CHAPTER 1
INTRODUCTION TO ACCOUNTING
(Fundamental Theories & Principles of Accounting)
Importance of Studying Accounting
In our day to day activities, we failed to realize that we have been working with accounting concept
and accounting information . Whatever we do, wherever we go, which involve decision making, accounting
is unconsciously applied. It has always been part of our daily struggle for survival. Thus studying accounting
is beneficial to everyone regardless of whatever profession one has.
Accounting is the process of identifying , measuring and communicating economic information to
permit informed judgment and decisions by users of information. Accounting is vital to any business
organization. It is equally essential to the successful operation of non-profit organization, governments units
or agencies and to non-government organization .
Importance of Accounting in Business
Profit is among the primary concern of any business organization. To be successful depends to a
great extent on the ability of the management to plan, control and render decisions. Management is likely
to give appropriate decision if furnished with relevant, accurate and timely data. With accounting,
management is provided with information essential to the effective conduct and evaluation of its business
activities.
Forms of Business Organization
Sole Proprietorship. This business organization is owned by one person called the proprietor who
generally is the manager. The owner receives all profits and absorbs all losses and is solely
responsible for the debt of the firm.
Partnership. Partnership is owned by two or more persons who bind themselves to contribute
money, property or services to the common fund, with the intention of dividing the profits among
themselves. Each partner is personally liable for any debts of the firm . It is easily formed and
dissolved.
Corporation. Corporation 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. It is owned by the stockholders and managed by the Board of Directors. Stockholders
are not personally liable for the corporation’s debt. The accumulated profit of a corporation is called
“Retained Earnings”. Stockholders receive their share in the profits of the corporation in the form of
“Dividends”.
Cooperatives. Cooperatives is a duly registered association of persons, with common bond of
interest, who have voluntarily joined together to achieve a lawful common social or economic end,
making equitable contributions to the capital required and accepting a fair share of the risks and
benefits of undertakings in accordance with universally accepted cooperative principles.
Types of Business Activities.
A Service Companies perform services for a fee. Law firm, Accounting firm, hotels, parlor shops,
hospitals, transportations & communications services and the like are typical examples of service
concern .
A Merchandising Company sells goods in substantially the same physical form it was acquired. It
is better known as “trading concern” or “buy and sell”. Hardware, bookstore, drugstore, department
store, supermarkets, sari-sari store and the like are good example of a merchandising concern.
A Manufacturing Company converts raw materials into finished product and sell them to other
companies or to end consumers. Multinational companies such as Dole, Pharmaceuticals, Cements,
Flours, Toyota Companies are engaged in producing their respective products.
An Agribusiness is engaged in the operation that are associated with farming like that of planting
of crops and sells its product for a profit.
Accounting Information System
Realizing the significance of accounting information, most business and non-business entity design
and install suitable Accounting Information System which will generate reliable financial information needed
by the decision makers in a timely manner. An Accounting Information System is the combination of
personnel, records and procedures that a business uses to meet its need for financial information.
An Accounting Manual is a guidebook that specifies the policies and procedure to be followed in
accumulating information within the Accounting Information System.
Keeping of Business Records as Required by Law
Maintaining a business record is a mandatory government requirement. Section 232A of the Internal
Revenue Code of the Philippines requires all corporations, companies, partnerships or persons which are
required by law to pay internal revenue taxes to keep books of accounts and records in accordance with
the standard accounting system. It is also done in compliance with Municipal of City ordinances regarding
local business taxation.
Who does the Recording, Accounting & Examination Process?
Basically, a “bookkeeper” does the recording process while the “accountant” transform accounting
data into a report form called “financial statements” . Accountants also analyze as well as interpret the report
thereof. Usually, accountant provides the owner with a guide and a basis for formulating and adapting
financial plans and policies that will lead to efficient management, thereby business goals and objectives
are attained . On the other hand, “Auditors” examines the financial statements that was prepared by the
accountant and renders an opinion as to its fairness and reliability of the report.
Generally Accepted Accounting Principle (GAAP)
Generally Accepted Accounting Principles are uniform set off accounting rules, procedures, practices
and standards that are followed in financial statement preparation . In the Philippines, the accounting
standards promulgated by the Accounting Standard Council constitute the GAAP.
Basic Accounting Concept/ Assumptions
1. Accounting Entity Concept. This assumes that business has a separate and distinct personality
from that of the owner.
2. Going-Concern Assumption. This assumes that the business has continuous life of existence
unless there is specific evidence to the contrary.
3. Periodicity Concept. This assumes that life of a business entity is meaningfully divided into equal
period such that financial statement are prepared every end of accounting period.
An Accounting period can be period of : 1- month (monthly basis); 3- months (quarterly basis); 6months (semi-annual basis) or 12- months (annual basis of yearly basis).
An accounting period of less than a year is called “fiscal period” and financial statements prepared
for less than a year are referred to as “Interim financial statements”.
3
Kinds of Annual Accounting Periods:
1. Calendar Year- Accounting period that starts at January 1 and ends at December 31 of that
year.
2. Fiscal Year – Accounting period will begin on the first day of any month of the year except
January 1 and will end on the last day of the twelfth month completing the one year period
3. Natural Business Year- is a twelve month period that ends on any month when the business is
at the lowest or experiencing slack season.
4.
Unit of Measure Assumption- This assume that peso is our unit of measure and the purchasing
power will not fluctuate and therefore, is stable.
5. Accrual Basis Assumption- This assumes that recording of income and expense follow the
accrual basis of accounting, where income is recognized when earned regardless of when received,
and expense is recognized when incurred regardless on when paid.
Basic Accounting Principles
The following are among the basic accounting principles that guides accountant in the accumulation
of financial information:
1. Objectivity Principle. This principle states that accounting record and statements should be
based on the most reliable data available so that they will be as accurate and as useful as
possible . All records should be supported by evidences such as official receipts, bill of payments,
vouchers, payrolls and the like.
2. Historical Cost. This principle states that acquired assets should be recorded at their actual
cost not at what management think they are worth at reporting period.
3. Revenue Recognition Principle. Revenue is to be recognized in the accounting period when
foods are delivered or services are rendered or performed.
4. Matching Principle. Expenses should be recognized in the accounting period in which the
goods and services are used that produce revenue and not when the entity pays for those
goods and services.
5. Consistency Principle. The firm should use the same accounting method from period to
achieve comparability over time. However, changes are permitted if justifiable and is disclosed
in the financial statements.
6. Materiality . Financial reporting is only concerned with information that is significant enough to
affect evaluation and decision.
7. Conservatism. Frequently, assets and liabilities are measured in a context of major uncertainties.
Accountants generally choose a method or procedure that yield the lesser amount of income
and asset value. This attitude is often expressed in the statement “ anticipate no profits and
provide for all losses”
8. Timeliness. Accounting information is communicated early enough to be used for the economic
decision that it might influence
9. Adequate Disclosure. This requires that all relevant information that would affect the users’
understanding and assessment of the accounting entity be disclosed in the financial statements.
The Five (5) Elