,000 loan. Interest is a charge for the use of money
over time. Interest expense is matched to a particular period during
which the benefit – the use of borrowed money – is received. The
interest is a fixed obligation and accrues regardless of the result of the
entity’s operations.
Interest rates are expressed at annual rates, so if interest is being calculated for less than a
year, the calculation must express time as a portion of a year. Thus, the
interest expense (simple) incurred on this note during the month is
determined by the following formula:
Interest
= Principal x Interest Rate x Length of time
= P210,000 x 20% per year x 1/12 of a year
= P210,000 x .20 x 1/12
= P3,500
The adjusting entry to record the interest expense incurred in May is as follows:
Transaction
Analysis
Accrual of unrecorded expense.
Liabilities increased. Owner’s equity decreased.
Entries
Decrease in owner’s equity is recorded by a debit to interest expense;
Increase in liabilities as credit to interest payable.
Debit
Credit
Interest Expense (OE:E)
3,500
Interest Payable (L)
3,500
Accrued Revenues
An entity may provide services during the period that are neither paid for by clients nor billed
at the end of the period. The value of these services represents revenue
earned by the entity. Any revenue that has been earned but not
recorded during the accounting period calls for an adjusting entry that
debits as asset account and credits an income account.
Accrued Consulting revenues (adj, i). Suppose that Weddings “R” Us agreed to arrange a
rush but simple civil wedding for a madly in love couple in the afternoon
of May 31. The entity intended to charge fees of P5,300 for the services,
which is earned but unbilled. This should be recorded as shown below:
Transaction
Analysis
Accrual of unrecorded revenue.
Assets increased. Owner’s equity increased.
Entries
Increase in assets is recorded by a debit to accounts receivable.
Increase in owner’s equity as a credit to consulting revenues.
Debit
Credit
Accounting Receivable (A)
5,300
Consulting Revenues (OE: I)
5,300
A total of P67,700 in consulting revenues was earned by the entity during the month.
The weddings “R” Us illustration did not tackle entries related to uncollectible accounts.
Hence, the ensuing discussion on the accrual of uncollectible accounts
is not in any way related to the Weddings “R” Us illustration. This is to
complete the illustrations on adjustment for accruals.
ACCRUAL FOR UNCOLLECTIBLE ACCOUNTS
Entities often allow clients to purchase goods or avail of services on credit. Some of these
accounts will never be collected; hence, is a need to reflect these as
charges against income. In practice, an expense is recognized for the
estimated uncollectible accounts in the period, rather than when
specific accounts actually become uncollectible.
This practice
produces a better matching of income and expenses. Estimates of
uncollectible accounts may be based on credit sales for the period or
on the accounts receivable balance.
Assume that an entity made credit sales of P1,100,000 in 2019 and prior experience indicates
an expected 1% average uncollectible accounts rate based on credit
sales. The contra account-allowance for uncollectible accounts has a
normal credit balance and is shown in the balance sheet as a
deduction from Accounts receivable. The allowance account need to
be increased by P11,000 (P1,100,000 x 1%) because accounts
receivables in that amount is doubtful of collection. The adjustment will
be:
Debit
Credit
Uncollectible accounts Expense (OE:E)
11,000
Allowance for Uncollectible Accounts (A)
11,000
Throughout the accounting period, when there is positive evidence that a specific account
is definitely uncollectible, the appropriate amount is written off against
the contra account. For example, if a P1,500 receivable were
considered uncollectible, that amount would be written off as follows:
Debit
Credit
Allowance for uncollectible accounts (A)
1,500
Accounts receivable
1,500
No entry is made to uncollectible accounts expense, since the adjusting entry has already
provided for an estimated expense based on previous experience for
all receivables.
Multiple Choice
1. Which of the following is an example of an adjusting entry?
a. Recording the purchase of supplies on account.
b. Recording depreciation expense on a truck
c. Recording the billing of customers for services rendered
d. Recording the payment of wages to employees
2. An adjusting entry to utilities used during a month for which no bill has yet been
received is an example of
a. Allocating assets to expense to reflect the actual operating expenses incurred
during the accounting period.
b. Allocating revenues received in advance to revenue to reflect actual
revenues earned during the accounting period.
c. Accruing expenses to reflect expenses incurred during the accounting period
that are not yet paid or recorded.
d. Accruing revenues to reflect revenues earned during the accounting period
that are not yet received or recorded.
3. The ending balance of the accounts receivable account was P120,000. Services
billed to customers for the period were P215,000 and collections on account from
customers were P236,000. What was the beginning balance of accounts receivable?
a. P335,000
b. P141,000
c. P99,000
d. P331,000
4. On January 2019, a P140,000 check was paid for rental expense of fourteen months.
The amount was recorded in the rent expense account. How much is the rent
expense incurred for the year ended December 31, 2019?
a. P10,000
b. P20,000
c. P120,000
d. P140,000
5. Daisy Dangayo will rent a warehouse from Realty from May 1, 2018 to April 30, 2020.
On April 1, 2018, Daisy Dangayo paid P360,000. It included a cleaning fee of P10,000,
two month’s rent, and a rental deposit amounting to three months’ rent. What should
be the related rental expense recorded on the income statement for the year ended
March 31, 2019?
a. P770,000
b. P792,000
c. P840,000
d. P980,000
6. Which of the following is not an application of accrual accounting?
a. Adjusting the accounts
b. Applying the cash basis of accounting
c. Applying the matching rule
d. Recognizing revenues when earned and expenses when incurred
7. The going concern assumption is not applied to
a. Entities about to file for bankruptcy.
b. Entities that have been in existence for less than a year.
c. Entities that have sustained losses for the previous two years
d. The partnership form of business.
8. A service vehicle might be depreciated over 5 years because
a. Income tax provisions require depreciation over the next 5 years.
b. It will be paid for in 5 years.
c. It will help generate revenue for the company over the next 5 years.
d. It will lose most of its market value in 5 years.
9. The journal entry to record an accrued expense results in which of the following types
of accounts being debited and credited?
a. Asset and income
b. Asset and liability
c. Expense and asset
d. Expense and liability
10. If a P2,500 adjustment for depreciation is omitted, which of the following financial
statement errors will occur?
a. Assets will be understated
b. Expenses will be overstated
c. Owner’s equity will be overstated
d. Profit will be understated
11. The amount of accrued but unpaid expenses at the end of the period is both an
expense and
a. A deferral
b. A liability
c. An asset
d. An income
12. Accrued revenues
a. decrease assets
b. decrease liabilities
c. increase assets
d. increase liabilities
13. Accrued expenses
a. decrease assets
b. decrease liabilities
c. increase assets
d. increase liabilities
14. An item that represents services received by the firm for which it will pay for in the
future is called
a. an accrued expense.
b. An accrued revenue.
c. An unearned revenue.
d. A prepaid expense.
15. An item that represents services provided by a firm for which it will receive payment in
the future is called
a. a prepaid expense
b. an accrued expense
c. an accrued revenue
d. an unearned revenue
EVALUATION: Quiz
Chapter 4:
Worksheet and Financial Statements
Learning Objectives:
After studying this chapter, you should be able to:
1. Describe the flow of accounting information from the unadjusted trial balance into
the adjusted trial balance and finally, who the income statement and balance sheet
columns of the worksheet.
2. Prepare accurately an in good form a ten column worksheet.
3. Understand and appreciate the usefulness of financial statements.
4. Develop skills in the preparation of financial statements.
5. Explain how the financial statements are interrelated.
THE WORKSHEET
Accountants often use a worksheet to help transfer data from the unadjusted trial balance
to the financial statements. This multi-column document provides an efficient way to
summarize the data for financial statements. The accountant generally prepares a
worksheet when it is time to adjust the accounts and prepare financial statements. Note,
however, that it is possible to prepare financial statements directly from the adjusted trial
balance at the end of the accounting period if the business has relatively few accounts.
The worksheet simplifies the adjusting and closing process. It can also reveals errors. The work
sheet is not part of the ledger or the journal, nor is it a financial statement. It is a summary
device used by the accountant for his convenience.
PREPARING THE WORKSHEET (step 5)
The steps in the preparation of a worksheet will be illustrated using the Wedding “R” Us case:
1. Enter the account balances in the unadjusted trial balance columns and total the
amounts.
The numbers, titles and balances of the accounts as at May 31 are lifted directly from
the ledger before the adjusting entries are prepared. The accounts are listed in the
worksheet in the order they appear in the ledger. Total debits must equal total credits,
as shown in Exhibit 4-1. Accounts with zero balances (e.g., salaries payable, interest
payable, etc.) are also presented. Listing all the accounts with their balances helps
identify the accounts that need adjustments. This practice will help ensure the
achievement of completeness and accuracy in the adjustment process.
2. Enter the adjusting entries in the adjustment columns and total the amounts.
When a worksheet is used, all adjustments are first entered in the worksheet. The
required adjustments for Weddings “R” Us were explained in the previous chapter. The
same adjustments are entered in the adjustments columns of the worksheet in Exhibit
4-2. As each adjustment is entered, a letter is used to identify the debit entry and the
corresponding credit entry. Note that the adjustments are not journalized until after
the worksheet is completed and the financial statements prepared.
3. Compute each account’s adjusted balance by combining the unadjusted trial
balance and the adjustment figures. Enter the adjusted amounts in the adjusted trial
balance columns.
Exhibit 4-3 exhibited the adjusted trial balance prepared by combining horizontally,
line by line, the amount of each account in the unadjusted trial balance columns with
the corresponding amounts in the adjustment columns. This procedure is called crossfooting. To illustrate, the first line showed cash with a debit amount of P22,200 in the
unadjusted trial balance. There is no adjustment to the cash account so that the
P22,200 is entered in the debit column of the adjusted trial balance. On the second
line is accounts receivable with a P12,000 balance in the unadjusted trial balance; a
debit of P5,300 is entered in the adjustments columns. The resulting balance is a
P17,300 debit in the adjusted trial balance.
Supplies, on the third line, showed a debit of P18,000 in the unadjusted trial balance
columns and a credit of P3,000 in the adjustments columns. The P3,000 credit is
subtracted from the P18,000 debit; the result is a P15,000 debit in the adjusted trial
balance. Consulting revenues, on the nineteenth line, reported a P62,400 credit in the
unadjusted trial balance and a P5,300 credit in the adjustments columns. These two
credit amounts are added, and the P67,700 sum is entered in the credit column of the
adjusted trial balance. This process is followed through all the accounts. The adjusted
trial balance columns are then totaled to check the accuracy of the cross-footing.
A simple convention to observe when extending amounts from the trial balance to
the adjusted trial balance follows:
 Add when the type of adjustment (debit or credit) is the same as the unadjusted
balance.
 Subtract when the type of adjustment (debit or credit) is different from the unadjusted
balance.
4. Extend the asset, liability and owner’s equity amounts from the adjusted trial balance
columns to the balance sheet columns. Extend the income and expense amounts to
the income statement columns. Total the statement columns.
Every account is either a balance sheet account or an income statement account.
Asset, liability, capital and withdrawal accounts are extended to the balance sheet
columns. Income and expense accounts are moved to the income statement
columns. Debits in the adjusted trial balance remain as debits in the statement
columns while credits as credits. Each accounts adjusted balance should appear in
only one statement column as shown in exhibit 4-4. At this stage, the initial totals of
the income statement and balance sheet columns are not equal.
5. Compute profit or loss as the difference between total revenues and total expenses
in the income statement. Enter profit or loss as a balancing amount in the income
statement and in the balance sheet, and compute the final column totals.
Profit or loss is equal to the difference between the debit and credit columns of the
income statement.
Revenues (Income statement credit column total)
P71,700
Expenses (Income statement debit column total)
36,700
PROFIT
P35,000
======
The profit or loss should always be the amount by which the debit and credit columns
for income statement, and the debit and credit columns for balance sheet differ. The
profit figure of P35,000 is entered in the debit column of the income statement and
the credit column of the balance sheet. After completion, total debits and total
credits in the income statement and balance sheet columns must equal.
The profit figure is extended to the credit column of the balance sheet because profit
increases owner’s equity are recorded as credits. Observe that the capital account
amount of P250,000 shown in the worksheet reflects the beginning rather than the
ending balance. Profit must be added and withdrawals subtracted to arrive at the
ending capital balance; this is done when the statement of changes in equity is
prepared.
ESSENCE OF FINANCIAL STATEMENTS
There are questions that the owner of a business periodically asks – how much did the business
entity earn? What is the financial condition of the business? How much is the owner’s interest
in the entity today? What happened to the cash receipts? Where did cash go? Investors,
creditors, taxing authorities and other users have their own questions about the business which
need to be answered.
The financial statements are the means by which the information accumulated and
processed in financial accounting is periodically communicated to the users. Without
accounting information embodied in the financial statements, users may not be able to arrive
at sound economic decisions.
Per March 2018 Conceptual framework for Financial Reporting (2018 conceptual framework),
the objective of financial statements is to provide financial information about the reporting
entity’s assets, liabilities, equity, income and expenses that is useful to users of financial
statements in assessing the prospects for future net cash inflows to the reporting entity and in
assessing management’s stewardship of the entity’s economic resources.
COMPLETE SET OF FINANCIAL STATEMENTS
Per revised PAS no. 1, a complete set of financial statements comprises:
1. A statement of financial position as at the end of the period;
2. A statement of financial performance for the period;
3. A statement of changes in equity for the period;
4. A statement of cash flows for the period;
5. Notes, comprising a summary of significant accounting policies and other explanatory
information; and
6. A statement of financial position as at the beginning of the earliest comparative
period when an entity applies an accounting policy retrospectively or makes a
retrospective restatement of items in its financial statements or when it reclassifies
items in its financial statements.
In a nutshell, the statement of financial position (or balance sheet) lists all the assets, liabilities
and equity of an entity as at a specific date. The statement of financial performance (or
income statement) presents a summary of the revenues and expenses of an entity for a
specific period. The statement of changes in equity presents a summary of the changes in
capital such as investments, profit or loss, and withdrawals during a specific period. The
statement of cash flows reports the amount of cash received and disbursed during the
period. Accounting policies are the specific principles, bases, conventions, rules and
practices adopted by an enterprise in preparing and presenting financial statements. Notes
to financial statements provide narrative description or disaggregation of items presented in
the statements and information about items that do not qualify for recognition in the
statements.
PREPARING THE FINANCIAL STATEMENTS (step 6)
Once the worksheet is completed, it is easy to prepare the financial statements for the
account balances have been extended to the appropriate income statement and balance
sheet columns. Most of the information needed to prepare the income statement, statement
of changes in equity and balance sheet are available from the worksheet. The statements
presented are those of Weddings “R” Us. Note that financial statements shall be presented
at least annually (per revised PAS no. 1)
Statement of Financial Performance
An entity can present all items of income and expense recognized in a period: in a single
statement of comprehensive income, or in two statements: a statement displaying
components of profit or loss (separate income statement) and a second statement
beginning with profit or loss and displaying components of other comprehensive income.
However, the 2018 conceptual framework does not specify whether the statement of
financial performance comprises a single statement or two statements.
The income statement is a statement showing the performance of the enterprise for a given
period of time. It summarizes the revenues earned and expenses incurred for that period of
time. The income statement for Weddings “R” Us (refer to exhibit 4-5) is prepared directly
from the income statement columns of the worksheet in exhibit 4-4.
Weddings “R” Us
Income Statement
For the month ended May 31, 2019
Revenues
Consulting Revenues
Referral Revenues
Total
Expenses
Salaries expense
Utilities expense
Rent expense
Depreciation expense –service vehicle
Interest expense
Supplies expense
Insurance expense
Depreciation expense – office equipment
Total
Profit
P67,700
4,000
P71,700
P15,600
4,400
4,000
4,000
3,500
3,000
1,200
1,000
36,700
P35,000
=======
Information about the performance of an enterprise, in particular its profitability, is required in
order to assess potential changes in the economic resources that it is likely to control in the
future. It is also useful in predicting the capacity of the enterprise to generate cash flows from
its existing resource base.
Statement of Changes in Equity
The statement of changes in equity summarizes the changes that occurred in owner’s equity.
This statement is now a required statement (per revised Philippine Accounting Standards
(PAS) no.1). Changes in an enterprise’s equity between two balance sheet dates reflect the
increase or decrease in its net assets during the period.
In the case of sole proprietorships, increases in owner’s equity arise from additional
investments by the owner and profit during the period. Decreases result from withdrawals by
the owner and from loss for the period. The beginning balance and additional investments
are taken from the owner’s capital account in the general ledger. The profit or loss figure
comes directly from the income statement while the withdrawals from the balance sheet
columns in the worksheet.
Weddings “R” Us
Statement of Changes in Equity
For the month ended May 31, 2019
Perez-Manalo, Owner’s equity, 5/1/2019
Add: additional investment by Perez-Manalo
Profit
Total
Less: withdrawals
Perez-Manalo, owner’s equity, 5/31/2019
Exhibit 5-6
P250,000
P
0
35,000
35,000
P285,000
14,000
P271,000
========
statement of changes in equity
Statement of Financial Position
The statement of financial position is a statement that shows the financial position or condition
of an entity by listing the assets, liabilities and owner’s equity as at a specific date. The
information needed for this statement are the net balances at the end of the period, rather
than the total for the period as in the income statement. This statement is also called the
balance sheet.
Users of financial statements analyze the balance sheet to evaluate an entity’s liquidity, its
financial flexibility, and its ability to generate profits, and its solvency. Liquidity refers to the
availability of cash in the near future after taking account of the financial commitments over
this period. Financial flexibility is the ability to take effective actions to alter the amounts and
timings of cash flows so that it can respond to expected needs and opportunities. This
includes the ability to raise new capital or tap into unused lines of credit. Solvency refers to
the availability of cash over the longer term to meet financial commitments as they fall due.
In preparing the balance sheet, it may not be necessary to make any further analysis of the
data. The needed data – that is, the balances of the asset, liability, and owner’s equity
accounts- are already available from the balance sheet columns of the worksheet. However,
the interim balance for owner’s equity must be revised to include profit or loss and owner’s
withdrawals for the accounting period. The adjusted amount for ending owner’s equity is
shown in the statement of changes in equity.
Format
The balance sheet can be presented in either the report format or the account format. The
report format simply lists the assets, followed by the liabilities then by the owner’s equity in
vertical sequence. The account format lists the assets on the left and the liabilities and
owner’s equity on the right. Either balance sheet format is acceptable.
Classification
The revised PAS no. 1 does not prescribe the order or format in which an entity presents items
in the statement of financial position; what is required is the current and non-current
distinction for assets and liabilities. Assets can be presented current then non-current, or vise
versa. Liabilities and equity can be presented current liabilities then non-current liabilities then
equity, or vice versa.
It is proper to present a classified balance sheet; that is, the assets and liabilities are separated
into various categories. Assets are sub-classified as current assets and non-current assets;
while liabilities as current liabilities and non-current liabilities. Classifying a balance sheet aids
in the analysis of financial statement data.
When presentation based on liquidity provides accounting information that is reliable and
more relevant to decision-makers then an entity shall present all assets and liabilities in order
of liquidity. For example,
 Assets are classified and presented in decreasing order of liquidity. Cash is the most
liquid. Assets that are least likely to be converted to cash are listed last.
 Liabilities are generally classified and presented based on time of maturity such that
obligations which are currently due are listed first.
It can be observed in Exhibit 4-7 that the total assets of P546,700 in the balance sheet does
not tally with the total debits of P565,700 in the balance sheet columns of the worksheet in
exhibit 4-4. Likewise, the total liabilities and owner’s equity do not equal the total credits in
the same exhibit. The reason for these differences is that accumulated depreciation and
withdrawals are subtracted from their related accounts in the balance sheet but added in
their respective columns in the worksheet. The classified balance sheet of Weddings “R” Us
in report format is:
Weddings “R” Us
Balance Sheet
May 31, 2019
Asset
Current assets
Cash
Accounts receivable
Supplies
Prepaid rent
Prepaid insurance
P 22,200
17,300
15,000
4,000
13,200
Total current assets
Property and Equipment (net)
Service Vehicles
Less: accumulated depreciation
Office equipment
Less: accumulated depreciation
Total assets
P 71,700
P420,000
4,000
P 60,000
1,000
416,000
59,000
475,000
P546,700
========
Liabilities
Current liabilities
Notes Payable
Accounts Payable
Salaries payable
Utilities payable
Interest payable
Unearned referral revenues
Total Current Liabilities
P 210,000
53,000
1,800
1,400
3,500
6,000
P275,700
Owner’s Equity
Perez-Manalo, capital, 5/31/2019
Total Liabilities and Owner’s Equity
271,000
P546,700
===========
Exhibit 4-7 statement of financial position
Statement of Cash Flows
The statement of cash flows provides information about the cash receipts and cash payments
of an entity during a period. It is a formal statement that classifies cash receipts (inflows) and
cash payments (outflows) into operating, investing and financing activities. This statement
shows the net increase or decrease in cash during the period and the cash balance at the
end of the period; it also helps project the future net cash flows of the entity. The discussion
below gives an overview of some important concepts involved in the preparation of the cash
flow statement.
Cash Flows from Operating Activities
Operating activities generally involve providing services, and producing and delivering
goods. Cash flows from operating activities are generally the cash effects of transactions
and other events that enter into the determination of profit or loss. This cash flow can be
presented using either the direct or the indirect method.
Using the direct method, the entity’s net cash provided by (used in) operating activities is
obtained by adding the individual operating cash inflows and then subtracting the individual
operating cash outflows.
The indirect method derives the net cash provided by (used in) operating activities by
adjusting profit for income and expense items not resulting from cash transactions. The
adjustment begins with profit followed by the addition of expenses and charges (e.g.
depreciation) that did not entail cash payments. Then, increases in current assets and
decreases in current liabilities involved in the determination of profit but which did not
actually increase or decrease cash, are subtracted from profit. Finally, decreases in current
assets and increases in current liabilities are added to profit to obtain net cash provided by
(used in) operating activities.
Profit
Adjustment for:
Non-cash expenses (e.g. depreciation)
Increases in current assets account
Decreases in current liabilities
Decreases in current assets
Increases in current liabilities
Cash flows from operating activities
Pxxx
xx
(xx)
(xx)
xx
xx
Pxxx
====
For example, increases in accounts receivable from sale of services or goods represented an
increase in profit without the corresponding increase in cash – for it is still a receivable. Since
these revenues are already included in the computation of profit, the increase in accounts
receivable should be deducted from the profit figure. To illustrate further, assume that salaries
payable increased. Increases in salaries payable meant that the entity did not pay the full
amount of salaries expense for the period.
The expense in the income statement, for cash flow purposes, is overstated by the amount of
unpaid salaries. If expense is overstated, then profit is understated by the same amount;
hence, the increase in current liability is added to profit.
Per Philippine Accounting Standards (PAS) no. 7, enterprises are encouraged to report cash
flows from operating activities the direct method but the indirect method is acceptable. Only
the direct method is illustrated here. The following are the major classes of operating cash
flows using the direct method.
Cash Inflows
 Receipts from sale of goods and performance of services
 Receipts from royalties, fees, commissions and other revenues
Cash Outflows
 Payments to suppliers of goods and services
 Payments to employees
 Payments for taxes
 Payments for interest expense
 Payments for other operating expenses
Cash Flows from Investing Activities
Investing activities include making and collecting loans; acquiring and disposing of
investments in debt or equity securities; and obtaining and selling or property and equipment
and other productive assets.
Cash Inflows
 Receipts from sale of property and equipment
 Receipts from sale of investments in debt or equity securities
 Receipts from collections on notes receivable
Cash Outflows
 Payments to acquire property and equipment
 Payments to acquire debt or equity securities
 Payments to make loans to others generally in the form of notes receivable
Cash Flows from Financing Activities
Financing activities include obtaining resources from owners and creditors.
Cash Inflows
 Receipts from investment by owners
 Receipts from issuance of notes payable
Cash Outflows
 Payments to owners in the form of withdrawals
 Payments to settle notes payable
Weddings “R” Us
Statement of Cash Flows
For the month ended May 31, 2019
Cash Flows from Operating Activities:
Cash received from clients
Payments to suppliers
Payments to employees
Payments for office rent
Payments for insurance
Payments for utilities
Net cash provided by (used) operating activities
Cash Flows from Investing Activities:
Payments to acquire service vehicle
Payments to acquire office equipment
Net cash provided by (used in) investing activities
Cash Flows from Financing Activities:
Cash received as investments by owner
Cash received from borrowings
Payments for withdrawals by owner
Net cash provided by (used in) financing activities
Net increase (decrease) in Cash
Cash balance at the beginning of the period
Cash balance at the end of the period
P 60,000
(10,000)
(13,800)
(8,000)
(14,400)
(3,000)
P11,200
P(420,000)
(15,000)
P(435,000)
P250,000
210,000
(14,000)
P446,000
P 22,200
-----------------P 22,200
===========
RELATIONSHIPS AMONG THE FINANCIAL STATEMENTS
The financial statements are based on the same underlying data are fundamentally related.
The following shows the basic interrelationships among the financial statements:
1. The income statement reports all income and expenses during the period. The profit
or loss is the final figure in this statement.
2. The statement of changes in equity considers the profit or loss figure from the income
statement as one of the determining factors that explains the change in owner’s
equity.
3. The statement of financial position reports the ending owner’s equity, taken directly
from the statement of changes in equity.
4. The statement of cash flows reports the net increase or decrease in cash during the
period and ends with the cash balance reported in the balance sheet. This statement
is prepared based on information from the income statement and the balance sheet.
Multiple Choice
1. Which of the following types of information is not found in financial statements?
a. Profits
b. Revenue
c. Selling prices
d. Assets
2. Accounting data flow from the
a. Balance sheet to the income statement
b. Income statement to the statement of owner’s equity
c. Statement of owner’s equity to the balance sheet
d. Both b and c are correct
3. Consider the steps in the accounting cycle. Which part of the accounting cycle
provides information to help a business decide whether to expand its operations?
a. Post-closing trial balance
b. Adjusting entries
c. Closing entries
d. Financial statements
4. Which columns of the accounting work sheet show unadjusted amounts?
a. Trial balance
b. Adjustments
c. Income statement
d. Balance sheet
5. Which columns of the work sheet show profit?
a. Trial balance
b. Adjustments
c. Income statement
d. Both b and c
6. Which situation indicates a loss on the income statement?
a. Total debits equal total credits
b. Total credits exceed total debits
c. Total debits exceed total credits
d. None of the above
7. Which of the following is a cash inflow from financing activities?
a. Receipt from collections on notes receivable.
b. Receipt from interest on notes receivable.
c. Receipt from issuance of notes payable.
d. Receipt from sale of property and equipment.
8. In the adjusted trial balance, the owner’s equity account reflects
a. The beginning of the period balance.
b. The increase to income and expense.
c. The period ending balance.
d. The results of adjusting entries.
9. Which of the following steps comes first in worksheet preparation?
a. Compute each account’s adjusted balance by combining the trial balance
and adjustment figures.
b. Compute profit or loss as the difference between total revenues and total
expenses on the income statement.
c. Enter the account balances in the unadjusted trial balance columns and total
the amounts.
d. Enter the adjusting entries in the adjustment columns and total the amounts.
10. If the income statement debit and credit columns are not equal after adding the
respective columns,
a. an error has been made.
b. The entity either generated a profit or incurred a loss.
c. The entity generated a profit.
d. The entity incurred a loss.
e. The liabilities must exceed the assets.
11. Worksheets are prepared because
a. They aid in the preparation of the financial statements, adjusting entries, and
closing entries.
b. They are necessary for the preparation of the financial statements.
c. They are required by generally accepted accounting principles.
d. They constitute a permanent record of all adjusting entries made for the
period.
12. Which of the following is an example of an investing activity?
a. Obtaining a bank loan
b. Paying taxes to the government
c. Producing goods and services
d. Purchasing a building
13. Which of the following is an example of a financing activity?
a. Acquiring land
b. Employing workers
c. Paying off a loan
d. Selling equipment
14. The statement of changes in equity would not show
a. revenues and expenses
b. the owner’s ending capital balance
c. the owner’s initial capital balance
d. the owner’s withdrawals for the period
EVALUATION : QUIZ
CHAPTER 5
Completing the Accounting Cycle
Learning Objectives:
After studying this chapter, you should be able to:
1. Explain why temporary accounts are closed each period.
2. Recognize the need for a post-closing trial balance and reversing entries in particular
instances.
3. Prepare and post adjusting entries, closing entries and reversing entries.
4. Prepare a post-closing trial balance.
ADJUSTMENTS ARE JOURNALIZED AND POSTED (step 7)
The adjustment process is a key element of accrual basis accounting. The worksheet helps
in the identification of the accounts that need adjustments. The adjusting entries are directly
entered in the worksheet. Most accountants prepare the financial statements immediately
after completing the worksheet. The adjustments are journalized and posted as the closing
entries are made. This step in the accounting cycle brings the ledger into agreement with the
data reported in the financial statements.
Illustration. The adjustments pertinent to the Weddings “R” Us illustration follow:
Journal
page 1
Date
Account titles and explanation
P. R.
Debit
Credit
2019
May 31 Rent expense
530
4,000
Prepaid rent
140
4,000
31
31
31
31
31
31
31
31
Insurance expense
Prepaid insurance
540
130
1,200
Supplies expense
Supplies
520
130
3,000
Depreciation expense-service vehicle
Accumulated depreciation- SV
560
165
4,000
Depreciation expense-Office equipment
Accumulated depreciation-Off. Equip.
570
175
1,000
Unearned referral revenues
Referral revenues
260
420
4,000
Salaries expense
Salaries payable
510
1,800
Interest expense
Interest payable
590
250
3,500
Accounts receivable
120
5,300
1,200
3,000
4,000
1,000
4,000
1,800
3,500
Consulting
410
5,300
CLOSING ENTRIES ARE JOURNALIZED AND POSTED (step 8)
Income, expense and withdrawal accounts are temporary accounts that accumulate
information related to a specific accounting period. These temporary accounts facilitate
income statement preparation. At the end of each year, the balances of these temporary
accounts are transferred to the capital account. Thus, the balance of the owner’s capital
account represents the cumulative net result of income, expense, and withdrawal
transactions. This phase of the cycle is called the closing procedure.
A temporary account is said to be closed when an entry is made such that its balance
becomes zero. Closing simply transfer the balance of one account to another account. In
this case, the balances of the temporary accounts are transferred to the capital account. A
summary account-Income Summary is used to close the income and expense accounts. The
steps in closing the accounts of an entity will be illustrated using the Weddings “R” Us case.
1. Close the income accounts
Income accounts have credit balances before the closing entries are posted. For this
reason, an entity debiting each revenue account in the amount of its balance is
needed to close the account. The credit is made to the income summary account.
The entry to close the income accounts for the Weddings “R” Us is as follows:
2019
May 31
Consulting Revenues
Referral Revenues
Income Summary
410
420
330
Debit
67,700
4,000
Credit
71,700
The dual effect of the entry is to make the balances of the income accounts equal to
zero, and to transfer the balances in total to the credit side of the income summary
account. Note that the data for closing the income accounts can be found in the
credit side of the income statement columns of the worksheet in exhibit 4-4.
2. Close the expense accounts
Expense accounts have debit balances before the closing entries are posted. For this
reason, a compound entry is needed crediting each expense account for its balance
and debiting the income summary for the total. These data can be found in the debit
side of the income statement columns of the worksheet.
2019
Debit
credit
May 31 Income Summary
330 36,700
Salaries Expense
510
15,600
Supplies Expense
520
3,000
Rent expense
530
4,000
Insurance expense
540
1,200
Utilities expense
550
4,400
Depreciation expense-SV
560
4,000
Depreciation expense – OE
Interest expense
570
590
1,000
3,500
The effect of posting the closing entry is to reduce the expense account balances to
zero and to transfer the total of the account balances to the debit side of the income
summary account.
3. Close the income summary account
After posting the closing entries involving the income and expense accounts, the
balance of the income summary account will be equal to the profit or loss for the
period. A profit is indicated by a credit balance and a loss by a debit balance. The
income summary account, regardless of the nature of its balance, must be closed to
the capital account. For the Weddings “R” Us, the entry is as follows:
2019
Debit
Credit
May 31 Income summary
330 35,000
Perez-Manalo, Capital
310
35,000
The effect of posting this closing entry is to close the income summary account
balance and to transfer the balance to Perez-Manalo’s capital account for the profit.
4. Close the withdrawals account
The withdrawals account shows the amount by which capital is reduced during the
period by withdrawals of cash or other assets of the business by the owner for personal
use. For this reason, the debit balance of the withdrawal account must be closed to
the capital account as follows:
2019
Debit
Credit
May 31 Perez-Manalo, Capital
310 14,000
Perez – Manalo, withdrawals
320
14,000
The effect of posting this closing entry is to close the withdrawal account and to
transfer the balance to the capital account.
PREPARATION OF A POST-CLOSING TRIAL BALANCE (step 9)
It is possible to commit an error in posting the adjustments and closing entries to the ledger
accounts; thus, it is necessary to test the equality of the accounts by preparing a new trial
balance. This final trial balance is called a post-closing trial balance.
 The post-closing trial balance verifies that all the debits equal the credits in the trial
balance.
 The trial balance contains only balance sheet items such as assets, liabilities, and
ending capital because all income and expense accounts, as well as the withdrawals
account, have zero balances.
Notice that only the balance sheet accounts have balances because at this point, all the
income statement accounts have been closed.
Weddings “R” Us
Post –Closing Trial Balance
May 31, 2019
Cash
Accounts receivable
Supplies
Prepaid rent
Prepaid insurance
Service vehicle
Accumulated Depreciation –service vehicle
Office equipment
Accumulated depreciation –office equipment
Notes payable
Accounts payable
Salaries payable
Utilities payable
Interest payable
Unearned referral revenues
Perez – Manalo, Capital
Debit
P 22,200
17,300
15,000
4,000
13,200
420,000
Credit
P 4,000
60,000
P 551,700
========
1,000
210,000
53,000
1,800
1,400
3,500
6,000
271,000
P 551,700
========
REVERSING ENTRIES (step 10)
Preparing the post-closing trial balance may not be the last step in the accounting cycle.
Some entities elect to reverse certain end-of-period adjustments on the first day of the new
period. A reversing entry is a journal entry which is the exact opposite of a related adjusting
entry made at the end of the period. It is basically a bookkeeping technique made to simply
the recording of regular transactions in the next accounting period.
It should be emphasized that reversing entries are optional. Also, the act of reversing a
previously recorded adjusting entry should not lead us to the conclusion that the entries
reversed are unnecessary or inaccurate.
Even when an entity follows the policy of making reversing entries, not all adjusting entries
should be reversed. Generally, a reversing entry should be made for any adjusting entry that
increased an asset or a liability account. Therefore, all accruals are reversed but only
deferrals initially recorded in income statement –income or expense – accounts are reversed
Using the summary of adjusting entries in chapter 4, the veracity of the general rule stated in
the previous paragraph can be proven. For example, in the case of a prepaid expense
initially recorded in an expense account, the adjusting entry debited an asset – prepaid
expense. An asset increased; hence, applying the general rule, this adjustment can be
reversed.
After analyzing the rest of the adjusting entries, the adjustments that can be reversed are as
follows: prepaid expenses (expense method), unearned revenues (income method),
accrued expenses and accrued revenues.
Illustration. To show how reversing entries can be helpful, consider the adjusting entry made
in the records of Weddings “R” Us to accrue salaries expense:
2019
May 31
Salaries expense
1,800
Salaries payable
1,800
When the employees are paid on the next regular payday, the entry would be:
2019
June 10 Salaries payable
1,800
Salaries expense
5,400
Cash
7,200
Note that when the payment is made, without a prior reversing entry, the accountant must
look into the records to find out how much of the P7,200 applies to the current accounting
period and how much was accrued at the beginning of the period.
This step may appear easy in this simple case, but think of the problems that may arise it the
company has many employees, especially if some of them are paid on different time
schedules such as weekly or monthly. A reversing entry is an accounting procedure that helps
to solve this difficult problem. As noted above, a reversing entry is exactly what its name
implies. It is a reversal of the adjusting entry made. For example, observe the following
sequence of transactions and their effects on the ledger account- salaries expense:
1. Adjusting Entry
2019
May 31
Salaries expense
Salaries payable
2. Closing Entry
2019
May 31
Income summary
Salaries expense
3. Reversing Entry
2019
June 1
Salaries payable
Salaries expense
4. Payment Entry
2019
June 10
Salaries expense
Cash
1,800
1,800
15,600
15,600
1,800
1,800
7,200
7,200
These transactions had the following effects on salaries expense:
a. Adjusted salaries expense to accrue P1,800 in the proper accounting period.
b. Closed the P15,600 in total salaries expense for May to income summary.
c. Established a credit balance of P1,800 on June 1 in salaries expense equal to
the expense recognized through the adjusting entry on May 31. The liability
account salaries payable was reduced to a zero balance.
d. Recorded the P7,200 payment of two week’ salaries in the usual manner. The
reversing entry has the effect of leaving a balance of P5,400 (P7,200 – P1,800)
in the salaries expense account. This P5,400 balance represented the salaries
expense for the nine working days in June.
Making the payment entry was simplified by the reversing entry. Reversing entries
apply to all accrued expenses or revenues.
Multiple Choice
1. Some entities adjust their accounts and close their books only on an annual basis.
a. worksheets may be prepared on an interim basis.
b. Worksheets are not needed.
c. Worksheets are prepared only on an annual basis.
d. Worksheet are not prepared.
2. The purpose of the post-closing trial balance is to
a. provide the account balances for the preparation of the balance sheet.
b. Ensure that the ledger is in balance for completion of the worksheet.
c. Aid the journalizing and posting of the closing entries.
d. Ensure that the ledger is in balance for the start of the next period.
3. Which of the following accounts will appear on the post-closing trial balance?
a. Building
b. Depreciation expense – building
c. Owner withdrawals
d. Service revenues
4. A final check on the adjusting and closing process is provided by the
a. Worksheet
b. Financial statement
c. Post-closing trial balance
d. Adjusted trial balance
5. If the last item on a trial balance reads “Owner’s equity”, this must be the
a. post –closing trial balance
b. unadjusted trial balance
c. adjusted trial balance
d. reversed trial balance
6. If a trial balance were to be prepared on the first day of the new year, and the
account salaries expense had a credit balance, you would know that
a. the trial balance is a post-closing trial balance.
b. The adjusting entries have been recorded.
c. The trial balance is an adjusted trial balance.
d. A reversing entry has been made
7. Reversing entries are
a. Optional
b. Made to record a change in corporate objectives.
c. Required by generally accepted accounting principles.
d. Made prior to preparing a post-closing trial balance.
8. Which of the following comes last in the accounting process?
a. preparation of a post –closing trial balance
b. preparation of an adjusted trial balance
c. worksheet preparation
d. journalizing external transactions
9. Which of the following accounts could appear in an adjusting entry, closing entry
and reversing entry?
a. interest income
b. salaries payable
c. depreciation expense-buildings
d. accumulated depreciation-buildings
10. When an entry has earned a profit, the profit amount is entered on the worksheet on
the
a. debit side of the income statement columns and the credit side of the
balance sheet columns
b. credit side of the income statement columns and the debit side of the
balance sheet columns
c. debit side of both the income statement and the balance sheet columns
d. credit side of both the income statement and the balance sheet columns
11. Probably the last account to be listed on a post-closing trial balance would be
a. salaries payable
b. salaries expense
c. owner’s equity
d. income summary
12. When there is a loss, the entry to close the Income summary account is
a. debit loss and credit income summary account
b. debit owner’s capital and credit income summary
c. debit income summary and credit loss
d. debit income summary and credit owner’s capital
13. The post- closing trial balance contains
a. real account only.
b. Nominal account only.
c. Both real accounts and nominal accounts.
d. Neither real accounts nor nominal accounts.
14. In which financial statement does income summary appear?
a. Income statement
b. Statement of changes in equity
c. Balance sheet
d. It does not appear in any financial statement
15. An important purpose of closing entries is to
a. adjust the accounts in the ledger.
b. Set nominal account balances to zero at the start of the next period.
c. Set real account balances to zero at the start of the next period.
d. Help in preparing financial statements.
EVALUATION:
1. Homework
2. quizzes
Chapter 6 - Merchandising Operations
Learning Objectives:
After studying this chapter, you should be able to:
1. Describe merchandising activities and identify the income components for a
merchandising entity.
2. Distinguish between income statements of service and merchandising
entities.
3. Illustrate the operating cycle of a merchandising entity.
4. Be familiar with the different source documents being used by merchandising
entities.
5. Compare cash discounts and trade discounts.
6. Summarize the treatment of transportation costs considering the freight terms
FOB destination, FOB shipping point, freight prepaid and freight collect.
7. Explain the inventory systems of merchandising entities.
8. Analyze and record transactions for merchandise sales under a periodic
inventory system.
9. Analyze and record transactions for merchandise purchases under a periodic
inventory system.
10. Prepare the entries showing the effects of value-added tax on merchandising
transactions.
11. Compare and contrast the entries needed for the periodic and perpetual
inventory system
COMPARISON OF INCOME STATEMENTS
Service entities perform services for a fee. In ascertaining profit, a basic income statement is
all that is needed. In figure 6-1, profit is measured as the difference between revenues from
services and expenses. In contrast, merchandising entities earn profit by buying and selling
goods. These entities use the same basic accounting methods as service entities, but the
process of buying and selling merchandise requires some additional accounts and concepts.
This process results in a more complex income statement. To provide a better measure of
performance, the income statement of a merchandising business is presented with additional
items:
Service
Merchandising
Income Statement
Income Statement
Revenue from Service
Minus
Expenses
Equals
Profit
Net Sales
Minus
cost of sales
Equals
Gross profit
Add or minus
Income or expenses
equals
profit
Figure 6-1 Components of Income Statements for Service and Merchandising Entities
In a merchandising business, net sales arise from sale of goods while cost of sales or cost of
goods sold represents the cost of inventory the entity has sold to customers. The difference
between net sales and cost of sales is called gross profit. Then, other operating income is
added and operating expenses (like distribution costs, administrative expenses and other
operating expenses) are deducted from gross profit to arrive at operating profit. Investment
revenues, other gains and losses, and finance costs (e.g. interest expense) are considered to
arrive at profit before tax then income tax expense is deducted to have profit from continuing
operations. Finally, profit from discontinued operations (net of tax) is taken to account to get
profit for the period.
Gloria Detoya traders
Income Statement
For the year ended December 31, 2019
Net sales
Cost of sales
Gross profit
Operating expenses
Operating profit
Finance costs
Profit
P 2,393,250
1,313,600
P 1,079,650
586,040
P 493,610
38,400
P 455,210
=========
Exhibit 6-1 part of an Income Statement for a Merchandising Entity
OPERATING CYCLE OF A MERCHANDISING BUSINESS
The merchandising entity purchases inventory, sells the inventory and uses the cash to
purchase more inventory –and the cycle continues. For cash sales, the cycle is from cash to
inventory and back to cash. For sales on account, the cycle is from cash to inventory to
accounts receivable and back to cash. In any industry, the manager strives to shorten the
cycle. The faster the sale of inventory and the collection of cash, the higher the profits
SOURCE DOCUMENTS
Merchandising businesses use various business forms and documents to help identify the
transactions that should be recorded in the books. These source documents contain vital
information about the nature and amount of the transactions.
1. Sales invoice is prepared by the seller of goods and sent to the buyer. This document
contains the name and address of the buyer, the date of sale and informationquantity, description and price – about the goods sold. It also specifies the amount
of sales, and the transportation and payment terms.
2. The bill of lading is a document issued by the carrier-a trucking, shipping or airline –
that specifies contractual conditions and terms of delivery such as freight terms, time,
place, and the person named to receive the goods.
3. The statement of account is a formal notice to the debtor detailing the accounts
already due.
4. The official receipt evidences the receipt of cash by the seller or the authorized
representative. It notes the invoices paid and other details of payment.
5. Deposits slips are printed forms with depositor’s name, account number and space
for details of the deposit. A validated deposit slip indicates that cash and checks with
the supplied details were actually deposited or credited to the account holder.
6. A check is a written order to a bank by a depositor to pay the amount specified in the
check from his checking account to the person named in the check. The entity issuing
the check is the payor while the receiver is the payee.
7. The purchase requisition is a written request to the purchaser of an entity from an
employee or user department of the same entity that goods be purchased.
8. The purchase order is an authorization made by the buyer to the seller to deliver the
merchandise as detailed in the form.
9. Receiving report is a document containing information about goods received from a
vendor. It formally records the quantities and description of the goods delivered.
10. A credit memorandum is a form used by the seller to notify the buyer that his account
is being decreased due to errors or other factors requiring adjustments.
STEPS IN A PURCHASE TRANSACTION
Whenever a purchase or sale of merchandise occurs, the buyer and the seller should agree
on the price of the merchandise, the payment terms and the party to shoulder the
transportation costs. Owners of small merchandising firms may settle these terms informally
by phone or by discussion with the vendor’s representative. Most large businesses, however,
follow certain procedures when purchasing merchandise.
The procedures are as follows:
1. When certain items are needed, the user department fills in a purchase requisition
form and sends it to the purchasing department.
2. The purchasing department then prepares a purchase order after checking with the
price lists, quotations, or catalogs of approved vendors. The purchase order,
addressed to the selected vendor, indicates the quantity, description, and price of
the merchandise ordered.
It also indicates expected payment terms and
transportation arrangements.
3. After receiving the purchase order, the seller forwards an invoice to the purchaser
upon shipment of the merchandise. The invoice –called a sales invoice by the seller
and a purchase invoice by the buyer-defines the terms of the transaction.
4. Upon receiving the shipment of merchandise, the purchaser’s receiving department
sees to it that the terms in the purchase order are complied with, and prepares a
receiving report.
5. Before approving the invoice for payment, the accounts payable department
compares copies of the purchase requisition, purchase order, receiving report and
invoice to ensure that quantities, descriptions, and prices agree.
All of the above forms – purchase requisition, purchase order, invoice and receiving report –
are source documents. When the goods are received or when title has passed, the entity
should record purchases and a liability (or a cash disbursement). Generally, the seller
recognizes the sales transaction in the records when the goods have been shipped.
TERMS OF TRANSACTIONS
Merchandise may be purchased and sold either on credit terms or for cash on delivery. When
goods are sold on account, a period of time called the credit period is allowed for payment.
The length of the credit period varies across industries and may even vary within an entity,
depending on the product.
When goods are sold on credit, both parties should have an understanding as to the amount
and time of payment. These terms are usually printed on the sales invoice and constitute part
of the sales agreement. If the credit period is 30 days, then payment is expected within 30
days from the invoice date. The credit period is usually described as the net credit period or
net terms. The credit period of 30 days is noted as “n/30”. If the invoice is due ten days after
the end of the month, it may be marked “n/10 eom”.
Cash Discounts
Some businesses gives discounts for prompt payment called cash discounts. If a trade
discount is also offered, cash discount is computed on the net amount after the trade
discount. This practice improves the seller’s cash position by reducing the amount of money
in accounts receivable. Cash discount is designated by such notation as “2/10” which means
the buyer may avail of a two percent discount if the invoice is paid within ten days from the
invoice date. The period covered by the discount, in this case –ten days, is called the
discount period.
Cash discounts are called purchase discounts from the buyer’s viewpoint and sales discounts
from the seller’s point of view.
It is usually worthwhile for the buyer to take a discount if offered although it may be necessary
to borrow the money to make the payment.
Illustration. Assume that an invoice for P150,000 with terms 2/10,n/30, is to be paid within the
discount period with money borrowed for the remaining 20 days of the credit period. If an
annual interest rate of 18 percent is assumed, the net savings to the buyer is P1,530 which is
determined as follows:
Cash discount of 2% on P150,000
P3,000
Interest for 20 days at annual rate of 18% on the amount
Due within the discount period. P147,000 x 18% x20/360
1,470
Savings effected by borrowing
P1,530
======
Trade Discounts
Suppliers furnish smaller wholesalers or retailers with price lists and catalogs showing suggested
retail prices for their products. These firms, however, also include a schedule of trade
discounts from the listed prices to enable the customer to determine the invoice price to be
paid. Trade discounts encourage the buyers to purchase products because of markdowns
from the list price. Trade discounts should not be confused with cash discounts. This type of
discount enables the suppliers to vary prices periodically without the inconvenience of
revising price lists and catalogs.
There is no trade discount account and there is no special accounting entry for this discount.
Instead, all accounting entries are based on the invoice price which is obtained by
subtracting the trade discount from the list price.
Illustration. Pinnacle Technologies quoted a list price of P2,500 for each 64 gigabyte flash
drive, less a trade discount of 20%. If Video Fantastic ordered seven units, the invoice price
would be as follows:
List price (P2,500 x 7)
P17,500
Less: 20% trade discount
3,500
Balance
P14,000
Less: 10% trade discount
1,400
Invoice price
P12,600
=======
In the first example, both the buyer and the seller would record only the P14,000 invoice price
while in the second example, the invoice price will be P12,600.
Transportation Costs
When merchandise is shipped by a common carrier – a trucking entity or an airline –the carrier
prepares a freight bill in accordance with the instructions of the party making the shipping
arrangements. The freight bill designates which party shoulders the costs, and whether the
shipment is freight prepaid or freight collect.
Freight bills usually show whether the shipping terms are FOB shipping point or FOB destination.
FOB is an abbreviation for “free on board”. When the freight terms are FOB shipping point,
the buyer shoulders the shipping costs; ownership over the goods passes from seller to the
buyer when the inventory leaves the seller’s place of business- the shipping point. The buyer
already owns the goods while still in transit and therefore, shoulders the transportation costs.
If the terms are FOB destination, the seller bears the shipping costs. Title passes only when the
goods are received by the buyer at the point of destination; while in transit, the seller is still
the owner of the goods so the seller shoulders the transportation costs.
In freight prepaid, the seller pays the transportation costs before shipping the goods sold;
while in freight collect, the freight entity collects from the buyer. Payment by either party will
not dictate who should ultimately shoulder the costs.
Normally, the party bearing the freight cost pays the carrier. Thus, goods are typically shipped
freight collect when the terms are FOB shipping point; and freight prepaid when the terms
are FOB destination.
Sometimes, as a matter of convenience, the firm not bearing the freight costs pays the carrier.
When this situation occurs, the seller and buyer simply adjust the amount of the payment for
the merchandise. Figure 6-3 shows which party- the buyer or the seller shoulders the
transportation costs and pays the shipper for various freight terms.
Freight Terms
who shoulders the transportation who pays the
Costs?
shipper?
FOB destination, freight prepaid
seller
seller
FOB shipping point, freight collect
buyer
buyer
FOB destination, freight collect
seller
buyer
FOB shipping point, freight prepaid
buyer
seller
Figure 6-3 treatment of transportation costs
The shipping costs borne by the buyer using the periodic inventory system are debited to
transportation in account. In accounting, the cost of an asset – the merchandise inventory –
includes all costs (e.g. shipping costs) incurred to bring the asset to its intended use. In the
cost of sales section of the income statement, the balance in this account is added to
purchases in computing for the net cost of purchases for the period.
Shipping costs borne by the seller are debited to transportation out account. This account
which is also called delivery expense, is an operating expense in the income statement.
INVENTORY SYSTEMS
Merchandise inventory is the key factor in determining cost of sales. Because merchandise
inventory represents goods available for sale, there must be a method of determining both
the quantity and the cost of these goods. There are two systems available to merchandising
entities to record events related to merchandise inventory: the perpetual inventory system
and the periodic inventory system.
Perpetual Inventory System
The perpetual inventory system is an alternative to the periodic inventory system. Under the
perpetual inventory system, the inventory account is continuously updated. Perpetually
updating the inventory account requires that at the time of purchase, merchandise
acquisitions be recorded as debits to the inventory account. At the time of sale, the cost of
sales is determined and recorded by a debit to the cost of sales account and a credit to the
inventory account. With a perpetual inventory system, both the inventory and cost of sales
accounts receive entries throughout the accounting period.
Many merchandising entities are now using the perpetual inventory system with point of sale
equipment. Computers have decreased in prices. These powerful machines have
dramatically reduced the time required to manage inventory. Supermarket and department
stores use point-of-sale scanners built into checkout counters to collect transactional data for
the cash register and to update their perpetual inventory system. In the absence of point of
sales scanners, the perpetual inventory system is more advisable for firms that sell low-volume,
high-priced goods such as motor vehicles, jewelry and furniture.
When an entity uses the perpetual inventory system, the ending inventory should reconcile
with the actual physical count at the end of the period assuming that no theft, spoilage, or
error has occurred. Even if there is a little chance for or suspicion of inventory discrepancy,
most entities make a physical count. At that time, the account is adjusted for any
inaccuracies discovered. The count provides an independent check on the amount of
inventory that should be reported at the end of the period.
Periodic Inventory System
The periodic inventory system is primarily used by businesses that sell relatively inexpensive
goods and that are not yet using computerized scanning systems to analyze goods sold. A
characteristic of the periodic inventory system is that no entities are made to the inventory
account as the merchandise is bought and sold. When goods are purchased, a separate
set of accounts –purchases, purchases discounts, purchases returns and allowances, and
transportation in –is used to accumulate information on the net cost of the purchases. Only
at the end of the period, when the inventory is counted, will entries be made to the inventory
account to establish it s proper balance. The periodic inventory system will be used in the
succeeding discussions. To illustrate the major parts of the merchandising income statement,
selected transactions made by G. Detoya Traders will be used unless otherwise stated.
Net sales
Net sales is the first part of the merchandising income statement as presented below:
Gloria Detoya Traders
Partial Income Statement
For the year ended December 31, 2019
Net sales
Gross sales
Less: Sales returns and allowances
Sales discounts
Net sales
P 2,463,500
P27,500
42,750
70,250
P 2,393,250
=========
Exhibit 6-2 partial Income Statement –net sales
Gross Sales
Under accrual accounting, revenues from the sale of merchandise are considered to be
earned in the accounting period in which the tittle of goods passes-usually at the point of
delivery –from the seller to the buyer. Gross sales consist of total sales for cash and on credit
during an accounting period. Although cash for the sale is uncollected, the revenue is
recognized as earned at the time of the sale. For this reason, there is likely to be a difference
between net sales and cash collected from those sales in a given period.
As an income account, the sales account is credited whenever sales on account or cash
sales are made. Only sales of merchandise held for resale are recorded in the sales account.
If a merchandising firm sold one of its delivery trucks, the credit would be made to the delivery
equipment account, not to sales account.
The journal entry to record the sale of merchandise for cash is as follows:
Sept. 16 Cash
25,000
Sales
To record sale of merchandise for cash
If the sale of merchandise is made on credit, the entry will be:
Sept. 16 Accounts Receivable
Sales
To record sale of merchandise on credit.
25,000
25,000
25,000
Sales Discounts
Assume that G. Detoya Traders sold merchandise on Sept. 20 for P3,000; terms 2/10, n/60. At
the time of sale, the entry is:
Sept. 20
Accounts Receivable
3,000
Sales
3,000
To record sales on credit; terms 2/10,n/60
The customer may take advantage of the sales discount any time on or before Sept. 30,
which is 10 days after the date of the invoice. If the client paid on Sept. 30, the entry is:
Sept. 30
Cash
2,940
Sales discounts
60
Accounts Receivable
3,000
To record collection on the sept. 20 sale, discounts
taken.
At the end of the accounting period, the sales discounts account has accumulated all the
sales discounts for the period. The account is considered a contra-income account and
deducted from gross sales in the income statement (see exhibit 6-2)
Sales Returns and Allowances
Buyers may be dissatisfied with the merchandise received either because the goods are
damaged or defective, of inferior quality or not in accordance with their specifications. In
such a cases, the buyer may return the goods to the seller for credit if the sale was made on
account or for cash refund if the sale was for cash.
Alternatively, the seller may just grant an allowance or deduction from the selling price. A
high sales returns and allowances figure is not commendable because it may signal poor
quality of goods and thus may result to dissatisfied customers.
Each return or allowance is recorded as a debit to an account called sales returns and
allowances. An example of such transaction follows:
Sept. 17
Sales returns and allowances
760
Accounts receivable or cash
760
To record return or allowance on
unsatisfactory merchandise
The seller usually issues the customer a credit memorandum (i.e. accounts receivable or cash
is credited), which is a formal acknowledgment that the seller has reduced the amount owed
by the customer. Sales returns and allowances is a contra-income account and is
accordingly deducted from gross sales in the income statement (see exhibit 6-2).
Transportation Out
When the freight term FOB destination, the seller shoulders the transportation costs; when the
term is FOB shipping point, the buyer bears the shipping costs.
Case 1. Assume that G. Detoya Traders sold merchandise totaling P17,000 FOB destination,
freight prepaid; terms 2/10, n/30. The transportation costs amounted to P1,900. The entry to
record this transaction would be:
Nov. 25
Accounts Receivable
17,000
Transportation out
1,900
Sales
17,000
Cash
1,900
Sales on account; terms 2/10,n/30; FOB
destination, freight prepaid P1,900
If this invoice is collected on December 5, the sales discount will be P340 (P17,000 x 2%).
Transportation out is an operating expense or selling expenses.
Dec. 5
Cash
16,660
Sales discounts
340
Accounts receivable
17,000
Case 2. Assume that G. Detoya Traders sold merchandise totaling P17,000 FOB shipping
point, freight collect; terms 2/10, n/30. The transportation costs amounted to P1,900. The
entry to record this transaction would be:
Nov. 25 Accounts receivable
17,000
Sales
17,000
To record merchandise on account; terms
2/10, n/30; FOB shipping point, freight collect
There is no debit to transportation out account since the shipping term provided that the
buyer should shoulder the transportation costs. If this invoice is collected on December 5,
the sales discount will be P340 (17,000 x 2%). The entry would be:
Dec. 5
Cash
16,660
Sales discounts
340
Accounts receivable
17,000
Case 3. Now, assume that G. Detoya Traders sold merchandise totaliing P17,000 FOB
destination, freight collect; terms 2/10, n/30. The transportation costs amounted to P1,900.
The entry to record this transaction would be:
Nov. 25
Accounts receivable
15,100
Transportation out
1,900
Sales
17,000
Sales on account; terms 2/10, n/30, FOB
destination, freight collect, P1,900.
Accounts receivable is decreased by the transportation charges paid by the buyer for the
benefit of the seller. If this invoice is collected on Dec. 5, the sales discount will be P340 (17,000
x 2%) since the discount applies to total sales.
Dec. 5
Cash
14,760
Sales discounts
340
Accounts receivable
15,100
Case 4. Assume further that G. Detoya Traders sold merchandise totaling P17,000 FOB
shipping point, freight prepaid; 2/10, n/30. The transportation costs amounted to P1,900. The
entry to record this transaction would be:
Nov. 25
Accounts receivable
18,900
Sales
17,000
Cash
1,900
Sales on account; terms 2/10, n/30; FOB
shipping point, freight prepaid, P1,900
If this invoice is collected on December 5, the sales discount will be P340 (P17,000 x 2%). The
discount only applies to total sales.
Dec. 5
Cash
18,560
Sales discounts
340
Accounts receivable
18,900
COST OF SALES
Cost of sales or cost of goods sold is the largest single expense of the merchandising business.
It is the cost of inventory that the entity has sold to customers. Every merchandising business
has goods available for sale to customers. The goods available for sale during the year is the
sum of two factors – merchandise inventory at the beginning of the year and net cost of
purchases during the period.
If an entity is able to sell all the goods available for sale during a given accounting period,
the cost of sales would then equal goods that had been available for sale. In most cases,
however, the business will have goods still unsold at the end of the year. To find the actual
cost of sales, the merchandise inventory at the end of the period is subtracted from the goods
available for sale.
Exhibit 6-3 showed goods costing P1,796,600 as available for sale-G. Detoya started with
P528,000 in beginning merchandise inventory and net cost of purchases (or cost of goods
purchased) of P1,268,600 during the year. At the end of the year, P483,000 of goods were
left unsold; this amount should appear as the merchandise inventory in the balance sheet.
When this ending merchandise inventory is subtracted from goods available for sale, the
resulting cost of sales is P1,313,600.
Gloria Detoya Traders
Partial Income Statement
For the year ended December 31, 2019
Cost of sales
Merchandise inventory, 1/1/2019
Purchases
Less: Purchases Returns and Allowances
Purchases discounts
Net purchases
Transportation In
Net cost of purchases
Goods available for sale
P 528,000
P 1,264,000
P 56,400
21,360
77,760
P 1,186,240
82,360
1,268,600
P1,796,600
Less: Merchandise inventory, 12/31/2019
Cost of sales
483,000
P1,313,600
=========
Exhibit 6-3 Partial Income Statement –cost of sales
Merchandise Inventory
The inventory of a merchandising entity consists of goods purchased for resale. For a grocery
store, inventory would be made up of meats, vegetables, canned goods, and other items.
For a lumber and hardware, it would be plywood, nails, paints, iron sheets, cement, tools and
other items.
Merchandising entities purchase their inventories from manufacturers,
wholesalers and other suppliers.
The merchandise inventory at the beginning of the accounting period is called the beginning
inventory. Conversely, the merchandise inventory at the end of the accounting period is
called the ending inventory. As presented in exhibit 6-3, beginning and ending inventory are
used in calculating cost of sales in the income statement. The ending inventory shown in the
income statement will be the merchandise inventory to be reported in the balance sheet.
Effectively, the ending inventory of the current period will be the beginning inventory of the
next period.
Net Cost of Purchases
Under the periodic inventory method, net cost of purchases consist of gross purchases minus
purchases discounts and purchases returns and allowances equals net purchases; plus
transportation costs.
Purchases
When the periodic inventory method is used, all purchases of merchandise are debited to
the purchases account as shown below:
Nov. 12
Purchases
15,000
Accounts payable
15,000
To record purchases of merchandise; terms
2/10, n/30
The purchases account, a temporary account, is used only for merchandise purchased for
resale. Its sole purpose is to accumulate the total cost of merchandise purchased during an
accounting period. Purchases of other assets such as equipment should be recorded in the
appropriate assets accounts. Recording merchandise purchases at invoice price is known
as the gross price method of recording purchases.
Purchases Returns and Allowances
Sales returns and allowances in the seller’s books are recorded as purchases returns and
allowances in the books of the buyer. This should be recorded as follows:
Nov. 14
Accounts payable
2,000
Purchases returns and allowances
2,000
Return of damaged merchandise purchased
on November 12.
Purchases returns and allowances is a contra account and is accordingly deducted from
purchases in the income statement (see exhibit 6-3). It is important that a separate account
be used to record purchases returns and allowances because management needs the
information for decision making.
It may be very costly to return merchandise. There are costs that cannot be recovered such
as ordering costs, accounting costs, transportation costs, and interest on the money invested
in the goods. There may also be lost sales resulting from poor ordering or unsaleable goods.
Frequent returns may call for new purchasing procedures or suppliers.
Purchases Discounts
Merchandise purchases are usually made on credit and commonly involve purchases
discounts for early payment. In relation to the Nov. 12 and 14 transactions, the payment is
recorded as follows:
Nov. 14
Accounts payable
13,000
Purchases discount (P13,000 x 2%)
260
Cash
12,740
Like purchases returns and allowances, purchases discounts is a contra account that is
deducted from purchases on the income statement. If the entity makes a partial payment
on an invoice, most creditors will allow the entity to take the discount applicable to the partial
payment. The discount does not apply to transportation or other charges that might appear
on the invoice.
Transportation In
Case 1. Assume that G. Detoya Traders made purchases totaling P17,000 FOB destination,
freight prepaid; terms 2/10, n/30. Transportation costs amounted to P1,900. The entry would
be:
Nov. 25
Purchases
17,000
Accounts payable
17,000
Purchased merchandise on account; terms 2/10,
n/30; FOB destination freight prepaid.
There is no debit to transportation in account since the shipping term provided that the seller
should shoulder the transportation costs. In addition, the seller prepaid the freight. If this
invoice is paid on December 5, the purchases discount will be P340 (P17,000 x 2%). The entry
would be:
Dec. 5
Accounts payable
17,000
Purchases discounts
340
Cash
16,660
Case 2. Assume that G. Detoya made purchases totaling P17,000 FOB shipping point, freight
collect; terms 2/10, n/30. The transportation costs amounted to P1,900. The entry to record
this transaction would be:
Nov. 25
Purchases
17,000
Transportation
1,900
Accounts payable
17,000
Cash
Purchases on account; terms 2/10, n/30; FOB
shipping point, freight collect, P1,900.
1,900
If this invoice is paid on Dec. 5, the purchases discount will be P340 (P17,000 x 2%).
Transportation in will form part of the net cost of purchases.
Dec. 5
Accounts payable
17,000
Purchases discounts
340
Cash
16,660
Case 3. Now, assume that G. Detoya Traders made purchases totaling P17,000 FOB
destination, freight collect; terms 2/10, n/30. The transportation costs amounted to P1,900.
The entry to record this transaction would be:
Nov. 25
Purchases
17,000
Accounts payable
15,100
Cash
1,900
Purchases on account; terms 2/10, n/30; FOB
destination, freight collect, P1,900.
Accounts payable is decreased by the transportation charges paid by the buyer for the
benefit of the seller. If this invoice is paid on Dec. 5, the purchases discount will be P340
(P17,000 x 2%) because the discount applies to total purchases.
Dec. 5
Accounts payable
15,100
Purchases discounts
340
Cash
14,760
Case 4. Assume further that G. Detoya Traders made purchases totaling P17,000 FOB
shipping point, freight prepaid; terms 2/10, n/30. The transportation costs amounted to
P1,900. The entry to record this transaction would be:
Nov. 25
Purchases
17,000
Transportation in
1,900
Accounts payable
18,900
Purchased merchandise on account; terms 2/10,
n/30; freight prepaid, P1,900.
If this invoice is paid on Dec. 5, the purchases discount will be P340 (P17,000 x 2%). The buyer
is not entitled to discounts on the transportation costs. Discounts apply only to total
purchases.
Dec. 5
Accounts payable
18,900
Purchases discount
340
Cash
18,560
It will be useful to contrast these “transportation In entries to the “transportation Out” entries
discussed earlier.
VALUE ADDED TAX ENTRIES
The foregoing entries for sales and purchases did not incorporate the effect of value –added
taxes on the transactions to simplify the illustrations. But the learning will not be complete
without the following illustration.
Illustration. Remedios Palaganas feeds based in Pangasinan trades specialty feeds for race
horses, fighting cocks, aquarium fish, zoo animals and other animals generally considered as
pets. On May 13, 2019, Remedios Palaganas feeds purchased on account specialty feeds
with a total amount payable of P784,000. A wholesaler operating in the region bought for
cash all of the available feeds on May 25, 2019; amount of cash received was P1,120,000.
Remedios Palaganas feeds paid the value added tax due by month end not minding the
actual deadline.
2019
May 13
Purchases
700,000
Input tax
84,000
Accounts payable
784,000
May 25
May 31
May 31
Cash
Sales
Output tax
1,120,000
1,000,000
120,000
Output Tax
Input tax
Vat payable
120,000
Vat payable
Cash in bank
36,000
84,000
36,000
36,000
Input tax increased the amount to be paid but has no effect on the cost of the purchases.
Output tax also increased the amount collected but not necessarily, the sales figure. The
value of goods or properties sold and subsequently returned or for which allowances were
granted by a VAT-registered person may be deducted from the gross sales or receipts for the
quarter in which the refund is made or a credit memorandum is issued. Sales discounts
granted or indicated in the invoice at the time of sale may be excluded from the gross sales
within the same quarter it was given.
Illustration. Assume that the wholesaler purchased the feeds from Dela Cruz on account and
that a 2% sales discount is available if the account is settled within 10 days from invoice date.
Dela Cruz was able to collect the account on May 30. The related entry follows:
May 30
Cash
1,097,600
Output tax
2,400
Sales discount
20,000
Accounts receivable
1,120,000
Remedios Palaganas, because of the sales discounts granted, will pay value-added tax due
of 33,600 only.
OPERATING EXPENSES
Operating expenses make up the third major part of the income statement for a
merchandising entity. These are expenses, other than the cost of sales, which are incurred to
generate profit from the entity’s major line of business- merchandising. It is customary to
group operating expenses into useful categories. Distribution costs, administrative expenses
and other operating expenses are the categories.
Distribution costs or selling expenses are those expenses related directly to the entity’s efforts
to generate sales. These include sales salaries and commissions, and the related employer
payroll expenses; advertising and store displays; traveling expenses; store supplies used;
depreciation of store property and equipment; and transportation out.
Administrative expenses are those expenses related to the general administration of the
business. These include officers and office salaries, and the related employer payroll
expenses; office supplies used; depreciation of office property and equipment; business
taxes; professional services; uncollectible accounts expense and other general office
expenses.
Other operating expenses are those expenses that are not related to the central operations
of the business. These are expenses and losses from peripheral or incidental transactions of
the enterprise; for example, loss on sale of investments or loss on sale of property and
equipment.
Multiple Choice
1. A supplier offers the following discounts: Trade discounts of 10% at list price and
another cash discount of 5% if paid in full before the due date. How much is to be
paid if a customer pays before due date at a list price of P16,000?
a. P13,680
b. P15,520
c. P14,000
d. P16,000
2. A trade discount is:
a. shown in the sales journal
b. shown in the purchase journal
c. shown in the general journal
d. not shown anywhere
3. Which account does a merchandiser, but not a service entity, use?
a. Sales
b. Inventory
c. Cost of goods sold
d. All of the above
4. The two main inventory accounting systems are the following
a. purchase and sale
b. returns and allowances
c. cash and accrual
d. perpetual and periodic
5. Which of the following activities is not a component of the operating cycle?
a. Collection of cash from merchandise sales.
b. Ordering of merchandise.
c. Purchase of merchandise.
d. Sale of merchandise.
6. Each of the following companies is a merchandising entity except a
a. candy store
b. car wash
c. furniture store
d. whole sale parts entity
7. A physical count of inventory is usually taken
a. at the end of the fiscal year
b. at the peak of the busy season
c. At the start of the fiscal year.
d. In the middle of the fiscal year.
8. A merchandiser will earn an operating income of exactly zero when
a. costs of goods sold equals gross margin
b. gross margin equals operating expenses
c. net sales equals cost of goods sold
d. operating expenses equal net sales
9. Gross margin equals the difference between net sales and
a. cost of goods sold
b. cost of goods sold plus operating expenses
c. operating expenses
d. profit
10. Operating income will result if gross margin exceeds
a. cost of goods sold
b. cost of goods sold plus operating expenses
c. operating expenses
d. purchases
11. Which of the following is not considered an operating expense?
a. administrative expenses
b. advertising expense
c. cost of goods sold
d. transportation out
12. An amount deducted from the catalog price for an item of merchandise is called a
a. customer discount
b. purchases discount
c. sales discount
d. trade discount
13. Under the perpetual inventory system, which of the following accounts would not be
used?
a. Cost of goods sold
b. Merchandise inventory
c. Purchases
d. Sales
QUIZ
CHAPTER 7
Completing the Cycle for a Merchandising Business
Learning Objectives:
After studying this chapter, you should be able to:
1.
Recognize the need for a physical count and analyze the effects of omitting the
procedure.
2. Determine the entries for merchandise inventory using either the adjusting entry
method or the closing entry method.
3. Prepare the adjusting entries for a merchandising entity.
4. Recognize the need for a worksheet and summarize how the new accounts related
to merchandising transactions are handled in the worksheet.
5. Prepare accurately and in good form a ten column worksheet.
6. Understand and appreciate the usefulness of financial statements.
7. Develop skills in the preparation of financial statements.
8. Compare income statements prepared under the nature of expense and function of
expense methods.
9. Explain why temporary accounts are closed each period.
10. Recognize the need for a post-closing trial balance and reversing entries in particular
instances.
11. Prepare closing entries, post –closing trial balance and reversing entries.
12. Explain how the worksheet under a perpetual inventory system differs from that
prepared under a periodic inventory system.
NEED FOR A PHYSICAL COUNT
In the periodic inventory system, purchases of merchandise are accumulated in the
purchases account. During the accounting period, no entry is made to the merchandise
inventory account such that its balance at the end of the period, before adjusting and
closing entries, is the same as the beginning inventory. With no perpetual record of the cost
of sales during the period, the only way to obtain the cost of the ending inventory to make a
physical count.
Dec. 31 Merchandise inventory, end
483,000
Temporary account with credit balance
xxx
Income summary
xxx
Notice that in both methods, merchandise inventory is credited for the beginning balance
and debited for the ending balance and that the opposite entries are made to income
summary.
PREPARING THE WORKSHEET
The worksheet of a merchandising business is the same as that of a service business except
that it has to deal with the new accounts related to merchandising transactions. These
accounts include sales, sales returns and allowances, sales discounts, purchases, purchases
returns and allowances, purchase discounts, transportation in, merchandise inventory and
transportation out. The worksheet for G. Detoya Traders using the closing entry method is
shown in exhibit 7-1. Each pair of columns in the worksheet, and the adjusting and closing
entries are discussed as follows.
Trial Balance Columns. The first step in the preparation of the worksheet is to enter the
balances from the ledger accounts into the trial balance columns. The merchandise
inventory account balance of P528,000 is the cost of beginning inventory.
Adjustment Columns. Under the closing entry method of handling merchandise inventory,
the adjusting entries for G. Detoya Traders are entered in the adjustments columns in the
same way that they were for service entities. These involve insurance expired during the
period (adjustment a); store and office supplies used (adjs. b & c); depreciation of building
and office equipment (adjs. d & e); accrual of interest expense (adj. f); no adjustment entry
is made for merchandise inventory because the closing entry method was used. After the
adjusting entries are entered in the worksheet, the trial balance columns and adjustment
columns are totaled to prove the equality of the debits and credits.
Omission of Adjusted Trial Balance Columns. These two columns are used when there are
many adjusting entries to be considered. When only a few adjusting entries are required, as
in this case, these columns are not necessary and may be omitted.
Income Statement and Balance Sheet Columns. After the trial balance columns have been
totaled, the adjustments entered, and the equality of the columns proved, the balances are
extended to the statement columns. Each account balance is entered in the proper column
of the income statement or balance sheet.
The extension of the beginning and ending inventory balances requires some new
procedures. First, the beginning inventory balance of P528,000 is extended to the debit
column of the income statement as illustrated in exhibit 7-1. This procedure has the effect of
adding beginning inventory to net cost of purchases; observe that the purchases account is
also in the debit column of the income statement.
Second, the ending inventory balance of P483,000 which is not in the trial balance is entered
in the credit column of the income statement. This procedure has the effect of subtracting
the ending inventory from goods available for sale. Note that two inventory amounts
appeared in the income statement columns. This because both the beginning inventory and
the ending inventory are needed in the computation of cost of sales.
Finally, the ending inventory is also entered in the debit column of the balance sheet. After
all the items have been extended to the proper statement columns, the four columns are
totaled. The profit or loss is determined as the difference between the debit and credit
columns of the income statement. In this case, G. Detoya Traders earned a profit of P455,210,
which is extended to the credit column of the balance sheet. The four columns are then
added to prove the equality of the debits and credits.
PREPARING THE FINANCIAL STATEMENTS
Income statement
The discussion on the major parts of the income statement for a merchandising entity has
been made in the previous chapter. The statement may be prepared by referring to the
income statement columns of the worksheet. Per revised PAS no. 1, an enterprise should
present an analysis of expenses using a classification based on either the nature of expenses
or their function within the entity, whichever provides information that is reliable and more
relevant. Entities are encouraged to present the analysis of expenses on the face of the
income statement.
Nature of Expense Method
Expenses are aggregated or combined in the income statement according to their nature
and are not reallocated among various functions within the entity. This method is simple to
apply in many smaller enterprises because no allocation of operating expenses between
functional classifications is necessary. Examples include raw materials and consumables
used, employee benefits expense, depreciation and amortization expense, transportation
costs, advertising costs and other operating expenses.
Function of Expense Method
This method, also referred to as the “cost of sales” method, classifies expenses according to
their function as part of cost of sales, distribution/selling, administrative and other operating
activities. This presentation often provides information that is more relevant to users than
nature of expense method but the allocation of costs to functions can be arbitrary and
involves considerable judgment.
This method provides multiple classifications and
intermediate differences to highlight significant relationships.
In a merchandising business, net sales arise from the sale of goods while cost of sales or cost
of goods sold represents the cost of inventory the entity has sold to customers. The difference
between net sales and cost of sales is called gross profit.
Then, other operating income is added and operating expenses (like distribution costs,
administrative expenses and other operating expenses) are deducted fro gross profit to arrive
at operating profit.
Investment revenue, other gains and losses, and finance costs (e.g. interest expense) are
considered to arrive at profit before tax then income tax expense is deducted to arrive at
profit from continuing operations. Finally, profit from discontinued operations (net of tax) is
taken to account to get profit for the period.
Net sales
Cost of sales
Gross profit
Other operating income
Total
Operating expenses
Distribution costs
Administrative expenses
Other operating expenses
Pxxx
(xxx)
xxx
xx
xxx
xx
xx
xx
xx
Operating income
Finance costs
Investment income
Profit from continuing operations
Profit from discontinued operations
Profit
Pxxx
(xx)
xx
Pxxx
x
Pxxx
====
The difference between the two methods lies in the items above operating profit. The
standard does not prescribe any format. The choice between the two methods depends on
historical and industry factors and the nature of the entity.
Exhibit 7-2 shows the income statement for G. Detoya Traders using the function of expense
method:
Gloria Detoya Traders
Income Statement
For the year ended December 31, 2019
Net sales
Gross sales
Less: Sales returns and allowances
Sales discounts
Net sales
Cost of sales
Merchandise inventory, 1/1/2019
Purchases
P1,264,000
Less: purchases returns and allows. P56,400
Purchases discounts
21,360
77,760
Net purchases
P1,186,240
Transportation In
82,360
Net cost of purchases
Goods available for sale
Less: merchandise inventory, 12/31/2019
Cost of sales
Gross profit
Operating expenses
Selling expenses
Sales salaries
P225,000
Transportation out
57,400
Store supplies expense
15,400
Insurance expense –selling
5,600
Total selling expenses
Administrative expenses
Office salaries
P171,000
Utilities expense
48,000
Depreciation expense-building
26,000
Depreciation expense- OE
22,000
Office supplies expense
12,040
Insurance expense –general
3,600
Total administrative expenses
P 2,463,500
P 27,500
42,750
70,250
P 2,393,250
P528,000
1,268.600
P1,796,600
483,000
1,313,600
P1,079,650
P 303,400
P282,640
Total operating expenses
Operating profit
Finance costs
Profit
586,040
P 493,610
38,400
P455,210
========
Exhibit 7-2 Income Statement (using the function of expense method)
Statement of Changes in Equity
Gloria Detoya Traders
Statement of Changes in Equity
For the year ended December 31, 2019
G. Detoya, Owner’s Equity, 1/12019
Add: Profit
Total
Less: withdrawals
G. Detorya, Owner’s Equity, 12/31/2019
Exhibit 7-3
P593,920
455,210
P1,049,130
200,000
P 849,130
=========
Statement if Changes in Equity
Balance Sheet
The balance sheet dated “December 31, 2019” is implicitly understood to mean “at the close
of business on December 31, 2019”
Gloria Detoya Traders
Balance Sheet
December 31, 2019
Assets
Current Assets
Cash
Accounts Receivable
Merchandise Inventory
Store Supplies
Office Supplies
Prepaid Insurance
Total current assets
Property and Equipment (net)
Land
Building
Less: Accumulated Depreciation
Office Equipment
Less: Accumulated Depreciation
Total Property and Equipment
Total Assets
P 304,500
484,200
483,000
10,600
6,360
4,600
P 1,293,260
P 145,000
P 202,600
82,500
P 86,000
50,000
120,100
36,000
P 301,100
P1,594,360
==========
Liabilities
Current Liabilities
Accounts Payable
Salaries Payable
Interest Payable
Total current liabilities
Non-Current Liabilities
16% Notes Payable, Due on June 30, 2021
Owner’s Equity
P 206,830
20,000
38,400
P 265,230
480,000
G. Detoya, Capital, December 31
Total Liabilities and Owner’s Equity
Exhibit 7-4
849,130
P1,594,360
===========
Classified Balance Sheet
ADJUSTING AND CLOSING ENTRIES
The adjusting entries are journalized and posted to the ledger as they would be in a service
entity. The closing entries for G. Detoya Traders under the closing entry method appear in
exhibit 7-5.
Note that merchandise inventory is credited in the 1st entry for the amount of the beginning
inventory, P528,000; and debited in the 2nd entry for the ending inventory, P483,000. Except
for the closing of the temporary accounts typical of a merchandising business, the closing
procedures are the same with that of a service business.
Exhibit 7-5
Closing Entries for G. Detoya Traders: Closing Entry Method
Journal
Date
Account Titles and Explanation
PR
2019
Dec. 31 Merchandise Inventory, End
Sales
Purchases returns & allowances
Purchases discounts
Income Summary
To close temporary accounts with credit
balances and to establish the ending
merchandise inventory.
Dec. 31 Income Summary
Merchandise Inventory Beg.
Sales Returns & Allowances
Sales discounts
Purchases
Transportation In
Sales salaries expense
Office salaries expense
Store supplies expenses
Office supplies expenses
Debit
Credit
483,000
2,463,500
56,400
21,360
3,024,260
2,569,050
528,000
27,500
42,750
1,264,000
82,360
225,000
171,000
15,400
12,040
Dec. 31
Dec. 31
Insurance expense-selling
Insurance expense –general
Transportation out
Utilities expense
Depreciation expense –store equipment
Depreciation expense – office equipment
Interest expense
To close temporary accounts with debit balances
and to remove beginning inventory
Income Summary
G. Detoya, Capital
To close the income summary account.
G. Detoya, Capital
G. Detoya, witdrawals
To close the withdrawals account.
5,600
3,600
57,400
48,000
26,000
22,000
38,400
455,210
455,210
200,000
200,000
POST CLOSING TRIAL BALANCE
A final trial balance is prepared to test the equality of the accounts after posting the adjusting
and closing entries. This trial balance is similar to the one discussed in the service business
except for the addition of the merchandise inventory account.
Gloria Detoya Traders
Post-Closing Trial Balance
December 31, 2019
Cash
Accounts Receivable
Merchandise Inventory
Store Supplies
Office Supplies
Prepaid insurance
Land
Building
Accumulated Depreciation –Building
Office Equipment
Accumulated Depreciation –Office Equipment
Accounts Payable
Salaries Payable
Interest Payable
Long-term Notes Payable
G. Detoya, Capital
P 304,500
484,200
483,000
10,600
6,360
4,600
145,000
202,600
P 82,500
86,000
P1,726,860
=========
Exhibit 7-6 Post- Closing Trial Balance
50,000
206,830
20,000
38,400
480,000
849,130
P1,726,860
=========
Multiple Choice
1.
2.
3.
4.
5.
6.
Jan Cahilig Traders started operating in 2019. For the year ended 2019, the sales,
purchases and closing inventory are P500,000, P200,000 and P10,000 respectively.
What is the amount of cost of goods sold for the year ended 2019?
a. P190,000
b. P200,000
c. P790,000
d. P800,000
Refer to Question 1, what is the gross profit for the entity?
a. P200,000
b. P300,000
c. P310,000
d. P490,000
Based on the following information, answer questions 3 to 7
An entity has the following accounting information for the year:
Sales
400,000
Purchases
90,000
Opening Inventory
30,000
Sales Returns
80,000
Purchases Returns
70,000
Transportation In
40,000
Transportation Out
10,000
Salaries
9,000
Other revenues
4,000
General expenses
7,000
Gross profit
250,000
What is the amount of net sales of the entity?
a. P260,000
b. P280,000
c. P320,000
d. P330,000
What is the amount of net purchases of the entity?
a. P20,000
b. P30,000
c. P50,000
d. P60,000
What is the amount of closing inventory of the entity?
a. P10,000
b. P20,000
c. P30,000
d. P40,000
What is the amount of profit for the year?
a. P48,000
b. P188,000
c. P198,000
d. P228,000
7.
Which of the following is/are not relevant to the calculation of net sales?
1. cash sales
2. sales returns
3. sales discounts
a. (2) only
b. (3) only
c. (1) and (2) only
d. (2) and (3) only
8. Suppose RJ Garciano Sound had sales of P300,000 and sales returns of P40,000. Cost
of goods sold was P160,000. How much gross profit did RJ Garciano Sound report?
a. P160,000
b. P180,000
c. P100,000
d. P260,000
9. On a worksheet for a merchandising entity that uses the perpetual inventory system,
a. The cost of goods sold is contained in one account in the Balance Sheet
columns.
b. The cost of goods sold is contained in one account in the Income Statement
columns.
c. The cost of goods sold is created by an entry in the adjustments columns.
d. The items composing cost of goods sold are scattered the Income Statement
columns.
10. Which of the following accounts is closed by debiting the account?
a. Purchases
b. Purchases Returns and allowances
c. Sales Returns and allowances
d. Transportation In
EVALUATION: QUIZ
CHAPTER 8
Manufacturing Operations
Learning Objectives:
After studying this chapter, you should be able to:
1. Compare the activities prevalent to merchandising and manufacturing entities.
2. Identify the elements of manufacturing costs.
3. List the manufacturing inventory accounts.
4. Show the pro-forma entries of the common transactions for a manufacturing entity.
5. Prepare a statement of cost of goods manufactured.
6. Prepare a statement of cost of goods sold.
7. Pinpoint the differences in the worksheet of a manufacturing entity as compared to a
merchandising entity.
ACCOUNTING FOR MANUFACTURING ACTIVITIES
Two accounting systems may be used in accounting for manufacturing activities –cost and
non-cost. The cost system keeps perpetual records of the costs of raw material, work in
process and finished goods inventories. This system provides more timely information about
those inventories and changes in their levels. It also produces timely information about
manufacturing costs per unit of product which managers use in their efforts to control costs.
Accounting for manufacturing activities using cost systems is the subject of course in higher
accounting.
The non-cost system produces a manufacturing accounting system based on the periodic
inventory system. The costs of raw materials, work in process and finished goods inventories
are based on physical counts of the quantities on hand at the end of each period. This
information is then used to compute the amounts consumed, finished and sold during the
period. This system does not provide for a detailed flow of costs in the manufacturing process.
In the discussion to follow, the non-cost system will be used. it is also assumed that the entity
uses the voucher system. The following are the pro-forma journal entries of the more common
transactions for a manufacturing entity.
1. To record purchase of raw materials and indirect materials on account:
Purchases –raw materials
xx
Indirect materials
xx
Vouchers payable
xx
2. To record cost of defective raw materials returned to vendor:
Vouchers payable
xx
Purchases returns and allowances
xx
3. To record payment of account within the discount period:
Vouchers payable
xx
Purchases discounts
xx
Cash in bank
xx
4. To record freight and handling of raw materials:
Transportation In
xx
Vouchers Payable
xx
5. To record payroll for factory employees:
Direct labor
xx
Indirect labor
xx
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
SSS contributions payable
Philheatlh Contribution payable
Pag-IBIG contributions payable
Withholding taxes payable
Vouchers payable
To record employer’s payroll expenses:
Employer’s payroll contribution-factory
xx
SSS contributions payable
Philhealth
EC contribution payable
Pag – IBIG contribution payable
To record distribution of Payroll:
Vouchers payable
xx
Cash in bank
To record accrual of factory payroll:
Direct labor
xx
Indirect labor
xx
Accrued payroll
To record depreciation of factory building:
Depreciation expenses- factory building
xx
Accumulated depreciation-factory building
To record repairs on factory building:
Repairs and maintenance –factory building
xx
Vouchers payable
To record amortization of patents:
Amortization of patents
xx
Patent
To record real property taxes on factory site:
Real Property taxes
xx
Vouchers payable
To record factory utilities incurred:
Factory Utilities
xx
Vouchers payable
To record cost of tools used:
Tools used
xx
Tools
To record sales of finished goods:
Accounts receivable
xx
Sales
To record sales returns and allowances from customers:
Sales returns and allowances
xx
Accounts receivables
Closing entries peculiar to manufacturing concerns:
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
In order for a manufacturer to summarize all the transactions that affect the
computation of the cost of goods manufactured, a manufacturing summary account
is maintained. It is credited for the results of the physical count of raw materials
inventory and work in process inventory at the end of the accounting period. The
contra- purchases accounts are also credited to this account. This account is debited
for the beginning balances of raw materials and work in process inventory, and the
manufacturing accounts with debit balances. The balance of the manufacturing
summary account is then closed to the income summary account.
a. To close manufacturing accounts with credit balances, and to record ending
inventory for materials and work in process:
Raw materials inventory, end
xx
Work in process inventory, end
xx
Purchases returns and allowances
xx
Purchases discounts
xx
Manufacturing summary
xx
b. To close manufacturing accounts with debit balances:
Manufacturing summary
xx
Raw materials inventory Beginning
Work in process inventory, beginning
Purchases –raw materials
Transportation in
Direct labor
Indirect labor
Indirect materials
Depreciation expense- factory bldg.
Repairs and Maintenance –factory bldg.
Amortization of Patents
Real property taxes
Factory utilities
Tools used
Employer’s payroll contributions-factory
Factory supplies expense
Miscellaneous factory expense
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
xx
c. To close manufacturing summary and beginning finished goods inventory to
income summary:
Income summary
xx
Manufacturing summary
xx
Finished goods inventory-beginning
xx
d. To establish the ending finished goods inventory:
Finished goods inventory, beginning
xx
Income summary
xx
The other closing entries after this procedure are the same as those for a
merchandising entity.
STATEMENT OF COST OF GOODS MANUFACTURED
Reynate Balocating Manufacturers
Statement of Cost of Goods Manufactured
For the year ended December 31, 2019
Direct materials used:
Raw materials inventory, beginning
Add: Net cost of purchases:
Purchases –raw materials
Less; Purchases returns and allowances
Pxx
Purchases discounts
xx
Net purchases
Add: transportation in
Raw material available for use
Less: Raw materials inventory, end
Direct labor
Manufacturing Overhead:
Indirect labor
Indirect materials
Depreciation expense-factory bldg.
Repairs and maintenance – factory bldg.
Amortization of Patents
Real property taxes
Factory utilities
Tools used
Employer’s payroll contribution –factory
Factory supplies expense
Miscellaneous factory expense
Total Manufacturing Costs
Add: work in process, beginning
Total cost of goods placed in process
Less: Work in process, end
Cost of Goods manufactured
Pxxx
Pxx
xx
Pxx
xx
xxx
Pxxx
xxx
Pxxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
Pxxx
xxx
xxx
Pxxx
xxx
Pxxx
xxx
Pxxx
======
Total manufacturing costs should not be confused with the cost of goods manufactured.
Total manufacturing costs are the costs of direct materials used, direct labor and
manufacturing overhead incurred and charged to production during an accounting period.
The cost of goods manufactured consists of the total manufacturing costs related to the
products completed during an accounting period. This statement is also called the
manufacturing statement.
STATEMENT OF COST OF GOODS SOLD
The difference in the income statement of a merchandising and a manufacturing entity lies
in the cost of goods sold section. As illustrated, observe that the merchandiser used the term
merchandise inventory while the manufacturer used the term finished goods inventory. A
merchandiser’s entire inventory is finished goods; a merchandiser has no materials inventory
and work in process inventory.
A manufacturer produces its own finished goods inventory. Cost of goods manufactured is
the manufacturer’s counterpart to the merchandiser’s bought for resale during the period.
Cost of goods manufactured is the manufacturing cost of the goods completed during a
production period.
Merchandising Entity
Manufacturing Entity
Merchandise inventory, beg.
Pxx
Finished goods inventory, Beg.
Pxx
Add: net cost of purchases
xx
add: Cost of Goods Manufactured
xx
Goods available for sales
Pxx
Goods available for sale
Pxx
Less: merchandise inventory, end
xx
less: Finished goods inventory, end
xx
Cost of goods sold
Pxx
Cost of goods sold
Pxx
===
===
WORKSHEET FOR MANUFACTURING ENTITY
The worksheet for a manufacturing entity is basically the same as that for a merchandising
entity except that it includes a pair of columns for cost of goods manufactured. All the
accounts that comprise the statement of cost of goods manufactured are extended to these
columns. Beginning raw materials inventory and work in process are debited in the
manufacturing columns while the related ending inventories are credited.
The other manufacturing accounts are either debited or credited as necessary. The
difference between the total debits and total credits of these two columns is then extended
to the debit column of the income statement. Beginning finished goods inventory being a
component in the computation of cost of goods sold is extended to the debit side of the
income statement columns while the ending finished goods inventory to the credit column.
Multiple Choice
1. Manufacturing costs would not include
a. Depreciation on factory equipment.
b. Indirect labor costs.
c. Indirect materials used.
d. Sales salaries expense.
2. Each of the following is true with respect to product costs, except
a. Direct labor is an example of a product cost.
b. Product costs are deducted from revenue when the manufacturing process is
completed.
c. Product costs are not regarded as expenses of the current period.
d. Product costs represent inventoriable costs.
3. Which of the following is not likely to be treated as a product cost?
a. Depreciation on the factory.
b. Interest paid on notes payable.
c. Portion of the cost of running the quality control department.
d. Wages paid to factory workers.
4. The purchases –raw materials account is debited when
a. Direct materials are placed into production.
b. Direct materials are purchased.
c. Indirect materials are placed into production.
d. Indirect materials are purchased.
5. The direct labor account is debited
a. At the end of the payroll period, when employees are paid.
b. When a new factory employee begins work.
c. When related labor costs are transferred into the work in process inventory
account.
d. When the goods manufactured are completed.
EVALUATION:
HOMEWORK
QUIZ
CHAPTER 9:
Accounting for Payroll
Learning Objectives:
After studying this chapter, you should be able to:
1. Recognize the terms used in payroll accounting.
2. Explain the basic labor laws affecting the gross pay computation.
3. Explain the major programs mandated to take care of employee benefits.
4. Understand and compute employee’s payroll deductions and employer’s payroll
expenses.
5. Identify and describe the payroll system.
6. Prepare the payroll register.
7. Journalize payroll-related entries.
8. Apply internal control over payrolls.
ACCOUNTING FOR PAYROLL
Definition of Terms
Employee refers to any individual who is a recipient of salaries or wages. It includes an officer,
employee or elected official of the Government of the Philippines or any political subdivision,
agency or instrumentality thereof. The term also includes an officer of a corporation.
Employer means a person for whom an individual performs or performed any service, of
whatever nature, as the employee of such person.
Payroll refers to the total amount paid to employees for services provided during a period.
Payroll period means a period for which an employer ordinarily makes payment of salaries or
wages to the employees.
Gross Pay
Salaries or wages means all remuneration paid for services performed by an employee for his
employer, including the cash value of all remuneration paid in any medium other than cash.
The term salary is usually applied to managerial, supervisory and administrative services. The
rate of salary is expressed in terms of a month or a year. Remuneration for skilled or unskilled
labor is ordinarily referred to as wages; the rates are stated on an hourly or piecemeal basis.
Commissions, bonuses, cost of living allowance and fringe benefits may increase the basic
salary or wage of an employee. The total earnings of an employee for a payroll period before
taxes and other deductions are taken out, is called gross pay.
Salary and wage rates are determined, in general, by agreement between the employer
and the employee subject to the Minimum Wages Law and the Labor Code of the Philippines.
Regular working hours shall not be more than eight hours in any one day nor more than 40
hours in any one week. Employees who worked for more than 8 hours a day should be paid
an additional compensation generally equivalent to regular pay plus at least 25%.
Every employee shall be paid a night shift differential of not less than 10% of his regular pay
for each hour of work performed between ten o’clock in the evening and six o’clock in the
morning. Work on Sundays calls for overtime pay at a premium of 30% while work on holidays
requires a 100% premium. For purposes of computing overtime and other additional
remuneration, the regular pay shall include only cash payments.
Employee Benefits
Private employees, whether permanent, temporary or provisional, who is not over 60 years
old, is subject to compulsory coverage under the Social Security System (SSS) and the
National Health Insurance Program (NHIP) and the Pag-IBIG fund. Employers who avail of the
services of another person in business, trade, industry or any undertaking must also be
registered with the SSS, NHIP and Pag-IBIG fund.
Covered employees are entitled to a package of benefits under the Social Security and
Employee’s Compensation in case of death, disability, sickness, maternity and old age. The
SSS administers the two programs, namely: the Social Security Program and the Employee’s
Compensation Program.
The Social Security System provides for a replacement of income lost on account of the
aforementioned contingencies. The benefits under the program are as follows: sickness,
maternity, disability, retirement and death benefits.
Although the SSS was mandated primarily to give social security protection, it has also
provided its members with loan programs from which the members can borrow for personal
purposes. These loans may be used for the member’s or his dependents’ education; or for
the purchase of stock investments in privatized government owned and controlled
corporations.
Recently, the SSS has required employers to serve as guarantors of their employees applying
for salary loans and cut down its repayment period from two years to one year. The employer
would be liable to pay the balance should the borrower resign or transfer to another
company.
Self- employed and voluntary members, who have no employer’s would need another
member of good standing to serve as co-maker of their loan application. The co-maker
would be liable If the self-employed or voluntary member reneged on the loan.
The Employees’ Compensation (EC) Program aims to assist workers who suffer work-related
sickness or injury resulting in disability or death. The benefits under the EC program may be
enjoyed simultaneously with benefits under the social security program. All SSS –registered
employers and their employees are compulsorily covered under this program. The benefits
under the EC program are as follow: medical services and supplies, rehabilitation services
and income cash benefit for temporary total disability or sickness, permanent total or partial
disability, and death.
The National Health Insurance Program (NHIP), formerly known as the Medicare, is a health
insurance program for SSS members and their dependents whereby the healthy subsidize the
sick who may find themselves in need of financial assistance when they get hospitalized.
The program aims to provide medical care residents of the country in an evolutionary way
within our economic means and capability as a nation. It also aims to provide our people
with a viable means of helping themselves pay for adequate medical care. The Philippine
health Insurance Corporation of Philhealth is the mandated administrator of the Medicare
program under the National Health Insurance Act of 1995. The benefits under the NHIP for a
single period of confinement are as follows: room and board, medical expenses (drugs and
medicines, laboratory charges), operating room fees for surgical procedures, medical and
dental practitioners’ fee, surgeon’s fee, anesthesiologist’s fees and fees for surgical family
planning procedures.
Effective July 1, 1999, Medicare collection and membership functions being performed by
the SSS for the private sector members shall now be assumed by Philhealth.
The Pag-IBIG Fund promotes home ownership through the establishment of an affordable
and adequate housing credit system for its members. It also provides small and short-term
loans. The members upon termination of membership will also receive the accumulated
dividend benefit. The Pag-IBIG Fund promotes the benefits of home ownerships and savings.
Membership in the fund is mandatory upon all employees covered by the Social Security
System and the Government Services Insurance System, and their respective employers.
However, the coverage of employees whose monthly compensation is less than P4,000 shall
be voluntary.
Employees’ Payroll Deductions and Employer’s Payroll Expenses
1. Contributions. The monthly contribution are based on the compensation-basic
monthly salary plus cost of living allowance – of the member and payable under the
three programs, as follows:
 Social Security Benefits -8.4% of average monthly compensation not exceeding
P12,000 and payable by both employer (5.04%) and employee(3.36%)
 Philhealth Benefits-2.75% computed straight based on the monthly basic salary, with a
salary floor of P10,000 and a ceiling of P40,000, to be equally shared by the employee
and their employer (updated per Philhealth Circular 2017-0024).
 Employee’s Compensation Benefits – 1% of average monthly compensation not
exceeding P1,000 and payable only by the employer
To simplify, a contribution schedule is provided to help determine the monthly contributions
of a member based on his monthly salary credit. the monthly salary credit is the
compensation base for contribution and benefits related to the total earnings for the month.
The contribution schedule for employed members can be found during the discussion of the
payroll register.
Pag-IBIG Fund Contributions


Employees earning not more than P1,500 per month – 1%, or
Employees earning more than P1,500 per month – 2%
Employers – 2% of the monthly compensation of the contributing employee.
Monthly compensation shall mean basic salary plus cost of living allowance (COLA).
Note that the maximum monthly compensation to be used in computing employee
and employer contribution shall not be more than P5,000; the effect will be a
maximum contribution of only P100. A member may be allowed to contribute more
than what is required. The employer, however, shall only be mandated to contribute
what is required unless the employer agrees to match the employee’s increased
contribution.
2. Withholding Taxes
Every employer making payment of wages shall deduct and withhold upon such
wages a tax determined in accordance with the rules and regulations prescribed by
the Secretary of the department of Finance, upon recommendation of the
Commissioner of the Bureau of Internal Revenue.
Withholding taxes are applied on gross pay after deducting the mandatory employee
contributions and other non-taxable benefits. According to Section 32(B) (7) (f) of the
tax Reform Act of 1997, GSIS or SSS, Medicare (now Philhealth) and Pag-IBIG
contributions and union dues of individuals are excluded from gross income effective
January 1, 1998.
Withholding tax tables are available for various periods, such as daily, weekly semimonthly and monthly. The revised withholding tax table under the TRAIN LAW
(effective Jan. 1, 2018 to Dec. 31, 2022) is given for illustrative purposes.
Net Pay
Gross pay for a payroll period less the payroll deductions – SSS, Philhealth, and Pag-IBIG
contributions of the employee; withholding taxes; union dues and other deductions- equals
net pay. Net pay or take-home pay is the amount to be paid to the employee.
The Payroll System
Expenditures for labor costs and related payroll expenses are usually significant for most
business entities for several reasons:
Employees are sensitive to payroll errors or irregularities, and maintaining good
employee morale requires that payroll be paid on a timely and accurate basis.
 Payroll is subject to various regulations.
 Payroll and other related expenses have a significant effect on the net income of most
entities.
To make payroll accounting accurate and timely, accountants have developed the payroll
system. The components of the payroll system follow:

Time Cards
A payroll system should include an accurate and reliable record of the employees’ work
hours during a particular payroll period. Employee time records are usually maintained in
time cards.
Time cards may be filled in either manually or through time clocks. Both systems record the
daily arrival and departure times of each employee. A typical time card has three sections
to keep track of employees’ in and out time in the morning, afternoon and overtime; and
another section to summarize the hours worked – regular and overtime.
Payroll Register
Each pay period, the entity organizes the payroll data in a special journal called the payroll
register. This register lists each employee and the related payroll amounts. This journal also
serves as the basis for preparing the payroll journal entries.
The register can have major sections for employees’ names, tax status, total hours worked,
gross pay, total deductions and net pay. The gross pay section may have columns for regular,
overtime pay and total earnings for each employee. Deductions include the SSS, Philhealth
, Pag-IBIG, withholding taxes, advances and other authorized deduction. The net pay section
lists each employee’s take-home pay and if payroll is paid through checks, the number of
the check issued to the employee.
Employee Earnings Record
Each employer must keep a detailed record of earnings and withholdings for each employee
in an employee earnings record. This form is designed to help the employer meet various
reporting requirements. The sections of this record are the same as that of a payroll register;
however, the record maintains a cumulative gross pay column and additional data on
employment specifics like SSS number, Philhealth identification number, taxpayer’s
identification number, pay rate, date of employment and tax status.
Pay Slip, Check or ATM
If payments of salaries or wages are made in cash, payroll slips should be prepared for every
payroll period. A pay slip is prepared for each employee; each slip contains the pertinent
payroll figures found in the payroll register. The employee upon receipt of cash signs this slip
and a duplicate copy is given to him.
Most employers with a large number of employees use a special bank account to disburse
paychecks to employees. Other employers do away with writing numerous checks and
instead pay their employees through their automated teller machine (ATM) accounts. The
bank is simply notified of the amounts to be credited to the account of each employee.
Payroll Entries
The following summarizes the employer’s entries to record the semi-monthly payroll of
P116,500 for the period Oct.16 to 31, 2018. The amounts used in the first entry are lifted directly
from the payroll register. The second entry recorded the cash payment to the employees.
The third entry presented the employer’s payroll expenses. Note that the contributions are
based on a semi-monthly payroll as explained in the notes to the payroll register (to be found
at the end of the chapter.) Entries for the remittances will entail debits to payables and
credits to cash in bank on specific dates.
2018
Oct. 31
Salaries Expense
SSS and EC Contributions Payable
Phil-health contribution payable
Pag-IBIG contribution payable
Withholding taxes payable
116,500
2,543.20
1,464,37
450.00
7,085.49
Salaries payable
To record payroll for the month
Oct. 30
Oct. 30
104,956.94
Salaries payable
Cash in bank
To record payment of salaries
104,956.94
SSS and EC contribution expense
Phil-health contribution expense
Pag-IBIG contribution expense
SSS and EC contributions payable
Phil-health contribution payable
Pag-IBIG contribution payable
To record employer’s payroll expenses
10,536.60
2,928.75
900.00
104,956.94
10,563.60
2,928.75
900.00
Remittances
The employer shall collect contributions of members through payroll deductions. At certain
dates, the employer is required to remit the employees’ contributions along with his
counterpart contributions.
The SSS, Phil-health and Ec contribution should be remitted by the employer on or before the
10th day of the month following the applicable month if the payment is to be done through
the electronic data interchange (EDI). If the payment is to be made over the counter, the
remittance should be made on or before the last day of the applicable month. The SSS has
phased out the acceptance of over-the-counter payments at the SSS main office.
When sending remittances through the bank, it is important to secure the duplicate copy of
the special bank receipt (SBR) and the original copy of the SSS form R5 (monthly contributions
payment return) issued by the bank for these would serve as the official receipt. At the end
of the quarter, the three form R5s and SBRs collected for past three months will be submitted
along with SSS form R3 (quarterly collection list).
In the case of Pag-IBIG contributions, the employer shall remit to the fund the contributions
as well as those of the covered employees on specific days of the month based on the initial
letter of the employer’s business name. employers with names starting with letters A to D will
have payment due dates on the 10th to the 14th day of the month; E to L 15th to the 19th ; M
to Q 20th to the 24th ; and R to Z 25th to the end of the month.
Taxes deducted and withheld by the employer on salaries or wages of employees shall be
covered by a return and paid on or before the 10th day of the month following the month in
which withholding was made. For taxes withheld on compensation for the month of
December, not later than January 15 of the following year.
Chapter 10:
Partnerships: Basic Considerations and Formation
Learning Objectives:
After studying this chapter, you should be able to:
1. Define partnership.
2. Identify the characteristics of a partnership.
3. Explain the advantages and disadvantages of a partnership.
4. Distinguish between partnership and corporation.
5. Identify and describe the different classifications of partnership and the different kinds
of partners.
6. Outline the essential contents of the articles of partnership.
7. Summarize how a partnership is registered with SEC.
8. Explain the accounting differences between a sole proprietorship and a partnership.
9. Distinguish between partner’s capital and drawing accounts.
10. Discuss the fair value concept.
11. Prepare and explain the entries for partnership formation.
DEFINITION
In a contract of partnership, two or more persons bind themselves to contribute money,
property, or industry to a common fund, with the intention of dividing the profit among
themselves. Two or more person may also form a partnership for the exercise of a
profession (civil code of the Philippines, article 1767).
An association of two or more persons to carry on, as co-owners, a business for profit
(uniform partnership act, section 6)
The partnership has a juridical personality separate and distinct from that of each of the
partners (civil code of the Philippines, article 1768). Thus, for example, where Vincent
Fabella and Wilhelmina Neis established a partnership, three persons are involved,
namely: the partnership and the partners, Fabella and Neis.
Partnership resemble sole proprietorships, except that there are two or more owners of
the business. Each owner is called a partner. Partnerships are often formed to bring
together various talents and knowledge. Partnerships provide a means of obtaining more
equity capital than a single individual can obtain and allow the sharing of risks for rapidly
growing businesses.
A profession is an occupation that involves a higher education or its equivalent, and
mental rather than manual labor. Strictly speaking, the exercise of a profession is not a
business or an enterprise for profit but the law allows two or more persons to act as
partners in the practice of their profession. Partnerships are generally associated with the
practice of law, public accounting, medicine and other professions. Partnerships of this
nature are called general professional partnerships. On the other hand, service industries,
retail trade, whole sale and manufacturing enterprises may also be organized as
partnership.
CHARACTERISTICS OF A PARTNERSHIP
The characteristics of partnership are different from the sole proprietorships already
studied in basic accounting. Some of the more important characteristics are as follows:
Mutual Contribution. There cannot be a partnership without contribution of money,
property or industry (i.e. work of services which may either be personal manual efforts or
intellectual) to a common fund.
Division of Profits or Losses. The essence of partnership is that each partner must share in
the profits or losses of the venture.
Co- Ownership of Contributed Assets. All assets contributed into the partnership are
owned by the partnership by virtue of its separate and distinct juridical personality. If one
partner contributes an asset to the business, all partners jointly own it in a special sense.
Mutual Agency. Any partner can bind the other partners to a contract if he is acting
within his express or implied authority.
Limited Life. A partnership has a limited life. It may be dissolved by the admission, death,
insolvency, incapacity, withdrawal of a partner or expiration of the term specified in the
partnership agreement.
Unlimited Liability. All partners (except limited partners), including industrial partners, are
personally liable for all debts incurred by the partnership. If the partnership cannot settle
its obligations, creditors’ claims will be satisfied from the personal assets of the partners
without prejudice to the rights of the separate creditors of the partners.
Income Taxes. Partnership, except general professional partnerships, are subject to tax
at the rate of 30% (per R.A no. 9337) of taxable income.
Partners’ Equity Accounts. Accounting for partnerships are much like accounting for sole
proprietorships. The difference lies in the number of partners’ equity accounts. Each
partner has a capital account and a withdrawal account that serves similar functions as
the related accounts for sole proprietorships.
ADVANTAGES AND DISADVANTAGES OF A PARTNERSHIP
A partnership offers certain advantages over a sole proprietorship and a corporation. It
also has a number of disadvantages. They are as follows:
Advantages versus Proprietorships
1. Brings greater financial capability to the business.
2. Combines special skills, expertise and experience of the partners.
3. Offers relative freedom and flexibility of action in decision-making.
Advantages versus Corporations
1. Easier and less expensive to organize.
2. More personal and informal
Disadvantages
1. Easily dissolved and thus unstable compared to a corporation.
2. Mutual agency and unlimited liability may create personal obligations to partners.
3. Less effective than a corporation in raising large amounts of capital.
PARTNERSHIP DISTINGUISHED FROM CORPORATION
Manner of Creation. A partnership is created by mere agreement of the partners while a
corporation is created by operation of law.
Number of Persons. Two or more persons may form a partnership; in a corporation, at least
five (5) persons, not exceeding fifteen (15).
Commencement of Juridical Personally. In a partnership, juridical personality issuance of
certificate of incorporation by the Securities and Exchange Commission.
Management. In a partnership, every partner is an agent of the partnership if the partners
did not appoint a managing partner; in a corporation, management is vested on the Board
of Directors.
Extent of Liability. In a partnership, each of the partners except a limited partner is liable to
the extent of his personal assets; in a corporation, stockholders are liable only to the extent of
their interest or investment in the corporation.
Right of Succession. In a partnership, there is no right of succession; in a corporation, there is
right of succession. A corporation has the capacity of continued existence regardless of the
death, withdrawals, insolvency or incapacity of its directors or stockholders.
Terms of Existence. In a partnership, for any period of time stipulated by the partners; as a
corporation, not to exceed fifty (50) years but subject to extension.
CLASSIFICATIONS OF PARTNERSHIPS
1. According to object:
A. Universal partnership of all present property. All contributions become part of
the partnership fund.
B. Universal partnership of profits. All that the partners may acquire by their
industry or work during the existence of the partnership and the use of
whatever the partners contributed at the time of the institution of the contract
belong to the partnership. If the articles of universal partnership did not specify
its nature, it will considered a universal partnership of profits.
C. Particular partnership. The object of the partnership is determinate – its use or
fruit, specific undertaking, or the exercise of a profession or vocation.
2. According to liability:
A. General. All partners are liable to the extent of their separate properties.
B. Limited. The limited partners are liable only to the extent of their personal
contributions. In a limited partnership, the law states that there shall be at least
one general partner.
3. According to duration:
A. Partnership with a fixed term or for a particular undertaking.
B. Partnership at will. One in which no term is specified and is not formed for any
particular undertaking.
4. According to purpose:
A. Commercial or trading partnership. One formed for the transaction of business.
B. Professional or non-trading partnership. One formed for the exercise of
profession.
5. According to legality of existence:
A. De jure partnership. One which has complied with all the legal requirements
for its establishment.
B. De facto partnership. One which has failed to comply with all the legal
requirements for its establishment.
KINDS OF PARTNERS
1. General partner. One who is liable to the extent of his separate property after all the
assets of the partnership are exhausted.
2. Limited partner. One who is liable only to the extent of his capital contribution. He is
not allowed to contribute industry or services only.
3. Capitalist partner. One who contributes money or property to the common fund of
the partnership.
4. Industrial partner. One who contributes his knowledge or personal service to the
partnership.
5. Managing partner. One whom the partners has appointed as manager of the
partnership.
6. Liquidating partner. One who is designated to wind up or settle the affairs of the
partnership after dissolution.
7. Dormant partner. One who does not take active part in the business of the partnership
and is not known as a partner.
8. Silent partner. One who does not take active part in the business of the partnership
though may be known as a partner.
9. Secret partner. One who takes active part in the business but is not known to be a
partner by outside parties.
10. Nominal partner or partner by estoppel. One who is actually not a partner but who
represents himself as one.
ARTICLES OF PARTNERSHIP
A partnership may be constituted orally or in writing. In the latter case, partnership
agreements are embodied in the Articles of Partnership. The following essential provisions
may be contained in the agreement.
1. The partnership name, nature, purpose, and location;
2. The names, citizenship and residences of the partners;
3. The date of formation and the duration of the partnership;
4. The capital contribution of each partner, the procedure for valuing non-cash
investments, treatment of excess contribution (as capital or as loan) and the penalties
for a partner’s failure to invest and maintain the agreed capital;
5. The rights and duties of each partner.
6. The accounting period to be adopted, the nature of accounting records, financial
statements and audits by independent public accountants;
7. The method of sharing profit or loss, frequency of income measurement and
distribution, including any provisions for the recognition of differences in contributions.
8. The drawings or salaries to be allowed to partners;
9. The provision for arbitration of disputes, dissolution, and liquidation.
A contract of partnership is void whenever immovable property or real rights are contributed
and a signed inventory of the said property is not made and attached to a public instrument.
SEC REGISTRATION
When the partnership capital is P3,000 or more, in money or property, the public instrument
must be recorded with the Security and Exchange Commission (SEC). Even if it not registered,
the partnership having a capital of P3,000 or more is still valid and therefore has legal
personality.
The SEC shall not registered any corporation organized for the practice of public
accountancy (The Philippine Accountancy act of 2004, sec. 28).
The purpose of the registration is to set “a condition for the issuance of the licenses to engage
in business or trade. In this way, the tax liabilities of big partnerships cannot be evaded, and
the public can also determine more accurately their membership and capital before dealing
with them. “
To register a partnership with the SEC, here are the basic steps to follow:

Have your proposed business name verified in the verification unit of SEC
The partnership name shall bear the word “Company” or “Co.” and if it’s a limited
partnership, the word “Limited “ or “Ltd.” A professional partnership may bear the word
“Company,” “ Associates” or “Partners” or other similar descriptions. (SEC
memorandum circular 5, series 2008).

Submit the following documents:
Articles of Partnership
Verification slip for the Business Name
Written undertaking to change business name if required
Tax identification number of each partner and/or that of the partnership
Registration data sheet for partnership duly accomplished in six copies
Other documents that may be required:
Endorsement from other government agencies if the proposed partnership will
engage in an industry regulated by the government.


For partnership with foreign partners: SEC form F-105, bank certificate on the
capital contribution of partners, proof of remittance of contribution of foreign
partners;
Pay the registration/filling and miscellaneous fees: filling fee equivalent to 1/5 of 1% of
the partnership capital but not less than P1,000 and legal research fee which is 1% of
the filling fee;
Forward documents to the SEC Commissioner for signature
ACCREDITATION TO PRACTICE PUBLIC ACCOUNTANCY
Certified public accountants (CPAs), firms and partnerships of CPAs, engaged in the
practice of public accountancy, including the partners and staff members thereof,
shall register with the Professional Regulation Commission and the Professional
regulatory board of Accountancy. The registration shall be renewed every three years
(the Philippines accountancy act of 2004, sec.31). the rules and regulations covering
the accreditation for the practice of public accountancy are specified in annex B of
the rules and regulation implanting republic act 9298 otherwise known as the
Philippine accountancy act of 2004.
ACCOUNTING FOR PARTNERSHIPS
Owners’ Equity Accounts
In the earlier chapters of this book, generally accepted accounting principles were
discussed in the context of a sole proprietorship. These accounting principles also
apply to a partnership. Thus, the recording of assets, liabilities, income and expenses
is consistent for both proprietorships and partnerships. Comparing two businesses of
the same nature, one organized as a sole proprietorship and another as a partnership,
there will be no marked difference in their operations.
However, differences arise between the two forms of business concerning owners’
equity. For a proprietorship, there is only a single owner. Therefore, there is only one
capital account and one drawing account. On the other hand, since a partnership
has two or more owners, separate capital and drawing accounts are established for
each partner.
A partner’s capital account is credited for his initial and additional net investments
(assets contributed less liabilities assumed by the partnership), and credit balance of
the drawing account at the end of the period. It is debited for his permanent
withdrawals and debit balance of the drawing account at the end of the period.
Typically, partners do not wait until the end of the year to determine how much of the
profits they wish to withdraw from the partnership. To meet personal living expenses,
partners customarily withdraw money on a periodic basis throughout the year. A
partner’s drawing account is debited to reflect assets temporarily withdrawn by him
from the partnership. At the end of each accounting period, the balances in the
drawing accounts are closed to the related capital accounts.
Partner’s Capital Accounts
Debit
credit
1. Permanent withdrawals
2. Debits balance of the drawing
Account at the end of the period
Debit
1. Original investment
2. Additional investment
3. Credit balance of the drawing
Account at the end of the
Period
Partner’s Drawing Account
credit
1. Temporary withdrawals
2. Share in loss (this may be debited
Directly to capital)
1. Share in profit (this may be
credited directly to capital
Permanent withdrawals are made with the intention of permanently decreasing the partner’s
capital while temporary withdrawals are regular advances made by the partners in
anticipation of their share in profit.
The use of drawing accounts for temporary withdrawals provides a record of each partner’s
drawings during an accounting period. Hence, drawings in excess of the allowed amounts
as stated in the partnership agreement may be controlled.
Notice that profit (or loss) is credited (or debited) either to the drawing account to the capital
account. The choice of the account to credit or debit depends on the intention of the
partners. If they wish to maintain their capital accounts for investments and permanent
withdrawals, then profit or loss should be entered in the drawing account.
On the other hand, if the purpose of the partners is to make profit or loss part of their capital,
then the capital account should be used. in either case, the resulting partners’ ending capital
balance will be the same.
Loans Receivable from or Payable to Partners
If a partner withdraws a substantial amount of money with the intention of repaying it, the
debit should be to loans receivable-partner account instead of to partner’s drawing
account. This account should be classified separately from the other receivables of the
partnership.
A partner may lend amounts to the partnership in excess of his intended permanent
investment. These advances should be credited to loans payable-partner account and not
to partner’s capital account classified among the liabilities but separate from liabilities to
outsiders. This distinction is important in case of liquidation. Loans payable to partners must
be paid after the claims of outside creditors have been paid in full.
These loans have priority over partners’ equity.
PARTNERSHIP FORMATION
Valuation of Investments by Partners
The books of the partnership are opened with entries reflecting the net contributions of the
partners to the firm. Asset accounts are debited for assets contributed to the partnership,
liability accounts are credited for any liabilities assumed by the partnership and separate
capital accounts are credited for the amount of each partner’s net investment (asset less
liabilities).
Partners may invest cash or non-cash assets in the partnership. When a partner invests noncash assets, they are to be recorded at values agreed upon by the partners. In the absence
of any agreement, the contributions will be recognized at their fair market values at the date
of transfer to the partnership.
The fair market value of an asset is the estimated amount that a willing seller would receive
from a financially capable buyer for the sale of the asset in a free market. Per international
financial reporting standards (IFRS) no. 3, fair value is the price at which an asset or liability
could be exchanged in a current transaction between knowledgeable, unrelated willing
parties.
Adjustment of Accounts Prior to Formation
In cases when the prospective partners have existing businesses, their respective books will
have to be adjusted to reflect the fair market values of their assets or to correct misstatements
in the accounts. If the adjustments will not be made, the initial capital balances of the
partners may be inequitable.
Illustration. A reconditioned printing equipment invested by Sonnie Ramos was recorded
incorrectly in the partnership books at P730,000 – its book value from the proprietorship’s
records. If the partnership immediately sold the printing equipment for its fair market value of
P800,000, the resulting P70,000 gain would increase the capital balances of both Partners
Sonnie Ramos and Teresita Galang. The printing equipment should have been recorded at
P800,000 and Ramos’ capital credited with P800,000. Simply stated, increases in asset values
accruing before formation should be for the benefit of the contributing partner.
The adjustments of the assets and liabilities prior to formation will be similar to the adjustments
that we are already familiar with. However, when the adjustment involves a debit or credit
to a nominal account, the capital account would instead be debited or credited. This is so
because the business has ceased to be a going concern. A business is not viewed as a going
concern if liquidation appears imminent. For example, two sole proprietorships will cease
operations because of their agreement to enter into a partnership. Both proprietorships have
ceased to be a going concerns.
Illustration. Emerita Geron and Emerita Modesto formed a general professional partnership.
Emerita Geron will invest sufficient cash to get an equal interest in the partnership while
Emerita Modesto will transfer the assets and liabilities of her business. The account balances
on the books of Modesto prior to partnership formation follows:
Debit
credit
Cash
180,000
Accounts receivable
300,000
Office equipment
1,500,000
Accumulated depreciation
600,000
Accounts payable
155,000
Salaries payable
25,000
Emerita Modesto, Capital
1,200,000
It is agreed that for purposes of establishing Emerita Geron’s interest, the following
adjustments shall be made in the books of Emerita Modesto:
1.
2.
3.
An allowance for uncollectible accounts of 5% of accounts receivable is to be
established.
Prepaid expenses amounting to P30,000 were omitted by the accountant. This is to
be recognized.
Additional salaries payable in the amount of P10,000 is to be established.
Using the accounting equation approach of analysis, the adjustments are as follows:
Assets
=
liabilities
+
Owner’s Equity
1.
P15,000
=
+
-P15,000
2.
+30,000
=
+
+30,000
3.
=
+P10,000
+
- 10,000
-------------------------= ---------------------- + --------------------+P15,000
=
+P10,000
+P5,000
+P15,000
=
+P15,000
==============
============
============
Entries and explanations:
1.
An allowance of 5% of P300,000 or 15,000 needs to be established. The account
allowance for uncollectible accounts is a contra asset account. When this account
is increased, the effect is to decrease the related asset account. The owner’s equity
is also decreased since this provision for uncollectible is considered as an expense in
the ordinary course of business.
Emerita Modesto, Capital
15,000
Allowance for uncollectible accounts
15,000
2.
An omission to record the asset –prepaid expenses will
the business are overstated. When the expenses
correspondingly the owner’s equity is understated.
expense, the entry will be:
Prepaid expenses
Emerita Modesto, capital
3.
denote that the expenses of
are overstated, profit and
To recognize the prepaid
30,000
30,000
The establishment of additional salaries payable will increase liabilities. It can be
deduced that the salaries expenses are understated and to correct the misstatement
the owner’s equity will be decreased.
Emerita Modesto, Capital
10,000
Salaries payable
10,000
Opening Entries of a Partnership Upon Formation
A partnership may be formed in any of the following ways:
1. Individuals with no existing business form a partnership.
2. Conversion of a sole proprietorship to a partnership.
a. A sole proprietor and an individual without an existing business form a
partnership.
b. Two or more sole proprietors form a partnership.
3. Admission or retirement of a partner (to be covered in another accounting subject).
Individuals with no Existing Business Form a Partnership
The opening entry to recognize the contributions of each partner into the partnership is simply
to debit the assets contributed, and to credit the liabilities assumed and the capital account
of each partner.
Illustration. On July 1, 2019, Nilo Burgos and Rey Fernan Refozar agreed to form a partnership.
The partnership agreement specified that Burgos is to invest cash of P700,000 and Refozar is
to contribute land with a fair market value of P1,300,000 with P300,000 mortgage to be
assumed by the partnership. The entries are as follows:
Cash
700,000
Land
1,300,000
Mortgage payable
300,000
Nilo Burgos, Capital
700,000
Rey Fernan Refozar, Capital
1,000,000
After the formation, the statement of financial position of the partnership is:
Burgos and Refozar
Statement of Financial Position
July 1, 2019
Assets
Cash
Land
Total Assets
P 700,000
1,300,000
P2,000,000
=========
Liabilities and Owners’ Equity
Mortgage payable
Nilo Burgos, Capital
Rey Fernan Refosar, Capital
Total liabilities and Owners’ Equity
P 300,000
700,000
1,000,000
P2,000,000
=========
Illustration. Suppose that Burgos and Refozar formed another partnership with Nora Elizabeth
Maniquiz. Burgos and Refozar considered Maniquiz who has a vast business network in Bicol
as an industrial partner. The partnership did not receive any asset from Maniquiz. In this case,
only a memorandum entry in the general journal will be made.
A Sole Proprietor and Another Individual Form a Partnership
A sole proprietor may consider forming a partnership with an individual who has no existing
business. Under this type of formation, the assets and the liabilities of the proprietor will be
transferred to the newly formed partnership at values agreed upon by all the partners or at
their current fair prices.
Illustration. The statement of financial position of Leopoldo Medina on Oct. 1, 2019, before
accepting John Karlo Dalangin as partner is shown as follows:
Leopoldo Medina
Statement of Financial Position
Oct.1, 2019
Assets
Cash
Notes Receivable
Accounts Receivable
Less: Allowance for uncollectible accounts
Merchandise Inventory
Furniture and Fixtures
Less: accumulated depreciation
Total assets
P 60,000
30,000
P240,000
10,000
P 60,000
6,000
Liabilities and Owner’s Equity
Notes payable
Accounts payable
Leopoldo Medina, Capital
Total liabilities and Owner’s Equity
230,000
80,000
54,000
P 454,000
========
P 40,000
100,000
314,000
P 454,000
========
John Karlo Dalangin offered to invest cash to get a capital credit equal to one-half of
Leopoldo Medina’s capital after giving effect to the adjustments below. Del mundo
accepted the offer.
1. The merchandise is to be valued at P74,000.
2. The accounts receivable is estimated to be 95% collectible.
3. Interest accrued on the notes receivable will be recognized: P10,000, 12% dated
July 1, 2019 and P20,000, 12% dated August 1, 2019.
4. Interest on notes payable to be accrued at 14% annually from April 1.
5. The furniture and fixtures are to be valued at P46,000.
6. Office supplies on hand that have been charged to expense in the past
amounted to P4,000. These will be used by the partnership.
New books for the Partnership (required per National Internal Revenue Code)
The following procedures may be used in recording the formation of the partnership:
Books of Leopoldo Medina:
1. Adjust the assets and liabilities of Leopoldo Medina in accordance with the
agreement. Adjustments are to be made to his capital account.
2. Close the books
Books of the Partnership:
1. Record the investment of Leopoldo Medina.
2. Record the investment of John Karlo Dalangin.
Following the procedures, the entries are:
Books of Leopoldo Medina
(1)
Leopoldo Medina, Capital
Office Supplies
Interest receivable
Merchandise Inventory
Allowance for uncollectible accounts
Interest payable
Accumulated depreciation
To record adjustments to restate Medina’s Capital.
(2)
Notes payable
Accounts payable
Interest payable
Allowance for Uncollectible accounts
Accumulated depreciation
Leopoldo Medina, Capital
Cash
Notes receivable
Accounts receivable
Interest receivable
Merchandise Inventory
Offices supplies
Furniture and Fixtures
To close the books of Medina.
14,100
4,000
700
6,000
2,000
2,800
8,000
40,000
100,000
2,800
12,000
14,000
299,900
60,000
30,000
240,000
700
74,000
4,000
60,000
Books of the Partnership
(1)
Cash
Notes Receivable
Accounts Receivable
Interest Receivable
Merchandise Inventory
Office Supplies
Furniture and Fixtures
Notes Payable
Accounts payable
Interest payable
Allowance for uncollectible accounts
Leopoldo Medina, Capital
To record the investment of Medina.
(2)
Cash
John Karlo Dalangin, Capital
To record the investment of Dalangin
60,000
30,000
240,000
700
74,000
4,000
46,000
40,000
100,000
2,800
12,000
299,900
149,950
149,950
Computations:
1. Merchandise inventory, per ledger
Merchandise inventory,as agreed
Decrease in Merchandise inventory
P80,000
74,000
6,000
======
2. Accounts Receivable, net per ledger
Accounts Receivable, net as agreed
Increase in Allowance
P230,000
228,000
P 2,000
=======
3. Interest accrued on Notes Receivable: interest = Principal x Rate x Time
On P10,000:
P10,000 x 12% x 3/12 = P300
On P20,000:
P20,000 x 12% x 2/12 = 400
P700
=====
4. Interest accrued on Notes payable:
On P40,000:
P40,000 x 14% x 6/12 = P2,800
=======
5. Furniture and Fixtures, net per ledger
Furniture and Fixtures, net as agreed
Increase in Accumulated depreciation
P54,000
46,000
P 8,000
======
6. Net effect of adjustments on capital:
Decrease in Merchandise Inventory
Increase in Allowance for uncollectible accounts
Increase in Interest Receivable
Increase in interest payable
Increase in Accumulated depreciation
Increase in Office Supplies
Decrease in Capital
P(6,000)
(2,000)
700
(2,800)
(8,000)
4,000
P(14,100)
=======
7. Furniture and Fixtures, cost per books
Furniture and Fixtures, cost as agreed
Write-down of Furniture and Fixtures
P60,000
46,000
14,000
=======
8. Leopoldo Medina, capital before adjustment
Net adjustments to Capital
Leopoldo Medina, Capital after adjustment
Agreed Capital credit for John karlo Dalangin
Cash investment of John Karlo Dalangin
P314,000
14,100
P299,900
50%
P149,950
=======
After the formation, the statement of financial position of the newly formed partnership is:
Medina and Dalangin
Statement of Financial Position
October 1, 2019
Assets
Cash
Notes Receivable
Accounts Receivable
Less: Allowance for Uncollectible accounts
Interest Receivable
Merchandise Inventory
Offices Supplies
Furniture and fixtures
Total Assets
P209,950
30,000
P240,000
12,000
228,000
700
74,000
4,000
46,000
P592,650
=======
Note that furniture and fixtures are now recorded in the partnership books at the agreed
amount of P46,000 which represented the cost of the asset to the partnership. On the other
hand, the accounts receivable is still recorded at gross amount of P240,000 with a related
allowance for uncollectible accounts of P12,000. The P12,000 is only a provision for possible
uncollectible.
Two or More Sole Proprietors Form a Partnership
Illustration. On June 30, 2019, Deogracia Corpuz and Esterlina Gevera, friendly competitors
in a certain line of business, decided to combine their talents and capital to form a
partnership. Their statements of financial position are as follows:
Deogracia Corpuz
Statement of Financial Position
June 30, 2019
Assets
Cash
Accounts Receivable
Merchandise Inventory
Furniture and Fixture
Total Assets
Liabilities and Owners’ Equity
Accounts Payable
Deogracia Corpuz, Capital
Total liabilities and Owners’ Equity
P 50,000
100,000
80,000
60,000
P290,000
=======
P 30,000
260,000
P290,000
========
Esterlina Gevera
Statement of Financial Position
June 30, 2019
Assets
Cash
Accounts Receivable
Merchandise Inventory
Delivery Equipment
Total Assets
P 40,000
80,000
100,000
90,000
P310,000
=======
Liabilities and Owners’ Equity
Accounts Payable
Esterlina Gevera, Capital
Total liabilities and Owners’ Equity
P 60,000
250,000
P310,000
========
The conditions and adjustments agreed upon by the partners for purposes of determining
their interests in the partnership are:
1. Actual count and bank reconciliation on Corpuz proprietorship’s cash account
revealed cash short and unrecorded expenses of P3,500.
2. Establishment of a 10% allowance for uncollectible accounts in each book.
3. The merchandise inventory of Gevera is to be increased by P10,000.
4. The furniture and fixtures of Corpuz are to be depreciated by P6,000.
5. The delivery equipment of Gevera is to be depreciated by P9,000.
New books for the Partnerships (required per National Internal revenue Code)
The following procedures may be used in recording the formation of the partnership:
Books of Deogracia Corpuz and Esterlina Gevera:
1. Adjust the accounts of both parties in accordance with the agreement.
2. Adjustments are to be made to their respective capital accounts.
Books of the Partnership:
1. Record the investment of Deogracia Corpuz.
2. Record the investment of Esterlina Gevera.
Following the procedures, the entries are:
Books of Deogracia Corpuz
(1)
Deogracia Corpuz, Capital
Cash
Allowance for uncollectible accounts
Accumulated depreciation
To record adjustments to restate Corpuz’s capital
19,500
3,500
10,000
6,000
(2)
Accounts payable
Allowance for uncollectible
Accumulated depreciation
Deogracia Corpuz, Capital
Cash
Accounts receivable
Merchandise inventory
Furniture and Fixtures
To close the books of Corpuz.
30,000
10,000
6,000
240,500
46,500
100,000
80,000
60,000
Books of Esterlina Gevera
(1)
Merchandise inventory
Esterlina Gevera, Capital
Allowance for uncollectible accounts
Accumulated depreciation
To record adjustments to restate Gevera’s capital.
10,000
7,000
8,000
9,000
(2)
Accounts payable
Allowance for uncollectible accounts
Accumulated depreciation
Esterlina Gevera, Capital
Cash
Accounts Receivable
Merchandise inventory
Delivery equipment
To close the books of Gevera.
60,000
8,000
9,000
243,000
40,000
80,000
110,000
90,000
Books of the Partnership
(1)
Cash
Accounts Receivable
Merchandise inventory
Furniture and Fixtures
Accounts Payable
Allowance for uncollectible accounts
Deogracia Corpuz, Capital
To record the investment of Deogracia Corpuz.
(2)
Cash
Accounts Receivable
Merchandise inventory
Delivery Equipment
Accounts Payable
Allowance for uncollectible accounts
Esterlina Gevera, Capital
To record the investment of Gevera.
46,500
100,000
80,000
54,000
30,000
10,000
240,500
40,000
80,000
110,000
81,000
60,000
8,000
243,000
After the formation, the Statement of financial position of the newly formed partnership is:
Corpus and Gevera
Statement of Financial Position
June 30, 2019
Assets
Cash
Accounts Receivable
Less: Allowance for uncollectible account
Merchandise Inventory
Furniture and Fixtures
Delivery Equipment
Total Assets
P 86,500
P180,000
18,000
162,000
190,000
54,000
81,000
P573,500
=======
Liabilities and Owners’ Equity
Accounts Payable
Deogracia Corpuz, Capital
Esterlina Gevera, Capital
Total Liabilities and Owners’ Equity
P 90,000
240,500
243,000
P573,500
=======
Multiple Choice:
1. Pentrante owns and operates a large hardware store in Cabanatuan City that
employs about forty-five personnel. She delegates some of the decision making to
two supervisors. Penetrante’s business is organized as a
a. Corporation
b. Partnership
c. Sole proprietorship
d. Limited partnership
2. Jumawan loves to cook. She receives unqualified praise whenever she prepares a
meal for someone. Encouraged by these compliments and eager to put her culinary
talents to good use, Jumawan decides to open a boutique restaurant in Dumaguete
City. Since she plans to maintain complete control of the business, she will most likely
organize it is a
a. Limited partnership
b. Corporation
c. General partnership
a. Sole proprietorship
2. A budding entrepreneur wants to start a business but is unsure of the legal form suited
for her. Short of cash, she has to take the form that is least expensive and most flexible
in terms of decision making and implementation. Which would you recommend?
a. Joint venture
b. Partnership
c. Sole proprietorship
d. Cooperative
e. Corporation
3. Unlimited liability means
a. There is no limit on the amount an owner can borrow.
b. Creditors will absorb any loss from non-payment of debt.
c. The owner is responsible for all business debts.
d. Shareholders can borrow money from the business.
4. Cabrera inherited a large amount from his parents. Cabrera wishes to start his own
business in Batangas. His lawyers encourage him to make it a corporation. What
disadvantage of a sole proprietorship are the lawyers trying to avoid?
a. Unlimited liability
b. Lack of management skills
c. Retention of all profits
d. Lack of money
5. After Russell has maximized her standby credit limit from the CDO bank and still cannot
cope with the working capital needs of her fast-growing business, what is her recourse
if she wants her company to continue growing?
a. Obtain a partner or form a corporation to access more funds.
b. Hire more employees.
c. Turn away potential new customers.
d. the
6. The person who assumes full co-ownership of a partnership including unlimited liability
is a
a. sole proprietor
b. shareholder
c. limited partner
d. general partner
7. The partner who can lose only what he has invested in a business is the
a. general partner
b. sole proprietor
c. manager
d. employee
e. limited partner
8. Alibangbang and Sol decided to go into business together. They started by listing the
essential terms of their agreement along with their rights and duties. Alibangbang and
Sol created a (n)
a. articles of partnership
b. licensing agreement
c. articles of incorporation
d. division of partnership agreement
EVALUATION:
QUIZ
CHAPTER 11
PARTNERSHIPS:
Operations and Financial Reporting
Learning Objectives:
After studying this chapter, you should be able to:
1. Contrast a partner’s equity in assets from share in profits or losses.
2. Summarize the rules for the distribution of profit or losses.
3. Explain prior period errors and interpret the effects on partners’ shares in profit or losses.
4. Identify, describe and account for the different methods of dividing partnership profit
or losses based on agreement.
5. Ascertain the effects of using original, beginning, ending and average capitals on the
partner’s share in profits or losses.
6. Show the treatment of interest on capital, partners’ salaries and bonus in the
distribution of profits or losses.
7. Propose equitable profits or losses sharing schemes after considering the partners’
contributions and other performance criteria.
8. Understand and appreciate the usefulness of financial statements.
9. Pinpoint the difference in the financial statements of a partnership as compared to a
sole proprietorship.
10. Develop skills in the preparation of basic financial statements.
PARTNERS’ EQUITY IN ASSETS CONTRASTED WITH SHARE IN PROFITS OR LOSSES
The basis on which profits or losses are shared is a matter of agreement among the partners
and may not necessarily be the same as their capital contribution ratio. The equity of a
partner in the net assets of the partnership should be distinguished from a partner’s share
profits or losses.
Illustration. “Nelson Daganta is a one-third partner” is an ambiguous statement. Daganta
may have one-third equity in the net assets of the partnership but might have a larger or
smaller share in the profit or loss of the firm. Such a statement may also be interpreted to
mean that Daganta is entitled to one-third of the profit or loss, although his capital account
may represent much more or much less than one-third of the total partners’ capital. Simply
put, partners may agree on any type of profit and loss ratio regardless of the amount of their
respective capital account balances.
FACTORS TO CONSIDER IN ARRIVING AT A PLAN FOR DIVIDING PROFITS OR LOSSES.
Money, Property or Industry
Partnership profits are realized as a result of putting together the contribution –money,
property or industry-of the partners. The amount of capital invested by each partner, the
amount of time each partner devotes to the business and other contributions are the factors
being considered in the formulation of an equitable profit and loss ratio.
There are profit-sharing plans which emphasize either the value of personal services rendered
by individual partners or the amounts of capital invested by each partner. Some agreements
consider the importance of both the amount and quality of managerial services rendered,
and the amount of capital invested by the partners for the success or failure of a partnership.
In this case, allowances may be provided for salaries to partners and interest on their
respective capital balances as a preliminary step in the division of profits or losses; the
balance may then be divided in a specified ratio. Among the other factors which may be
considered are as follows:
1. A partner has considerable personal financial resources, thus giving the partnership a
strong credit rating. In general, partners have unlimited liability. A very solvent partner
will make the partnership attractive to creditors.
2. A partner who is well known in a profession or an industry may contribute immensely
to the success of the partnership although he may not participate actively in the
operations of the partnership.
These two factors may be incorporated in the plan to arrive at a ratio by which any remaining
profits or losses are to be divided.
Illustration. Daria Tolentino and Eleonor Tan are partners in a coco water business. Partner
Daria Tolentino contributed most of the assets of the business but spends little time for its daily
operations. On one hand, Partner Eleonor Tan contributed less in assets but devotes her full
knowledge and attention to the partnership. To divide profits or losses based on capital
contributions alone will result to inequities. The profit and loss sharing agreement should have
considered the provision of salaries or even bonus in recognition of the talent and time being
contributed by Partner Eleonor Tan.
Performance Methods
Many partnerships use profit and loss sharing arrangements that give some weight to the
specific performance of each partner to provide incentives to perform well. This allocation
of profits to a partner on the basis of performance is frequently referred to as a bonus.
Examples of the use of performance criteria are:
1. Chargeable hours. These are the total number of hours that a partner incurred on
client related assignments. Weight may be given to hours in excess of a standard.
2. Total billings. The total amount billed to clients for work performed and supervised by
a partner constitutes total billings. Weight may be given to billings in excess of norm.
3. Write-offs. Consist of uncollectible billings. Weight may be given to a write-off
percentage below a norm.
4. Promotional and civic activities. Time devoted to developing future business and
enhancing the partnership name in the community is considered promotional and
civic activity. Weight may be given to time spent in excess of a norm or to specific
accomplishments resulting in new clients.
5. Profits in excess of specified levels. Designed partners commonly receive a certain
percentage of profits in excess of a specified level of earnings.
RULES FOR THE DISTRUBUTION OF PROFITS OR LOSSES
The profits or losses shall be distributed in conformity with the agreement. If only the share of
each partner in the profits has been agreed upon, the share of each in the losses shall be in
the same proportion.
In the absence of stipulation, the share of each partner in profits or losses shall be in proportion
to what he may have contributed (according to the ratio of original capital investments or in
its absence, the ratio of capital balances at the beginning of the year), but the industrial
partner may not be liable for the losses.
As for the profits, the industrial partner shall receive such share as may be just and equitable
under the circumstances. If aside from his services he has contributed capital, he shall also
receive a share in the profits in proportion to his capital (civil code of the Philippines, article
1797). A stipulation which excludes one or more partners from any share in the profits or losses
is void. (article 1799). The partnership must exist for the common benefit or interest of the
partners. A summary of the above legal provisions is prepared as follows:
1. Profits
a. The profits will be divided according to partners’ agreement.
b. If there is no agreement:
^ as to capitalist partners, the profits shall be divided according to their capital
contributions (according to the ratio of original capital investments or in its
absence, the ratio of capital balances at the beginning of the year).
^ as to industrial partners (if any), such share as may be just and equitable
under the circumstances, provided, that the industrial partner shall receive
such share before the capitalist partners shall divide the profits
2. Losses
a. The losses will be divided according to partners’ agreement.
b. If there is no agreement as to distribution of losses but there is an agreement as
to profits, the losses shall be distributed according to the profit sharing ratio.
c. In the absence of any agreement.
^ as to capitalist partners, the losses shall be divided according to their capital
contributions (according to the ratio of original capital investments or in its
absence, the ration of capital balances at the beginning of the year).
^ as to purely industrial partners (if there’s any), shall not be liable for any losses.
The industrial partner is not liable for losses because he cannot withdraw the work or labor
already done by him, unlike the capitalist partners who can withdraw their capital. In
addition, if the partnership failed to realize any profits, then he has labored in vain and in a
real sense, he has already contributed his share in the loss.
CORRECTION OF PRIOR PERIOD ERRORS
Any business entity will from time to time discover errors made in the measurement of profit in
prior accounting periods. Good internal control and the exercise of due care should serve
to minimize the number of financial reporting errors that occur; however, these safeguards
cannot be expected to completely eliminate errors in the financial statements.
Per International Accounting Standard (IAS) no.8 Accounting Policies, Changes in
Accounting Estimates and Errors, prior period errors are omissions from and other
misstatements of the entity’s financial statements for one or more prior periods that are
discovered in the current period. Errors ,ay occur as a result of mathematical mistakes,
mistakes in applying accounting policies, misinterpretation of facts, fraud or oversights.
Examples include errors in the estimation of depreciation, errors in inventory valuation, and
omission of accruals of revenue and expenses.
Material prior periods must be restated to report financial position and results of operations
as they would have been presented had the error never taken place. The amount of the
correction of a prior period error that relates to prior periods should be reported by adjusting
the opening balances of partners’ equity and affected assets and liabilities. The correction
of a prior period error is excluded from profit or loss for the period in which the error is
discovered.
If an error resulted an understatement of profit in previous periods, a correcting entry would
be needed to increase capital. If an error overstated profit in prior periods, then capital
would have to be decreased. The effect of the error correction will be divided based on the
applicable profit and loss ratio.
DISTRIBUTION OF PROFITS OR LOSSES BASED ON PARTNERS’ AGREEMENT
In general, profits or losses shall be divided in accordance with the agreement of the partners.
The ratio in which profits or losses from partnership operations are distributed is recognized as
the profit and loss ratio.
The partners may agree on any of the following scheme in distributing profits or losses:
1. Equally or in other agreed ratio.
2. Based on partners’ capital contributions:
a. ratio of original capital investments
b. ratio of capital balances at the beginning of the year
c. ratio of capital balances at the end of the year
d. ratio of average capital balances
3. By allowing interest on partners’ capital and the balance in an agreed ratio
4. By allowing salaries to partners and the balance in an agreed ratio
5. By allowing bonus to the managing partner based on profit and the balance in an
agreed ratio
6. By allowing salaries, interest on partners’ capital bonus to the managing partner
and the balance in an agreed ratio (combination of 3 to 5)
Note that the partners can agree on not using a residual sharing ratio (“the balance in an
agreed ratio”) if profits do not exceed the total salary and interest allowances. In such a
case, the partners must agree on the priority of the various profit or loss distribution schemes.
Illustration. The following series of illustrations are based on the figures obtained from the
Aguilar and Porras Partnership which had a profit of P300,000 for the year ended December
31, 2019, the first year of operations. The partnership contract provided that each partner
may withdraw P5,000 on the last day of each month; both partners did so during the year.
The drawings are recorded by debits to the partners’ drawing accounts and shall not be
considered in the division of profit or loss. It is the intention of the partners that each partner’s
share in the profit or loss be either credited or debited to the drawing account.
Lord Aguilar invested P400,000 on Jan. 1, 2019 and an additional P100,000 on April 1. Devzon
Porras invested P800,000 on Jan. 1 and withdrew P50,000 on July 1.
Equally or In other Agreed Ratio
Partnership contracts may provide that profit or loss be divided equally. The profit of P300,000
for the Aguilar and Porras Partnership is transferred by a closing entry on December 31, 2019,
from the Income Summary ledger account to the partners’ drawing accounts:
Income summary
Lord Aguilar, drawing
Devzon Porras, drawing
To record the division of profits
300,000
150,000
150,000
If the partnership had a loss of P200,000 for the year ended December 31, 2019, the income
summary ledger account would have a debit balance of P200,000. This loss would be
transferred to the partners’ drawing accounts by a debit to each drawing account for
P100,000 and a credit to the income summary account for P200,000.
Lord Aguilar, drawing
Devzon Porras, drawing
Income summary
To record the division of profits
100,000
100,000
200,000
Assume instead that Aguilar and Porras share profits and losses in a ratio of 60:40 and profit
was P300,000, the profit would be divided as follows:
Income summary
Lord Aguilar, drawing
Devzon Porras, drawing
To record the division of profits.
Computation:
Aguilar: 60% x P300,000 =
Porras : 40% x P300,000 =
300,000
180,000
120,000
P180,000
120,000
Based on Partners’ Capital Contributions
Division of partnership profits in proportion to the capital invested by each partner is most
likely to be found in partnerships in which substantial investments is the principal ingredient for
success. It is essential that the partnership contract be specific with respect to the concept
of capital. Capital may refer to either of the following:
Ratio of Original Capital Investments. Assume that the partnership agreement provides for
the division of profits in the ratio of original capital investments. The original investments of
Aguilar and Porras are P400,000 and P800,000, respectively. The profit of P300,000 for 2019 is
divided as follows:
Income summary
Lord Aguilar, drawing
Devzon Porras, drawing
To record the division of profits
300,000
100,000
200,000
Computation:
Aguilar: P300,000 x P400,000/P1,200,000 =
Porras: P300,000 x P800,000/P1,200,000 =
P100,000
200,000
After the entry allocating the profits of P300,000 to Aguilar and Porras, are the partners
supposed to receive cash for their respective share in the profits? No, the partners share in
the profits cannot be attributed to any particular asset, including cash. The entry increased
the equity of Aguilar and Porras in all the assets of the partnership.
Ration of Capital Balances at the Beginning of the year. Assume that the partnership
agreement provided for the division of profits in the ratio of capital balances at the beginning
of the year. In this case, the original capital investments are also the capital balances at the
beginning of the year since the partnership is only on its first year of operations. The profit of
P300,000 for 2019 is divided as follows:
Income summary
Lord Aguilar, drawing
Devzon Porras, drawing
To record the division of profits.
Computation:
Aguilar: P300,000 x P400,000/P1,200,000
Porras: P300,000 x P800,000/P1,200,000
300,000
100,000
200,000
P100,000
200,000
Ratio of Capital Balances at the End of the Year. Assume that the profit is divided in the ratio
of capital balances at the end of the year before drawings and the distribution of profit. The
ending balances are P500,000 for Aguilar and P750,000 for Porras; the profit of P300,000 for
2019 is divided as follows:
Income summary
Lord Aguilar, drawing
Devzon Porras, drawing
300,000
120,000
180,000
Computation:
Aguilar: P300,000 x P500,000/1,250,000
Porras: P300,000 x P750,000/1,250,000
Ratio of Average Capital Balances. Division of profits or losses on the basis of the three
preceding capital concepts –original capital investments; capital balances at the beginning
of the year; or capital balances at the end of the year – may prove inequitable if there are
material changes in the capital accounts during the year.
When beginning capital balances are used in allocating profits, additional investments during
the year are discouraged because the partners making such investments are not
compensated in the division of profits until the next year.
If ending capital balances are used, year-end investments are encouraged, but there is no
incentive for a partner to make any investments before year end. In addition, amounts earlier
withdrawn may be reinvested before year-end. These considerations suggest that using
average balances as a basis for distributing profits or losses is preferable because it reflects
the capital actually available for use by the partnership during the year.
The agreement should also state the amount of drawings each partner may make. These
drawings are considered temporary and are recorded as debits to the partner’s drawing
account. Drawings within the allowable amount will not affect the computation of the
average capital balance. On the contrary, drawings in excess of the allowable amount are
considered permanent reductions in capital; hence, the computation of the average capital
balance is affected.
In the continuing illustration for the Aguilar and Porras Partnership, the partners are entitled to
withdraw P5,000 monthly or a total of P60,000 per annum. Any additional withdrawals are
directly debited to the partner’s capital accounts and therefore will affect the computation
of the average capital ratio.
Aguilar and Porras
Computation of the Average Capital Balances
For the Year ended December 31, 2019
Date
Jan. 1
Apr. 1
capital account
P400,000
500,000
Average capital
Jan. 1
July 1
P800,000
750,000
Average capital
Lord Aguilar, Capital
portion of the year unchanged
x
3/12
=
x
9/12
=
Devzon Porras, Capital
x
6/12
=
x
6/12
=
P400,000
375,000
P775,000
Total Average capital Balances
P1,250,000
=========
The entry to record the division of P300,000 profits is as follows:
Income summary
Lord Aguilar, drawing
Devzon Porras, drawing
To record the division of profits.
Computation:
Aguilar: P300,000 x P475,000/1,250,000
Porras: P300,000 x P775,000/1,250,000
average capital bal.
P100,000
375,000
P475,000
300,000
114,000
186,000
P114,000
186,000
By allowing Interest on Capital and the Balance in an Agreed Ratio
In the preceding section, the plan for dividing the total profits in the ratio of partners’ capital
balances was based on the assumption that capital investments were the controlling fator in
the success of the partnership. However, it is not always the case. Consequently, partnerships
may choose to allocate a portion of the total profits in the capital ratio and the balance
equally or in other agreed ratio after due consideration of the partners’ other contributions.
To allow interest on partners’ capital account balances is almost similar to dividing part of
profits in the ratio of partners’ capital balances. If the partners agree to allow interest on
capital as a first step in the division of profit, they should specify the interest rate to be used.
it should also state whether interest is to be computed on capital balances on specific dates
or on average capital balances during the year.
Partners invested in a partnership for profits, not for interest. The interest on partners’ capital,
along with the other profit sharing plans to be discussed in the remainder of the chapter, are
to be considered as mere techniques to share partnerships profits of losses equitably and not
as expenses of the partnership. On the other hand, the interest on loans from partners is
recognized as expense and a factor in the measurement of profit or loss of the partnership.
Similarly, interest earned on loans to partners recognized as partnership income. This
treatment is consistent with the discussion in the previous chapter that loans receivable from
or payable to partners are assets and liabilities, respectively, of the partnership.
Continuing the illustration of Aguilar and Porras Partnership with a profit of P300,000 for 2019
and capital balances as already shown, assume that the partnership agreement allowed
15% interest on average capital account balances, with the balance to be divided equally.
The profit of P300,000 for 2019 is divided as follows:
Aguilar
Porras
Total
15% interest on average capital:
Aguilar: P475,000 x 15%
P71,250
Porras : P775,000 x 15%
P116,250
Sub total
P187,500
Balance to be divided Equally
(P300,000-P187,500 = P112,500)
Aguilar: P112,500 x 50%
56,250
Porras: P112,500 x 50%
56,250
112,500
--------------------------------------Share of Partners in Profits
P127,500
P172,500
P300,000
=======
=======
=======
The Journal entry to close the income summary ledger account on December 31, 2019
follows:
Income summary
300,000
Lord Aguilar, drawing
127,500
Devzon Porras, drawing
172,500
To record the division of profits.
In a related case, assume that the Aguilar and Porras Partnership had a loss of P10,000 for the
year ended December 31, 2019. If the partnership agreement provided for interest on capital
accounts, this provision must be honored regardless of whether operations yielded profits or
not.
The loss will be shared by the partners in the same manner as the P300,000 profit. The total
interest allowance of P187,500 would still be given to the partners. The only difference is that
the division of profits or losses after the interest allowances would involve a larger negative
amount of P197,500 which will be divided equally between Aguilar and Porras.
Aguilar
15% interest on Average capital:
Aguilar: P475,000 x 15%
Porras: P775,000 x 15%
Subtotal
Balance to be divided Equally
( (P10,000)-P187,500 = P(197,500)):
Aguilar: P(197,500) x 50%
Porras: P(197,500) x 50%
Subtotal
Share of partners In profits (losses)
Porras
Total
P71,250
P116,250
P187,500
(98,750)
(98,750)
P(27,500)
=======
P17,500
======
P(197,500)
P(10,000)
=======
The journal entry to close the income summary ledger account on December 31, 2019 follows:
Lord Aguilar, drawing
27,500
Income summary
10,000
Devzon Porras, drawing
17,500
After initial consideration, the idea that a loss of P10,000 should cause one partner’s capital
to increase and the other partner’s capital to decrease may appear unreasonable.
However, this result was planned and was with good reason. Partner Porras invested more
capital than Partner Aguilar; this capital was used to carry out operations, and the
partnership’s incurrence of a loss in the first year is no reason to disregard Porras’s larger
capital investment.
Comparison of distribution based solely on capital ratios as against distribution with interest
on capital balances. There will be a significant difference between the two distribution plans
if the partnership is operating at a loss. Under the capital ratio plan, the partner who invested
more capital will ultimately shoulder a bigger share of the loss. This result may be considered
inequitable because the investment of capital presumably is not the cause of the loss.
Under the interest plan, the partner who invested more capital is credited (increased) for an
interest on his capital and is ultimately debited (decreased) with a lesser share of the loss; in
some cases, the result may even be a net credit (increase).
By Allowing Salaries to Partners and the Balance in an Agreed Ratio
The sharing agreement may provide for variations in compensating the personal services
contributed by partners. Even among partners who devote equal service time, one partner’s
superior experience and knowledge may command a greater share of the profit. To
acknowledge the harder working or more valuable partner, the profit-sharing plan may
provide for salary allowances.
The partnership agreement should be clear on the treatment of salary allowances when
losses are incurred. In the absence of an agreement to govern this situation, salary
allowances will be provided even when operations yielded losses. This allowance should not
be confused with salaries expense or with the partner’s drawing account which is debited for
periodic salary allowances. The cash withdrawals will in no way affect the division of profits;
the division of profits is governed by the sharing agreement.
Partners are the partnership’s owners; they are not employees of the business. If partners
devote their time and services to the affairs of the partnership, they are understood to do so
for profit, not for salary. Therefore, when the partners calculate the profit of the partnership,
salaries to the partners are not deducted as expenses in the statement of recognized income
and expense.
Continuing the illustration for the Aguilar and Porras Partnership, assume that the partnership
agreement provided for an annual salary of P100,000 to Aguilar and P60,000 to Porras, and
the balance to be divided equally. The profit of P300,000 for 2019 is divided as follows:
Aguilar
Porras
Total
Salary allowances
P100,000
P60,000
P160,000
Balance to be divided equally
(P300,000 – P160,000 = P140,000):
Aguilar: P140,000 x 50%
70,000
Porras: P140,000 x 50%
70,000
140,000
Share of Partners in Profits
P170,000
P130,000
P300,000
=======
=======
========
The journal entry to close the income summary ledger account on December 31, 2019 follows:
Income summary
300,000
Lord Aguilar, drawing
170,000
Devzon Porras, drawing
130,000
By Allowing Bonus to the Managing Partner Based on Profit and the Balance in an Agreed
Ratio
A partnership contract may provide for a special compensation in the form of bonus to the
managing partner when the results of operations of the partnerships are favorable. This
allowance is given in order to encourage the partner to maximize the profit potentials of the
partnership. Bonus is not being considered in the computation of profit, rather it is a mere
technique to distribute profits.
Assume that the Aguilar and Porras Partnership agreement provided for a bonus of 25% of
profit before bonus to Partner Aguilar and the balance to be divided equally. The profit is
P300,000.
Aguilar
Porras
Total
Bonus (25% x P300,000)
P 75,000
P 75,000
Balance to be divided equally
(P300,000-P75,000 = P225,000):
Aguilar: P225,000 x 50%
Porras: P225,000 x 50%
Share of Partners in Profits
112,500
112,500
225,000
P187,500
P112,500
P300,000
=======
=======
=======
The journal entry to close the income summary ledger account on December 31, 2019 follows:
Income summary
300,000
Lord Aguilar, drawing
187,500
Devzon Porras, drawing
112,500
Assumed instead that the Aguilar and Porras Partnership agreement provided for a bonus of
25% of profit after bonus to Partner Aguilar and the balance to be divided equally. It is
understood in the wording of the agreement that the 25% bonus will be based on the
difference after deducting bonus from a certain amount. This certain amount is the profit
after considering all the operating expenses but before this bonus.
Here, the P300,000 profit still includes the bonus. The difference between this profit and bonus
shall be the basis for the 25% bonus rate. Hence, profit after bonus represents 100% while the
profit of P300,000 before bonus represents 125%.
Profit before Bonus
Profit after bonus
Bonus
Bonus
Balance to be divided equally
(P300,000-P60,000 = P240,000)
Aguilar: P240,000 x 50%
Porras: P240,000 x 50%
Share of Partners in Profits
P300,000
240,000
60,000
========
Aguilar
Porras
P 60,000
125%
100%
25%
=====
Total
P 60,000
120,000
P180,000
=======
120,000
P120,000
=======
240,000
P300,000
=======
Journal entry to close the income summary ledger account on December 31, 2019 follows:
Income summary
Lord Aguilar, drawing
Devzon Porras, drawing
To record the division of profits.
300,000
180,000
120,000
By Allowing Salaries, Interest on Capital, Bonus to managing Partner and the balance in an
Agreed Ratio
The service contributions and capital contributions of the partners are often not equal. If the
service contributions are not equal, salary allowances can compensate for the differences.
Or, when capital contributions are not equal, interest allowances can make up for the
unequal investments. When both service and capital contributions are unequal, the
allocation of profits or losses may include salary allowances, interest on their capital balances,
bonus to the managing partner, and the balance to be divided in an agreed ratio.
Note that the provisions for salaries and interest in the partnership agreement are called
allowances. These allowances are not reported in the statement of recognized income and
expense as salaries and interest expense; they are merely means of allocating profit to the
partners.
Assume that the profit for the year is P400,000 and the partnership agreement for the Aguilar
and Porras Partnership provided for the following:
1. Bonus to Aguilar of 25% of profit after salaries and interest but before bonus;
2. Annual salaries of P100,000 to Aguilar and P60,000 to Porras;
3. Interest on average capital balances of P71,250 and P116,250 to Aguilar and
Porras, respectively;
4. Balance to be divided in a ratio of 40:60.
Aguilar
Porras
Total
Salary Allowances
P 100,000
P 60,00 0
P160,000
Interest on average capital balances
71,250
116,250
187,500
Bonus (25% P400,000-P100,000-P60,000
-P71,250-P116,250)
13,125
13,125
Balance to be divided in a ratio of 40:60
(P400,000-P160,000-P187,500-P13,125 =P39,375)
Aguilar:
P39,375 x 40%
Porras:
P39,375 x 60%
Share of Partners in Profits
15,750
P200,125
=======
23,625
P199,875
=======
39,375
P400,000
=======
Journal entry to close the income summary ledger account on December 31, 2019 follows:
Income summary
400,000
Lord Aguilar, drawing
200,125
Devzon Porras, drawing
199,875
To record the division of profits
Assume instead that the bonus to Aguilar is 25% of profit after salaries, interest and after bonus.
The computation of the follows:
Profit before salaries, interest and bonus
Less: salaries
P160,000
Interest
187,500
Profit after salaries and interest but before bonus
Profit after salaries, interest, and after bonus
Bonus
Salary Allowance
Interest on Average capital balances
Bonus
P400,000
Aguilar
P100,000
71,250
10,500
347,500
P 52,500
42,000
P 10,500
=======
Porras
P60,000
116,250
125%
100%
25%
====
Total
P160,000
187,500
Balance to be divided in a ratio of 40:60
(P400,000-P160,000-P187,500-P10,500= P42,000)
Aguilar: P42,000 x 40%
Porras: P42,000 x 60%
Share of Partners in Profits
16,800
P198,550
=======
25,200
P201,450
========
42,000
P400,000
========
The journal entry to close the income summary ledger account on December 31, 2019 follows:
Income summary
400,000
Lord Aguilar, drawing
198,550
Devzon Porras, drawing
201,450
Unfamiliar terms in the succeeding discussions which are partly based on IAS no. 1 (revised
2007) will be fully appreciated in higher accounting subjects. Suffice it to say, though, that at
this point you’re in a better situation than the users of other textbooks.
FINANCIAL REPORTING
Purpose of Financial Statements
Financial statements are a structured representation with the objective of providing
information about the financial position, financial performance and cash flows of an entity
that is useful to a wide range of users in making economic decisions. Financial statements
also show the results of the management’s stewardship of the resources entrusted to it. To
meet the objective, financial statements provide information about an entity’s assets,
liabilities, equity, income and expenses, other changes in equity and cash flows.
Overall Considerations
Fair Presentation and Compliance with International Financial Reporting Standards (IFRSs).
The financial statements shall present fairly the financial position, financial performance and
cash flows of the entity. Fair presentation requires the faithful representation of the effects of
transactions, other events and conditions in accordance with the definitions and recognition
criteria for assets, liabilities, income and expenses set out in the IASB’s new Conceptual
Framework. Under IAS no. 1 (revised 2007), entities are required to make an explicit and
unreserved statement of compliance with IFRS in the notes.
Going Concern. Financial statements should be prepared on a going concern basis unless
management intends to liquidate the entity or cease trading or has no realistic option but to
do so.
Accrual Basis of Accounting. An entity shall prepare its financial statements, except for cash
flow information, using the accrual basis of accounting.
Materiality and Aggregation. An entity shall present separately each material class of similar
items. Material items that are dissimilar in nature or function should be separately disclosed.
Offsetting. An entity shall not offset assets and liabilities, income and expenses unless required
or permitted by an IFRS.
Frequency of Reporting and Comparative Information. At least annually, an entity shall
present with equal prominence each financial statement in a complete set of financial
statements including comparative information in respect of the previous period for all
amounts reported in the current period’s financial statements.
Consistency of Presentation. An entity shall retain the presentation and classification of items
in the financial statements in successive periods unless an alternative would be more
appropriate or an IFRS requires a change in presentation.
Identification of the Financial Statements. An entity shall clearly identify the financial
statements and distinguish them from other information in the same published document.
International financial Reporting Standard (IFRSs) apply only to the financial statements and
not necessarily to other information presented in an annual report, a regulatory filing or
another document.
An entity shall clearly identify each financial statement and the notes. An entity shall display
the following information prominently:
 Name of the reporting entity.
 Whether the financial statements are of the individual entity or a group of entities;
 The date of the end of the reporting period or the period covered by the set of
financial statements or notes;
 The presentation currency;
 And the level of rounding used in presenting amounts in the financial statements.
Complete Set of Financial Statements
Per revised International Accounting Standards (IAS) no. 1, Presentation of Financial
Statements, a complete set of financial statements comprises:
a. statement of financial position as at the end of the period;
b. a statement of financial performance for the period;
c. a statement of changes in equity for the period;
d. a statement of cash flows for the period;
e. notes, comprising a summary significant accounting policies and other
explanatory information; and
f. a statement of financial position as at the beginning of the earliest
comparative period when an entity applies an accounting policy
retrospectively or makes a retrospective restatement of items in its financial
statements, or when it reclassifies items in its financial statements.
Statement of Financial Performance
The form and content of the income statement of the partnership resemble those of the sole
proprietorship with the exception of the presentation of the division of profits or losses at the
lower portion of the statement.
Aguilar and Porras
Partial Income Statement
For the year ended Dec. 31, 2019
Profit
Division of profit (equally):
Partner Aguilar
Partner Porras
Total
P300,000
========
P150,000
150,000
P300,000
=======
The component of profits or loss may be presented either as part of a single statement of
comprehensive income or in an income statement, as permitted by paragraph 81 of IAS no.
1 (revised 2007). When an income statement is presented, it is part of a complete set of
financial statements and shall be displayed immediately before the statement of
comprehensive income.
As a minimum, the statement of financial performance shall include line items that present
the following amounts for the period:
a. Revenue;
b. Finance costs;
c. Share of profit or loss of associates and joint ventures accounted for using
the equity method;
d. Tax expense;
e. A single amount comprising the total of:
i.
The post-tax profit or loss of discontinued operations; and
ii.
The post-tax gain or loss recognized on the measurement to
fair value less costs to sell on the disposal of the assets or
disposal group(s) constituting the discontinued operations;
f. Profit or loss;
g. Each component of other financial performance classified by nature
(excluding amounts in (h) below);
h. Share of the other financial performance of associates and joint ventures
accounted for using the equity method; and
i. Total financial performance.
Statement of Changes in Equity
An entity shall present a statement of changes in equity, showing in the statement:
a. total financial performance for the period showing separately the total amounts
attributable to owners of the parent and to minority interests;
b. for each component of equity, the effects of retrospective restatement
recognized in accordance with IAS no. 8 accounting policies, changes in
accounting estimates and errors;
c. the amounts of transactions with owners in their capacity as owners, showing
separately contributions by and distributions to owners; and
d. for each component of equity, a reconciliation between the carrying amount at
the beginning and the end of the period, separately disclosing each change.
The components of equity referred to above include for example, each class of contributed
equity, the accumulated balance of each class of other comprehensive income and
retained earnings (these are applicable to corporations). The amount of dividends
recognized as distributions to owners during the period, and the related amount per share,
shall be presented either in the statement of changes in equity or in the notes.
In the case of Aguilar and Porras, as contrasted with a sole proprietorship, the number of
capital and drawing accounts has made the preparation of this statement all the more
useful. Changes in an entity’s equity between the beginning and the end of the reporting
period reflect the increase or decrease in its net assets during the period.
Aguilar and Porras
Statement of Changes in Partners’ Equity
For the year ended Dec. 31, 2019
Original Investments
Aguilar
Porras
Total
P400,000
P800,000
P1,200,000
Add: additional Investments
Total
Less: permanent withdrawals
Balances
Add: profit
Total
Less: temporary withdrawals
Partners’ Equity, Dec. 31
100,000
P500,000
P500,000
150,000
P650,000
60,000
P590,000
=======
P800,000
50,000
P750,000
150,000
P900,000
60,000
P840,000
=======
100,000
P1,300,000
50,000
P1,250,000
300,000
P1,550,000
120,000
P1,430,000
=========
Statement of Financial Position
After all the components of the statement of financial performance along with the changes
in partners’ equity for the period have been properly presented, the preparation of the
statement of financial position will present no major difficulty. The assets and liabilities will be
presented in the statement of financial position as those of a sole proprietorship but the
owners’ equity section should exhibit separately the capital balance of P590,000 and
P840,000 for Aguilar and Porras, respectively.
Though some of the items are not as familiar yet, per revised international accounting
standards (IAS) no. 1 presentation of financial statements, as a minimum, the face of the
statement of financial position shall include line items that present the following amounts:
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
l.
m.
n.
o.
p.
q.
r.
Property, plant and equipment;
Investment property;
Intangible assets;
Financial assets (excluding amounts shown under e, h and i);
Investment accounted for using equity method.
Biological assets;
Inventories;
Trade and other receivables;
Cash and cash equivalents;
The total of assets classified as held for sale and assets included in
disposal groups classified as held for sale in accordance with IFRS 5;
Trade and other payables;
Provisions;
Financial liabilities (excluding amounts shown under k and l);
Liabilities and assets for current tax, as defined in IAS 12;
Deferred tax liabilities and deferred tax assets, as defined in IAS12;
Liabilities in disposal groups classified as held for sale in accordance
with IFRS 5;
Minority interest, presented within equity; and
Issued capital and reserves attributable to equity holders of the
parent.
IAS no.1 (revised 2007) does not prescribe the order or format in which an entity presents
items. The above enumeration (from Paragraph 54 of IAS no.1 revised 2007) simply provides
a list of items that are sufficiently different in nature or function to warrant a separate
presentation in the statement of financial position.
Note that an entity makes the judgment about whether to present additional items
separately on the basis of an assessment of:
a. the nature and liquidity of assets;
b. the function of assets within the entity; and
c. the amounts, nature and timing of liabilities.
Current and noncurrent assets and liabilities should be separately classified on the face of
the statement of financial position except when a presentation based on liquidity provides
more reliable and relevant information.
An entity shall classified as asset as current when it satisfies any of the following criteria:




it expects to realize the assets, intends to sell or consume it, in its normal operating
cycle; or
it holds the asset primarily for the purpose of trading; or
it expects to realize the asset within 12 months after the end of the reporting period;
or
the asset is cash or a cash equivalent as defined in IAS no.7
All other assets are non-current. Operating cycle is the time between the acquisition of assets
for processing and their realization in cash or cash equivalents.
A liability should be classified as a current liability when it:
 is expected to be settled in the normal operating cycle; or
 is held primarily for the purpose of trading ; or
 is due to be settled within 12 months after the end of the reporting period; or
 does not have an unconditional right to defer settlement of the liability for at least 12
months after the reporting period.
All other liabilities should be classified as non-current liabilities.
The statement of cash flows has been discussed in an earlier chapter.
Solve the following problems. (not graded)
1. Distribution of profits or losses based on partners’ agreement
Ables and Galang divide partnership profits and losses solely on the basis of their
average capital balances. Ables had P275,000 invested during all of 2019; Galang
had P200,000 invested from January 1 to August 31, and he invested another P75,000
on September 1. If profit was P800,000 during 2019, how much should each partner
receive?
2. Abad, Aglugud, and Onate agreed to share profits and losses according to the ratio
of their respective investments at the beginning of the year of P300,000, P250,000, and
P450,000. Calculate the share of each partner under the following conditions: (a)
P270,000 profit; (b) 240,000 loss.
Evaluation: Quiz, Homework, graded problems
Chapter 12
Corporations: Basic Considerations
Learning Objectives:
After studying this chapter, you should be able to:
1. Define corporation.
2. Identify the attributes of a corporation.
3. Identify and explain the advantages and disadvantages of a corporation.
4. Identify and describe the classes of corporations under the Corporation Code of
the Philippines.
5. Identify and describe the other classification of corporations.
6. Outline the steps in the creation of a corporation.
7. Summarize the essential contents of the articles of incorporation and the by laws.
8. List some of the rights of a shareholder.
9. Detail the components of a corporation.
10. Expound on the necessity of independent directors.
11. Describe the classes of shares in general.
12. Apply the 25%-25% requirement at the time of incorporation.
13. Interpret the basic corporate organizational structure.
14. Name the corporate books and records.
DEFINITION
A corporation is an artificial being created by operation of law, having the right of succession
and the powers, attributes and properties expressly authorized by law or incident to its
existence (The Corporation Code of the Philippines, sec. 2)
ATTRUBUTES OF A CORPORATION
1. A corporation is an artificial being with a personally separate and apart from its
individual shareholders or members.
2. It is created by operation of law. It cannot come into existence by mere agreement
of the parties as in the case of business partnership. Corporations require special
authority or grant from the State, either by a special incorporation law that directly
creates the corporation or by means of a general corporation law (i.e.., the
corporation code of the Philippines).
3. It enjoy the right of succession. A corporation has the capacity of continued existence
subject to the period stated in the Articles of Incorporation. The death, withdrawal,
insolvency or incapacity of the individual shareholders or members will not dissolve the
corporation. The transfer of ownership of shares of stock does not dissolve the
corporation.
4. It has the powers, attributes and properties expressly authorized by law or incident to
its existence.
ADVANTAGES OF A CORPORATION
1.
2.
3.
4.
The corporation has the legal capacity to acts as a legal entity.
Shareholders have limited liability.
It has continuing of existence.
Shares of stock can be transferred without the consent of the other shareholders.
5. Its management is centralized in the board of directors.
6. Shareholders are not general agents of the business.
7. Greater ability to acquire funds.
DISADVANTAGES OF A CORPORATION
1.
2.
3.
4.
5.
6.
A corporation is relatively complicated in formation and management.
There is a greater degree of government control and supervision.
It requires a relatively high cost of formation and operation.
It is subject to heavier taxation than other forms of business organizations.
Minority shareholders are subservient to the wishes of the majority.
In large corporations, management and control have been separated from
ownership.
7. Transferability of shares permits the uniting of incompatible and conflicting elements
in one venture.
CLASSES OF CORPORATIONS
Section 3 of the Corporation Code classified private corporations into:
1. Stock corporation. Corporations which have share capital divided into shares and are
authorized to distribute to the holders of such shares dividends or allotments of the
surplus profits on the basis of the shares held.
2. Non-stock corporation. A non-stock corporation is one where no part of its income is
distributable as dividends to its members, trustees or officers. Any profit that a nonstock corporation may obtain as an incident to its operation shall, whenever
necessary or proper, be used for the furtherance of the purpose or purposes for which
the corporation was organized ( the Corporation Code of the Philippines, Sec. 87).
Non-stock corporations may be formed or organized for charitable, religious,
educational, professional, cultural, recreational, fraternal, literary, scientific, social,
civic service, or similar purposes (sec. 88).
OTHER CLASSIFICATIONS OF CORPORATIONS
1. According to number of persons:
A. Corporation aggregate.
A corporation consisting of more than one
corporator.
B. Corporation sole or a special form of corporation usually associated with the
clergy. It is a corporation which consists of only one member or corporator and
his successors such as a bishop.
2. According to nationality:
A. Domestic corporation. A corporation organized under Philippine laws.
B. Foreign corporation. A corporation organized under foreign laws.
3. According to whether for public or private purpose:
A. Public corporation. A corporation formed or organized for the government of
a portion of the state (e.g., provinces, cities, municipalities and barangays).
B. Private corporation. A corporation created for private aim, benefit or purpose.
4. According to whether for charitable purpose or not:
A. Ecclesiastical corporation. Those organized for religious purposes.
B. Eleemosynary corporation. Those established for public charity.
C. Civil corporation. Those established for business or profit.
5. According to their legal right to corporate existence.
A. De jure corporation. A corporation existing in fact and in law. It is organized in
strict conformity with the law.
B. De facto corporation. A corporation existing in fact but not in law.
6. According to degree of public participation with regard to share ownership.
A. Close corporation. A corporation whose share ownership is limited to selected
persons or members of a family not exceeding 20 persons.
B. Open corporation. A corporation where the share is available for subscription
or purchase by any person.
C. Publicly –held corporation. A corporation with a class of equity securities listed
on an exchange or with assets in excess of P50,000,000 and having 200 or more
holders, at least 200 of which are holding at least 100 shares of a class of its
equity securities (SRC rule 3-1.M, amended IRR of the Securities Regulations
code (RA 8799).
7. According to their relation to another corporation:
A. Parent or holding corporation. A corporation that is related to another
corporation that it has the power to either directly or indirectly elect the
majority of the directors of a subsidiary corporation.
B. Subsidiary corporation. A corporation controlled by another corporation
known as a parent corporation.
STEPS IN THE CREATION OF A CORPORATION
There are three steps in the creation and organization of a corporation, namely:
1. Promotion. It is the process of bringing together the incorporators or the persons
interested in the business, of procuring subscriptions or capital for the corporation and
of setting in motion the machinery that leads to the incorporation of the corporation
itself.
2. Incorporation. This step includes the following:
a. Verification from the records of the Securities and Exchange Commission (SEC)
that the proposed corporate name is not the same or similar to an existing
corporation. The corporate name shall contain the word “Corporation” or
“Incorporated”, or the abbreviations “Corp.” or “Inc.,” respectively. The
corporate name of a foundation shall use the word “foundation”. A term that
describes the business of a corporation in its name should refer to its primary
purpose (SEC Memorandum Circular 5, Series of 2008).
b. Drafting and execution of the articles of incorporation (AI) by the
incorporators. The person elected as temporary treasurer should execute an
affidavit regarding the share capital subscribed and paid up. The treasurer
should also submit a sworn statement of assets and liabilities of the corporation.
c. Deposit by the treasurer of the cash paid for the shares subscribed in the bank
in the name of the treasurer in trust for and to the credit of the corporation.
The bank is required to issue a certificate of deposit.
d. Filling of the articles of incorporation with the SEC together with treasurer’s
affidavit, statement of financial position, certificate of bank deposit, and
certificate as to the name of the corporation;
e. Payment of the filling fees: for the AI, equivalent to 1/5 of 1% of the authorized
capital stock of the proposed corporation but not less than P1,000 for the by
laws, P510; for SEC form F-100, P2,000; and a legal research fee which is 1% of
the filling fee for the AI;
f. Endorsement from other government agencies if the proposed corporation will
engage in an industry regulated by the government, other requirements for
corporations with foreign equity and additional requirements based on the
kind of payment of subscriptions; and
g. Issuance by the SEC of the certificate of incorporation.
3.
Formal organization and commencement of business operations.
Formal
organization requires the adoption of by-laws and the election of the board of
directors and of the administrative officers. It also includes the taking of such other
steps as are necessary to enable the corporation to transact the legitimate business
or accomplish the purpose for which was created.
Section 22 of the Corporation Code states that if a corporation does not formally
organize and commence the transaction of its business within two (2) years from the
date of its incorporation, its corporate powers shall cease and the corporation shall
be deemed dissolved.
However, if a corporation has commenced business but subsequently becomes
continuously inoperative for a period of at least five (5) years, the same shall be a
ground for the suspension or revocation of its certificate of incorporation.
ARTICLES OF INCORPORATION
In the Philippines, the general law which governs the creation of private corporations is the
Corporation Code of the Philippines. Section 14 provides that all corporations organized
under this code shall file with the SEC articles of incorporation in any of the official languages
duly signed and acknowledged by all of the incorporators, containing substantially the
following matters except as otherwise prescribed by this Code or by special law:
1.
2.
3.
4.
5.
6.
The name of the corporation;
The specific purpose or purposes for which the corporation is formed.
The principal place of business which must be within the Philippines;
The term of existence;
The names, nationalities and residences of the incorporators;
The number of directors or trustees, which shall not be less than five (5) nor more than
fifteen (15);
7. The names, nationalities and residences of the persons who shall act as directors or
trustees until the first regular directors or trustees are elected and qualified.
8. If it be a stock corporation:
a. Amount of authorized share capital in pesos,
b. Number of shares into which it is divided,
c. In case the shares are par value shares:
^ the par value of each share,
^ names, nationalities and residences of the original subscribers.
^ the amount subscribed and paid by each subscriber on his subscription.
d. In case of no par value, the articles need only state such fact, and the number
of shares into which said share capital is divided.
9. If it be a non-stock corporation, the amount of its capital, the names, nationalities and
residences of the contributors and the amount contributed.
BY LAWS
These are the rules of action adopted by the corporation for its internal government and for
the government of its officers, shareholders or members. The by-laws shall be adopted within
one month from the issuance of the certificate of incorporation by the SEC. failure to file a
code of by-laws shall render the corporation liable for the revocation of its registration. A
private corporation may provide in its by-laws for:
1. The time, place and manner of calling and conducting regular or special meetings of
the directors;
2. The time and manner of calling and conducting regular or special meetings of the
shareholders or members.
3. The required quorum in meetings of shareholders or members and the manner of
voting there in;
4. The form for proxies of shareholders and members and manner of voting them;
5. The qualifications, duties and compensation of directors or trustees, officers and
employees.
6. The time for holding the annual election of directors or trustees and the mode or
manner of giving notice thereof;
7. The manner of election or appointment and the term of office of all officers other than
directors or trustees.
8. The penalties for violation of the by-laws.
9. In the case of stock corporations, the manner of issuing stock certificates; and
10. Such other matters as may be necessary for the proper or convenient transaction of
its corporate business and affairs.
RIGHTS OF A SHAREHOLDER
The following are some of the rights of a shareholder:
1.
2.
3.
4.
5.
6.
7.
8.
Right to be issued certificate of stock or other evidence of share ownership and to
transfer such shares.
Right to attend and vote in person or by proxy at shareholders’ meeting.
Right to elect and remove directors.
Right to adopt, amend or repeal the by-laws.
Right to purchase a portion of any new shares issued to maintain the same
percentage of stock ownership. This right is known as the pre-emptive right. However,
this right is not absolute and may be denied.
Right to receive dividends when declared.
Right to inspect corporate books and records, and to receive financial reports of the
corporation’s operations.
Right to participate in the distribution of corporate assets upon dissolution.
COMPONENTS OF A CORPORATION
1. Corporators are those who compose a corporation whether as shareholders or
members, at anytime. This term includes incorporators, shareholders or members (Sec.
5). Note: A corporation or a partnership can be a corporator, but cannot be an
incorporator. A partnership can be a corporator in a corporation but a corporation
cannot be a general partner in a partnership.
2. Incorporators are shareholders or members mentioned in the articles of incorporation
as originally forming and composing the corporation and are signatories to said
articles of Incorporation (section 5). They must be natural persons (i.e. human beings)
as distinguished from artificial beings (e.g., a corporation or a partnership). An
incorporator will always retain his status as such though no longer having an interest in
the corporation.
3. Shareholders or stockholders are corporators in a stock corporation (section 5).
Shareholders may be natural or juridical persons.
4. Members are corporators of a non-stock corporation (section 5).
5. Subscribers are persons who have agreed to take and pay for original, unissued shares
of a corporation formed or to be formed. Note: all incorporators are subscribers but
a subscriber need not be an incorporator.
6. Promoters are persons who bring about or cause to bring about the formation and
organization of a corporation.
7. Underwriters are usually investment bankers who have
j. agreed, alone or with others, to buy at stated terms an entire or a
substantial part of an issue of securities; or
k. guaranteed the sale of an issue by agreement to buy from the issuing
corporation any unsold portion at a stated price; or
l. agreed to use his best efforts to market all or part of an issue; or
m. offered for sale shares he has purchased from a controlling stockholder.
8. Independent director is a person who apart from his fees and shareholdings is
independent of management and free from any business or other relationship which
could, or could reasonably be perceived to, materially interfere with his exercise of
independent judgment in carrying out the responsibilities of a director.
A publicly-held corporation, as earlier defined, shall have at least two independent
directors or at least 20% of the member of the board, whichever is the lesser (section
38 of the SRC). This is being done to protect the interest of the shareholders and
investors. The election of the independent directors is done during the annual
stockholders meeting by the stockholders themselves.
CLASSES OF SHARES IN GENERAL
1. Par value shares. One in which a specific amount is fixed in the articles of
incorporation and appearing on the certificate of stock. The par value is the minimum
issue price of the shares.
Section 6 of the code states that preference (or preferred) shares of stock may be
issued only as par value shares.
2. No-par value shares. One without any value appearing on the face of the certificate
of stock. A no-par value share may have a stated value which may be fixed in the
articles of incorporation or by the board of directors or the shareholders. Thus, the
issue price may vary from time to time as it is usually fixed based on the book value of
the corporation’s shares.
3. However, the minimum stated value of a no-par value share is five pesos (P5.00) per
share (section 6). In addition, shares issued without par value are deemed fully paid.
Banks, trust companies, insurance companies, public utilities, and building and loan
associations are not permitted to issue no-par value shares of stock.
4. Voting shares. Those issued with the right to vote.
5. Non-voting shares. Those issued without the right to vote.
6. Ordinary shares. These shares entitle the holder to an equal pro-rata division of profits
without any preference.
7. Preference shares. These shares entitle the holder to certain advantages or benefits
over the holders of ordinary shares.
8. Promotion shares. Those issued to promoters as compensation in promoting the
welfare of the corporation.
9. Treasury shares. A stock that has been issued by the corporation as fully paid and later
reacquired but not retired.
10. Convertible shares. A stock which is convertible or changeable from one class to
another class.
MINIMUM SUBSCRIPTION AND PAID – IN CAPITAL
At the time of incorporation, at least twenty – five (25%) percent of the authorized capital
stock (or share capital) as stated in the articles of incorporation must be subscribed and at
least twenty – five (25%) percent of the total subscription must be paid upon subscription, the
balance to be payable on a date or dates fixed in the contract of subscription without need
of a call, or in the absence of a fixed date or dates, upon call for payment by the board of
directors. In no case shall the paid-in capital be less than five thousand (P5,000) pesos. (the
Corporation Code of the Philippines, Sec. 13). In practice, the SEC requires higher minimum
capital requirements for particular types of corporations.
These requirements are mandatory. The SEC shall not accept the articles of incorporation of
any stock corporation unless accompanied by a sworn statement of the treasurer elected by
the subscribers showing that the minimum subscription and paid-in capital requirements have
been complied with. Observe that the new Corporation Code used the term “total”
subscription as the basis for the application of the second 25%. It is not necessary that each
and every subscriber shall pay twenty-five percent of his subscription. It is enough that 25%
of the total subscription is paid.
Illustration. Assume that the authorized share capital is P2,000,000 divided into 20,000 shares
with a par value of P100 per share. The subscribed share capital must be P500,000 which is
25% of the authorized share capital of P2,000,000. The paid-in capital should be P125,000
which is 25% of the subscribed share capital of P500,000.
Suppose that the authorized share capital is P60,000 divided into 6,000 P10 par value shares.
Applying the 25%-25% rule, the paid in capital will only amount to P3,750. The incorporators
must pay P5,000 because this is the minimum paid-in capital required by law.
In case of no-par value shares, the 25% requirement will be based on the authorized number
of shares. If the authorized capital is pegged at 2,000 no-par value shares, then at least 500
no-par value shares must be subscribed.
BASIC CORPORATE ORGANIZATIONAL STRUCTURE
The ultimate control of the corporation rests with the shareholders. They are the owners of
the corporation. The shareholders elect the top governing body of the corporation, the
members of the board directors. The board of directors is responsible for the formulation of
the overall policies for the corporation and for the exercise of corporate powers. The board
also elects a chairman of the board.
The election of the professional management team or the administrative officers is entrusted
to the board. This team may include the president; executive vice- president; vice-presidents
in charge of sales, manufacturing, accounting, finance, administration and other key areas;
secretary; and controller. These officers implement the policies of the board of directors and
actively manage the day-to-day affairs of the corporation. Annually, a corporation holds the
shareholders’ meeting during which the shareholders elect their directors and make other
decisions.
Hierarchy of Corporate Structure
Shareholders
Elect the
Board of Directors
Elect the
Officers
Hire
Employees
Sec. 25 of the Corporation Code of the Philippines, states that the president of a corporation
must be a director of the corporation, but he cannot act as president and secretary or as
president and treasurer at the same time. The president is the only officer required by law to
be a director.
The corporate secretary must be a resident and a citizen of the Philippines. He need not be
a director unless required by the corporate by-laws. It is generally the duty of the secretary
to make and keep its records and to make proper entries of the votes, resolutions and
proceedings of the shareholders and directors in the management of the corporation. The
corporate treasurer is the proper officer entrusted with the authority to receive and keep the
money of the corporation and to disburse them as he may be authorized. The treasurer may
or may not be a director.
There is no prohibition in the law against a shareholder being a director or officer of two or
more corporations. The Corporation Code does not prohibit a corporate officer from
occupying the same position in another corporation organized for the same purpose.
However, such situation may be prohibited by special law, the articles of incorporation or the
corporate by-laws. There is a particular case involving a business tycoon who wanted to
become a San Miguel Corporation director although he was already occupying the same
post in two corporations directly competing with the food and beverage giant. At that time,
San Miguel amended its by-laws to provide for the disqualification of a shareholder from
being a director of the corporation if the former already occupies the same position in a
competing firm. The Supreme Court later upheld the decision of San Miguel. Thus, a
corporation is authorized to prescribe qualifications for its directors (Gokongwei vs. sec, 89
SCRA 336).
CORPORATE BOOKS AND RECORDS
Every private corporation, stock or non-stock, is required to keep books and records at its
principal office of the following.
1. Minutes book. It contains the minutes of the meetings of the directors and
shareholders.
2. Stock and transfer book. It is a record of the names of shareholders, installments paid
and unpaid by shareholders and dates of payment, any transfer of stock and dates
thereof, by whom and to whom made.
3. Books of accounts. These represent the record of all business transactions. The books
of accounts normally include the journal and the ledger.
4. Subscription book. It is a book of printed blank subscription.
5. Shareholders’ ledger. It is a ledger which details the number of shares issued to each
shareholders.
6. Subscribers’ ledger. It is a subsidiary ledger for the subscriptions receivable account;
it reports the individual subscriptions of the subscribers.
7. Stock certificate book. It is a book of printed blank certificate of stock.
Multiple Choice
1. A corporation whose stock can be purchased by anyone and is traded in stock
markets is known as a (n)
a. government-owned corporation
b. close corporation
c. open corporation
d. not-for-profit corporation
2. When organizing a corporation, the incorporators submit articles of incorporation to
a. Judge
b. The SEC
c. The NBI
d. The Board of Investments
3. Ordinary shares carry all the following rights except the right to
a. shares in profits
b. receive information about the corporation
c. receive part of the profit before other classes of shares
d. attend the annual shareholders’ meeting
4. The top governing body of a corporation is known as the
a. Incorporators
b. Shareholders
c. Management
d. Board of directors
5. Which of the following is not a disadvantage of the corporate form of ownership?
a. difficulty of formation
b. limited liability
c. expense of incorporation and selling stock
d. lack of secrecy
6. Right of the corporation to continue as a juridical entity for the period stated in the
Articles of Incorporation despite the death of any shareholder:
a. right of succession
b. right of pre-emption
c. right of existence
d. none of the above
7. The directors of a corporation are responsible for
a. declaring dividends
b. maintaining shareholders records.
c. The day to day managing of the business
d. Preparation of accounting records and financial statements
8. A corporation has the following attributes except
a. an artificial being with a personality separate and apart from its shareholders
b. created by operation of law
c. enjoys the right of succession
d. has the powers, attributes and properties expressly authorized by law or
incident to its existence.
9. The owners of shares in a stock corporation are called
a. Incorporators
b. Promoters
c. Members
d. Shareholders
10. Refers to an equitable right of shareholders to subscribe to newly issued shares of the
corporation in proportion to their present shares in order to maintain their equity in their
surplus as well as proportionate standing in the corporation.
a. right of redemption
b. pre-emptive right
c. right to be sued
d. concept of corporation entity
EVALUATION
1. Homework
2. Seatwork
3. Quizzes
4. Exam.
Chapter 13
CORPORATION: Share Capital, Retained Earnings and
Financial Reporting
Learning Objectives:
After studying this chapter, you should be able to:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
Identify the basic components of shareholder’ equity.
Explain the characteristics of the basic types of shares.
Distinguish the terms related to share capital.
Differentiate par value from no-par value shares.
Record the share issuances for cash.
Illustrate the share subscription process including delinquency sale.
Define treasury stock
Record purchase, reissuance and retirement of treasury stocks.
Define retained earnings and show how it is affected by some accounting events.
Discuss dividends in general.
Identify the important dates in the dividends distribution.
Analyze and record transactions involving cash dividends and share dividends.
Summarize the effects of dividends.
Prepare a statement of retained earnings.
Prepare a statement of changes in shareholders’ equity.
OVERVIEW OF SHAREHOLDERS’ EQUITY
Generally, the type of business organization-sole proprietorship, partnership or corporation,
does not affect the asset and liability sections of the statement of financial position. The only
difference in the owners’ equity sections. Sole proprietorships and partnerships use capital
accounts and ultimately combine the owners’ contributions and accumulated profits in
accordance with some legal provisions
The owners’ equity section of a corporation’s statement of financial position is called
shareholders’ equity. Shareholders equity has two major components – share capital
(contributed or paid –in capital) and retained earnings. Share capital reflects the amount of
resources received by a corporation as a result of investment by shareholders, donation or
other share capital transactions. Retained earnings (or accumulated profits or losses) is the
amount of capital accumulated and retained through the profitable operations of the
business.
The following is the shareholders’ equity section of a statement of financial position.
Shareholders’ Equity
Share Capital
Preference shares – P50 par, 1,000 shares authorized
Issued and outstanding
Ordinary shares – P5 par, 30,000 shares authorized,
20,000 shares issued and outstanding
Share premium – Ordinary
P50,000
P100,000
50,000
150,000
Total share capital
P200,000
Retained earnings
Total Shareholders’ Equity
80,000
P280,000
========
SHARE CAPITAL
It is the shares to be subscribed and paid in or secured to be in by the shareholders, either in
money, property or services, at the time of organization of the corporation or afterwards, and
upon which it is to conduct its operations. The share, contributed or paid-in capital is further
divided into the following:
Legal Capital. Capital contributed by shareholders comes from the sale of shares of stock.
The shares of stock issued are generally referred to as share capital. Legal capital is that
portion of the contributed capital or the minimum amount of paid-in capital, which must
remain in the corporation for the protection of corporate creditors. The amount of legal
capital is determined as follows:
In case of par value shares, legal capital is the aggregate par value of all issued and
subscribed shares.
In case of no-par value shares, legal capital is the total consideration received by the
corporation for the issuance of its shares to the shareholders including the excess of issue price
over the stated value ( section 6, par. 3, Corporation Code of the Philippines).
Share Premium. ( or additional Paid-In Capital). It is the portion of the paid –in capital
representing amounts paid by shareholders in excess of par. It may also from transactions
involving treasury stocks, retirement of shares, donated capital, share dividends and any
other “gain” on the corporation’s own stock transactions.
TWO BASIC TYPES OF SHARES
Share capital is divided into transferable shares of stock. A share of stock represents the
interest or right of a shareholder in a corporation and is evidenced by a certificate of stock.
Share capital includes all types of ownership shares in a corporation. Shareholders acquire
either of the following basic types of share capital:
Ordinary Share. This share represents the basic ownership class of the corporation. When
only one class of share is issued, it must be ordinary share. Ordinary shares are the entity’s
residual equity.
Preference Share. This share gives its owners certain advantages over ordinary shareholders.
These special benefits relate either to the receipt of dividends when declared before the
ordinary shareholders (preferred as to dividends) or to priority claims on assets in the event of
corporate liquidation (preferred as to assets).
TERMS RELATED TO SHARE CAPITAL
Authorized Share Capital. The number of authorized shares indicates the maximum number
of shares the corporation can issue as specified in the article of incorporation. This maximum
number of shares capital. Note that any increase or decrease in the authorized share capital
requires prior approval of the SEC and formal amendment to the articles of incorporation.
Issued Share Capital. These are shares which have been sold and paid for in full. Issued
share may include treasury shares. Share capital, either ordinary shares account or
preference shares account, is credited for the total par value of fully collected subscriptions
or in the case of no-par value shares, for the total consideration received in relation to the
issue. Share capital is debited only when the issued shares are retired, redeemed or
cancelled by the corporation.
Subscribed Share Capital. It is the portion of the authorized share capital that has been
subscribed but not fully paid. This shareholders’ equity account is credited for the total par
value of the shares subscribed and debited for the total par value of the collected
subscriptions.
Outstanding Share Capital. These are issued shares, which are in the hands of the
shareholders. The number of outstanding shares will equal the difference the issued shares
and the treasury shares.
Treasury Stock. These are issued shares acquired by the corporation but not retired and are
therefore, waiting to be reissued at a later date.
ACCOUNTING FOR ISSUANCE OF SHARE CAPITAL
The entry to record the issuance of share capital depends on whether the stock is with or
without par value.
When shares with par value are sold, the proceeds should be credited to the share
capital account to the extent of the par value of the shares, with any excess being
reflected as share premium.
When shares without par value are sold, the proceeds should be credited to the share
capital account. If the no-par stock has a stated value, the excess proceeds over
stated value may alternatively be credited to share premium.
Section 65 of the Corporation Code prohibits the original issue of share capital (or capital
stock) for a consideration less than the par or stated value (i.e. issued at a discount).
Corporation set the par value of their ordinary shares at nominal amounts such as P1 per
share. The par value is no indication of its market value; it merely indicates the amount per
share to be entered in the share capital account.
CONSIDERATIONS FOR ISSUANCE OF SHARES
Share capital may be issued in exchange for any of the following considerations:
1. Actual cash paid to the corporation.
2. Tangible or intangible properties actually received by the corporation.
3. Labor already performed for or services actually rendered to the corporation.
4. Previously incurred indebtedness by the corporation.
In issuing its share capital, a corporation may avail of the services of an investment banker
who is specialist in marketing shares to investors. The investment banker may underwrite a
share issue which means that the banker agrees to buy the shares of the corporation and to
sell them to investors. The corporation considers the shares as sold because the underwriter
will buy the shares that he is not able to sell. The underwriter bears this risk in return for gains
from selling the shares at a price higher than that paid to the corporation. An investment
banker who is not willing to underwrite may handle a share issue on a best efforts basis. In this
case, the banker undertakes to sell as many shares as possible at a set price but the
corporation bears the risk on unsold shares.
Share issue costs can be quite substantial given the work involved. The costs include costs
associated with preparing, printing and filling the relevant documentation and marketing the
share issue. Various experts are consulted to ensure a successful issue.
Accounting for share issue costs is covered in paragraph 37 of International Accounting
Standard (IAS) no. 32, Financial Instruments: Presentation:
An entity typically incurs various costs in issuing or acquiring its own equity instruments.
Those costs might include registration and other regulatory fees, amounts paid to
legal, accounting and other professional advisers, printing costs and stamp duties. The
transaction costs of an equity transaction are accounted for as a deduction from
equity (net of any related income tax benefit) to the extent they are incremental costs
directly attributable to the equity transaction that otherwise would have been
avoided. The costs of an equity transaction that is abandoned are recognized as an
expense.
Per Philippine Interpretations Committee (PIC), the costs of listing shares in the stock market
are not considered as costs of an “equity transaction” since no equity instrument has been
issued and, hence, such costs are recognized as an expense in profit or loss when incurred.
They are as follows: road show presentation, public relations consultation’s fees, and stock
exchange listing fees.
Per IAS 32, paragraph 38, transaction costs that relate jointly to more than one transaction
(for example, costs of a concurrent offering of some shares and a stock exchange listing of
other shares) should be allocated on a rational and consistent basis. Examples of joint costs
are as follows: Audit and other professional advice relating to prospectus, opinion of counsel,
tax opinion, fairness opinion and valuation report, and prospectus design and printing.
SHARE ISSUANCES FOR CASH
Most share issues are for cash since the primary reason for issuing shares is to raise capital for
a corporation’s operating activities. The entries to record the issuance of shares for cash will
depend on whether the share is with or without par value.
With Par Value
Issuing Share Capital at Par
Illustration. Narsan Holdings is authorized to issue P1,000,000 ordinary shares dividend into
10,000 shares, with a par value of P100 per share. The diversified corporation issued on cash
basis 2,000 shares at par. The share issuance entry will be:
Cash
200,000
Ordinary shares
200,000
The amount of P200,000 invested in the corporation is called paid-in capital or contributed
capital. The credit to Ordinary shares increases the share capital of the corporation.
Issuing Share Capital Above Par
Illustration. Suppose the 2,000 shares were sold at P150 per share, the entry follows:
Cash
300,000
Ordinary shares
Share premium
200,000
100,000
This sale of shares increases the corporation’s contributed capital by P300,000. When the
shares with par value are sold, the proceeds should be credited to the ordinary shares
account to the extent of the par value – in this case, P200,000; with any excess to be reflected
in the share premium account. The excess of P100,000 is not a “gain”. The corporation can
neither earn a profit nor incur a loss when it issues shares to or acquires shares from its
shareholders.
Without Par Value
Issuing No-Par Share Capital
Illustration. Morning Star Travel is a domestic corporation engaged in the business of
organizing tour packages for Asian and European visitors to the Philippines. The entity which
is located at J. Bocobo st., Manila, has two classes of shares –preference shares and no-par
ordinary shares. 5,000 ordinary shares were issued for P85,000. The entry to record the issue
of these no-par shares will be:
Cash
85,000
Ordinary shares
85,000
When shares without par value are sold, the proceeds should be credited to the ordinary
share account. Accounting for issuance of preference shares is basically the same as that of
ordinary shares. Note, however, that Section 6 of the Corporation Code prohibits the issue of
no-par value preference shares.
Issuing No-Par Share Capital with Stated Value
Illustration. Suppose that Morning Star travel’s no-par ordinary shares have a stated value of
P20. The entity issued 5,000 shares at P25 per share. The entry will be:
Cash
125,000
Ordinary shares
125,000
When shares without par value are sold, the proceeds should be credited to the ordinary
shares account. If the no-par stock has a stated value, the excess proceeds over stated
value – in this case, P5 per share, may alternatively be credited to share premium.
Cash
125,000
Ordinary shares
100,000
Share Premium
25,000
SUBSCRIPTION OF SHARES
There are times when a corporation sells its shares directly to investors on a subscription basis.
The subscription contract is a legally binding contract which provides for the number of shares
subscribed, the subscription price, the terms of payment and other conditions of the
transaction. A subscriber becomes a shareholder upon subscription but the stock certificates
evidencing ownership over shares of stocks are not issued until the full collection of the
subscription.
Illustration. Warranty Auto Shop, Inc. is a quality car care center located at St. Paul St., San
Antonio Village, Makati City. Assume that 5,000 shares of P10 par value ordinary shares of
the corporation were sold on subscription at P12 per share on Sept. 1, 2019 to Ashley Langga.
Subscription installments of P24,000 and P36,000 will be due on Sept. 16 and 30, respectively.
The related entries follow:
Subscriptions Receivable
Subscribed Ordinary shares
Share premium
To record subscriptions above par.
60,000
Cash
24,000
50,000
10,000
Subscriptions Receivable
To record initial installment
Cash
24,000
36,000
Subscriptions Receivable
To record final installment.
Subscribed Ordinary Shares
Ordinary shares
36,000
50,000
50,000
Subscriptions Receivable is a shareholders’ equity account. It is presented in the statement
of financial position as a deduction from the related subscribed ordinary shares; however,
when it is collectible within one year, this may be shown as a current asset. It is debited for
the total proceeds of the subscriptions to the ordinary shares and credited for the collections
on the subscriptions.
There are instances when a subscriber fails to settle the subscriptions in full on the date
specified in the subscription contract or in the “call” made by the board of directors. In such
case, the subscribed shares are declared delinquent shares. The usual remedy is to dispose
of these shares in a public auction for the account of the delinquent subscriber. These shares
will be sold to the person who is willing to pay the “offer price” which includes the full amount
of the subscription balance plus accrued interest, cost of advertisement and expenses of
auction sale in exchange for the smallest number of shares. This person is referred to as the
highest bidder.
Illustration. Assuming the same facts as above except that the subscriber failed to settle part
of his subscriptions in the amount of P48,000. After complying with the legal procedures
pertaining to delinquency sale, a public auction was held. The offer price is P56,000 including
P3,000 accrued interest and P5,000 expenses of sale. Three bidders are willing to pay the offer
price, namely:
Lenore Loqueloque
Luz Un
Winnie Villanueva
4,300 shares
4,500 shares
4,700 shares
Loqueloque is the highest bidder. The 5,000 shares are deemed fully paid. Ashley Lagga, the
original subscriber, gets 700 shares and Loqueloque receives 4,300 shares.
Subscriptions Receivable
Subscribed ordinary shares
Share premium
To record subscriptions above par.
60,000
Cash
12,000
50,000
10,000
Subscriptions Receivable
To record partial initial installment.
Receivable from highest bidder
Interest revenues
To record auction expenses.
Cash
12,000
3,000
3,000
56,000
Receivable from highest bidder
Subscriptions Receivable
To record sale at public auction.
Subscribed ordinary shares
Ordinary shares
To record issuance of stock certificates.
8,000
48,000
50,000
50,000
If there is no bidder, the corporation may bid for the delinquent shares and the total amount
due shall be credited as paid in full in the books of the corporation. These shares shall be
considered as treasury shares. All the other entries will be the same except for the following:
Treasury Stock
Receivable from highest bidder
Subscriptions Receivable
To record purchase of own shares.
56,000
8,000
48,000
A shareholder may be sued directly by creditors to the extent of their unpaid subscriptions to
the corporation (Keller vs. COB Marketing, 141 SCRA 86)
TREASURY STOCKS
Treasury stocks are shares of stock which have been issued and fully paid for, but
subsequently reacquired by the issuing corporation either by purchase, redemption,
donation or through other lawful means. Such shares may again be disposed of for a
reasonable price fixed by the board of directors.
Section 41 of Corporation Code provides that a stock corporation has the power to purchase
its own shares for a legitimate purpose it has unrestricted retained earnings. Some of the
reasons for the purchase of treasury stock are as follows: (1) to support employee stock
compensation plans; (2) to improve the stock market price by decreasing the supply of
shares; (3) to avoid takeover by an outside party.
Paragraph 33 of International Accounting Standard (IAS) no.32, Financial Instruments:
presentation, states that, if an entity reacquires its own equity instruments, these instruments
(treasury shares) shall be deducted from equity. No gain or loss shall be recognized in profit
or loss on the purchase, sale issue or cancellation of an entity’s own equity instruments. Such
treasury shares may be acquired and held by the entity or by other members of the
consolidated group. Consideration paid or received shall be recognized directly in equity.
Treasury stock is not an asset because the corporation may not own shares itself. To reiterate,
it is reported as a deduction from the total shareholders’ equity. There are two methods of
accounting for treasury stock transactions, namely: (1) par or stated value method and (2)
cost method. In the first method, treasury stock is debited for an amount equal to the par or
stated value of the stock reacquired. The cost method is the preferred method of accounting
for treasury stocks by the accounting standard council as stated in SFAS no. 18, par. 6. Only
the cost method will be illustrated.
Purchase of Treasury Stock
When the cost method is used, treasury stock is recorded at cost regardless of whether the
share is acquired below or above par or stated value. If treasury stock is purchased for cash,
the cost is equal to the cash payment. If the treasury stock is acquired for non-cash assets
consideration, the cost is usually measured by the recorded amount of the non-cash assets
surrendered or given in exchange.
The purchase of treasury shares does not decrease the number of shares issued; only the
outstanding shares decrease. The effect of the purchase is to decrease both total assets and
total shareholders’ equity. Treasury stock transactions may affect cash flows but they have
no effect on the profit of the corporation.
Illustration. Plantation EcoResort is world class destination in Indang, Cavite. The operations
have been successful. To consolidate control over the enterprise and thus avoid a corporate
takeover by outsiders, the board of directors decided to minimize outstanding shares by
purchasing 1,500 shares with a par value of 1,000 for P2,000.
The entry will be:
Treasury stock
3,000,000
Cash
To record acquisition of treasury shares.
3,000,000
Reissuance of Treasury stock
At cost. Assume that the treasury shares were subsequently reissued at cost.
Cash
3,000,000
Treasury stock
To record reissue of treasury shares at cost.
3,000,000
Above cost. Assume that all treasury shares were reissued at P2,500 per share.
Cash
3,750,000
Treasury stock
Share premium-treasury
To record reissue of treasury shares above cost.
3,000,000
750,000
Treasury stock is always debited for the cost of the shares purchased or credited for the cost
of the shares reissued. There is no reference to par value. The excess over cost of P750,000 is
not regarded as a “gain” but as a component of share premium.
Below Cost. Assume that the 1,500 treasury shares were reissued at P1,500 per share.
Cash
2,250,000
Retained earnings
750,000
Treasury stock
3,000,000
To record reissue of treasury shares below cost.
The excess of the cost over reissue price of P750,000 should be debited to share premium –
treasury to the extent of its balance. In the absence of any balance in this account, the “loss”
is debited to retained earnings. It is assumed in the above illustration that the share premiumtreasury has a zero balance.
Retirement of Treasury Stock
The shares purchased may be subsequently retired. The ordinary shares account is reduced
by its par value. The number of shares issued is reduced by the stock retired. The treasury
stock account is credited at cost. Retirement may result in a “gain” or “loss” (note IAS 32, par.
33).
With Gain on Retirement. Assume that Plantation EcoResort purchased the treasury shares for
P750 per share. Observe that there is a “gain” on retirement if the cost of treasury shares is
less than par value.
Ordinary shares (1,500 shs. X P1,000 par)
Share premium
Treasury stock (1,500shs. X P750 cost)
To record retirement of treasury shares.
1,500,000
375,000
1,125,000
With loss on Retirement. Assume that a total of 10,000 shares have been issued at P1,500 per
share prior to the purchase of treasury shares. Plantation EcoResort purchased 1,500 treasury
shares for P2,000 per share; these were not reissued and were ultimately retired.
Ordinary shares (1,500shs. X P1,000 par)
Share premium
Retained earnings
Treasury stock (1,500 shs x P2,000 cost)
To record retirement of treasury shares.
1,500,000
750,000
750,000
3,000,000
The “loss” on retirement of P1,500,000 should be debited to the following accounts in the order
given:
(1) share premium to the extent of the credit when the share is issued;
(2) share premium from treasury stock transactions of the same class of
share;
(3) retained earnings
In relation to the illustration above, the credit to share premium applicable to the 1,500 shares
when originally issued was P750,000 (P1,500 issue-P1,000 par) x 1,500 shares. Hence, when the
shares are retired the debit to share premium is only to the extent of P750,000. The first priority
was satisfied after taking special notice of the of the limitation. There is no share premium –
treasury so the balance of P750,000 was debited to retained earnings.
Illustration. The accounts below appeared in the trial balance of Jocelyn Cruz events
Management Corporation as at December 31, 2019:
Ordinary shares, P150 par, 20,000 shares authorized,
18,000 shares issued
Subscription Receivable
Subscribed ordinary shares
Retained earnings
Share premium
Treasury stock, 1,000 shares, at cost
1.
2.
3.
4.
5.
P2,700,000
170,000
270,000
2,000,000
950,000
250,000
Total authorized ordinary shares: 20,000shares x P150 =P3,000,000
Total unissued ordinary shares:
2,000 shares x P150 = P300,000
Total issued ordinary shares:
18,000 shares x P150 = P2,700,000
Ordinary shares subscribed: P270,000
Total Shareholders’ Equity:
Ordinary shares
Share premium
Subscribed ordinary shares
Less: subscription receivable
Retained earnings
Total
Less: Treasury Stock
Total Shareholders’ Equity
6. Number of shares issued: 18,000 shares
P2,700,000
950,000
P270,000
170,000
100,000
2,000,000
P5,750,000
250,000
P5,500,000
=========
7. Number of shares subscribed : P270,000/P150 =1,800 shares
8. Number of treasury shares: 1,000 shares
9. Number of outstanding shares: 18,000 – 1,000 = 17,000 shares
SUMMARY OF THE EFFECT ON ASSETS, LIABILITIES AND EQUITY
At this point, it is useful to summarize the effects of the basic shareholders’ equity transactions
on the elements of the statement of financial position:
Transactions
assets
liabilities
shareholders’ equity
Issuance of shares
increase
no effect
increase
Purchase of treasury stock
decrease
no effect
decrease
Reissuance of treasury stock
increase
no effect
increase
OVERVIEW OF RETAINED EARNINGS
Retained earnings represent the component of the shareholders’ equity arising from the
retention of assets generated from the profit-directed activities of the corporation. At the
end of an accounting period, the income summary account of a corporation is closed to the
retained earnings account. The retained earnings account is credited with the corporation’s
profit or debited with the loss. The basic source of retained earnings is profit. Distributions to
shareholders of cash, property or stocks from unrestricted retained earnings on the basis of all
issued and fully paid shares, and all subscribed par value shares except treasury shares are
called dividends. Dividend declarations reduce retained earnings.
Other less common situations that cause increases or decreases in retained earnings are as
follows: debits resulting from reissuance of treasury stocks below cost and loss on retirement
of treasury stocks; and debits or credits for prior period errors.
Prior period errors are errors discovered in the current period that are of such significance that
the financial statements of one or more prior periods can no longer be considered to have
been reliable at the date of their issue. Note that credit entries increase the retained earnings
balance and debits decrease it.
A debit balance in the Retained Earnings may be restricted or appropriated, and unrestricted
or unappropriated. Unrestricted retained earnings are free and can be declared as
dividends. Retained earnings restrictions may be legal, contractual or voluntary.
DIVIDENDS in GENERAL
Retained earnings is not a cash fund waiting to be distributed as dividends. Instead, it is an
owners’ equity account representing claim on all assets in general and not on any asset in
particular. In fact, the corporation may have a sizeable balance in this account but may not
have cash to pay a cash dividend. Shareholders are not guaranteed dividends and
dividends do not become a liability of the corporation until the board of directors has formally
declared a dividend distribution. Section 43 of the Corporation Code states that dividends
should only be declared out of the unrestricted retained earnings. Thus, dividends cannot be
declared out of the legal capital of the corporation for the security of its creditors.
Dividends may take the form of cash, property or additional shares of stock of the
corporation. As a general rule, any form of dividend declaration should be based on the
total subscription of a shareholder and not merely on the shares already paid. Subscribers
are considered shareholders from the time their subscriptions are accepted by the
corporation and not from the time they are issued stock certificates.
The declaration and payment of dividends involve three important dates and they are:
Date of Declaration
On the date of declaration, the board of directors will adopt a resolution declaring that a
dividends is to be paid. The resolution will specify the amount, type and date of payment of
this dividend. It will also set a date of record. Cash dividends are declared solely by the
board of directors while share dividends will necessitate the concurrence at least two-thirds
of the outstanding shareholders.
Legally, declared dividends are obligations of the firm. Dividends to be paid in cash or
property become a liability on this dates. Shares distributable is also recognized. An entry is
made debiting retained earnings and crediting a dividend liability or shares distributable
account. Some corporations debit a dividends declared account instead of the retained
earnings account. This account is nevertheless closed to the retained earnings account at
the end of the year.
Paragraph 10 of IFRIC 17 provides that the liability to pay a dividend shall be recognized when
the dividend is appropriately authorized and is no longer at the discretion of the entity, which
is the date:
(a) when declaration of the dividend, e.g. by management or the board of
directors, is approved by the relevant authority, e. g. the shareholders, if the
jurisdiction requires such approval, or
(b) when the dividend is declared, e.g. by management or the board of
directors, if the jurisdiction does not require further approval
IFRIC 17 Distributions of Non- cash assets to owners was developed by the International
Financial Reporting Interpretation Committee and issued by the International Standards
Board in November 2008. Its effectivity date is July 1 2009.
Date of Record
A list of shareholders entitled to the declared dividends is prepared at the date of record. If
an investor buys a share of stock after this date, he will not receive the dividend. The share is
said to be traded ex-dividend. No entry is required on this date.
Date of Payment
The corporation settles its liability on this date. An entry is made debiting the dividend liability
or shares distributable account and crediting cash, property distributed or share capital.
CASH DIVIDENDS
Majority of dividends distributed by corporations is paid in cash. In declaring cash dividends,
a corporation must have both an appropriate amount of retained earnings and the
necessary amount of cash. Some investors view that a large retained earnings balance
automatically permits generous dividend distributions.
A corporation, however, may successfully accumulate earnings and at the same time not be
sufficiently liquid to pay large dividends. Many corporations, especially new firms in growth
industries, finance their expansion from assets generated through earnings and pay out small
cash dividends or non at all.
Dividends on par value shares are stated as a certain percentage of the par value. As to nopar value shares, the dividends are stated at a certain amount per share. When the board of
directors declares a cash dividend, an entry is made debiting retained earnings and crediting
cash dividends payable.
Illustration. Made Easy Bookstore, Inc., a nationally-known business books distribution entity,
declared a cash dividend of P12 per share of ordinary shares on July 1. The dividends are
payable on August 1 to shareholders of record on July 21. The entity has 100,000 ordinary
shares issued of which 7,000 shares are held in treasury. The entries to record the dividend
declaration and payment are as follows:

Retained Earnings*
1,116,000
Cash dividends payable
1,116,000
To record declaration of dividend.
P12 per share (100,000 issued shares – 7,000 treasury shares) = P1,116,000.
The account, cash dividend declared, may be used in place of the debit to retained
earnings. At the end of the accounting period, this temporary shareholders’ equity account
will be closed by debiting retained earnings and crediting cash dividends declared.
Cash dividend payable
Cash
To record payment of dividend.
1,116,000
1,116,000
Cash dividends payable are reported as current liabilities in the statement of financial
position. Note that cash dividends decrease total assets and total shareholders’ equity.
It is worthwhile to reiterate that with the exception of treasury shares, all issued and fully paid
shares, and all subscribed par value shares are entitled to dividends when declared. The
subscribed shares must be par value shares. No-par value shares are considered as legally
issued only when fully paid. Unissued shares, subscribed no-par value shares and treasury
shares are not entitled to dividends.
SHARE DIVIDENDS
A corporation may distribute to shareholders additional shares of the entity’s own share as
share dividends. Share dividends or bonus issues are fundamentally different from cash or
property dividends because share dividends do not transfer assets to the shareholders. This
type of dividend affects only the accounts within the shareholders’ equity. Share dividends
increase the total share capital and decrease the retained earnings account. Because both
of these are components of shareholders’ equity, total shareholders’ equity in unchanged.
From the shareholders’ point of view, a share dividend does not change their percentage
interest in the corporation although total outstanding shares have increased. The accounting
entries depend upon the size of the share dividend.
Small Share Dividends
Small share dividends are dividends in which the additional shares issued are less than 20% of
the previously outstanding shares. These share dividends are recorded by transferring from
retained earnings to share capital (ordinary shares and share premium accounts) the fair
market value of the additional shares to be issued. In cases when the fair market value is
lower than the par or stated value, the par or stated value will be the basis for recording.
Illustration. Siobel Your Japanese Fastfood, Inc., chain is blessed with years of profitable
operations for its commitment to serve affordable and healthy Japanese food favorites. The
shareholders’ equity before declaration of a 10% share dividend is as follows:
Ordinary shares, P50 par, 20,000 shares
Issued and outstanding
Share Premium
Total share capital
Retained Earnings
Total Shareholders’ Equity
P1,000,000
200,000
P1,200,000
650,000
P1,850,000
=========
The declaration of a 10% share dividend will require the issuance of an additional 2,000 shares.
Assume that the corporation’s share is being traded at the stock exchange and that the stock
market price per share is P110. The fair market value of the shares to be distributed is P220,000.
The entries will be:
Retained Earnings
220,000
Shares Distributable
Share premium
To record declaration of 10% share dividends.
100,000
120,000
Shares Distributable
Ordinary shares
To record issuance of share dividends.
100,000
100,000
Retained Earnings (or the temporary account, share dividends declared) is debited for the
fair market value of the share dividends. Shares distributable is credited for the par value of
the shares to be distributed and share premium for the balance.
If a statement of financial position is prepared between the declaration date and the
distribution date of a share dividend, the shares distributable account will be shown in the
shareholders’ equity immediately after the ordinary shares account.
When the share is distributed, only the components of the shareholders’ equity changes;
retained earnings decreased by P220,000 (P650,000 minus P430,000) and total share capital
increased by P220,000 (P1,420,000 minus P1,200,000). The total shareholders’ equity did not
change.
A comparison of the shareholders’ equity and outstanding shares before and after the share
dividend appears below:
Ordinary shares, P50 par, 20,000 shares
Issued and outstanding
Share Premium
Total Share Capital
Retained Earnings
Total Shareholders’ Equity
Shares Issued and Outstanding
Before
After
Increase/(decrease)
P1,000,000
200,000
P1,200,000
650,000
P1,850,000
=========
20,000
========
P1,100,000
320,000
P1,420,000
430,000
P1,850,000
=========
22,000
=======
P100,000
120,000
220,000
(220,000)
========
2,000
=====
The receipt of a share dividend does not alter the relative position of a shareholder. If a 10%
share dividend is distributed, all shareholders increase their proportionate holdings by 10%,
and the total share outstanding is increased by the same proportion. No profit is realized by
the shareholders.
Large Share Dividend
If the share dividend is 20% or more of the previously outstanding shares such that the effect
is to reduce materially the market value per share, then only the par or stated value is
credited to ordinary shares with a corresponding debit to retained earnings.
Illustration. Assume instead that Siobel Your Japanese Fastfood, Inc., chain declared a 20%
share dividend on its 20,000 issued and outstanding P50 par value shares. The corporation
will issue additional 4,000 shares due to the share dividend. The entries will be:
Retained Earnings
200,000
Shares Distributable
To record declaration of 20% share dividends.
200,000
Shares Distributable
200,000
Ordinary shares
To record issuance of share dividends.
200,000
The account titles used to record a large share dividend are the same as those for small share
dividends. Note though that the balance in the account – share premium remained the
same; this is because large share dividends are recorded at par value.
Ordinary shares, P50 par, 20,000
Shares issued and outstanding
Share Premium
Total Share Capital
Retained Earnings
Total Shareholders’ Equity
Shares Issued and Outstanding
Before
Dividends
After
dividends
Increase
(decrease)
P1,000,000
200,000
P1,200,000
650,000
P1,850,000
=========
20,000
======
P1,200,000
200,000
P1,400,000
450,000
P1,850,000
=========
24,000
======
P200,000
P200,000
(200,000)
=======
4,000
======
STATEMENT OF RETAINED EARNINGS
This statement is not required per revised International Accounting Standard (IAS) no. 1. The
required financial statements were enumerated in an earlier chapter. A retained earnings
statement is normally divided into two major sections:


Appropriated. This section presents the beginning balance of the retained earnings
appropriated account, any additions or deductions during the period, and ending
balance.
Unappropriated. This section shows the beginning balance of the retained earnings
unappropriated account, correction of prior period error, profit or loss for the period,
dividends, transfers to and from the appropriated and unappropriated accounts, and
the ending balance.
The statement concludes with the total retained earnings as of the end of the period. An
example of a retained earnings statement follows:
Dynasty Bookstore Asia Corporation
Statement of Retained Earnings
For the year ended December 31. 2019
Appropriated:
Balance, 1/1/2019, as reported
For plant expansion
For treasury stock, 4/8/2019
Retained earnings Appropriate, 12/31/2019
Unappropriated:
Balance, 1/1/2019, as previously reported
Correction of prior period error
Balance, 1/1 2019, as restated
Add: Profit
Total
Less: Cash dividend declared
P 65,000
Share dividend declared
60,000
Transfer to appro. For treasury
100,000
Retained Earnings Unappropriated, 12/31/ 2019
Total Retained Earnings
P 180,000
100,000
P 280,000
P1,414,500
100,000
P1,514,500
480,000
P1,994,500
225,000
1,769,500
P2,049,500
=========
Multiple choice: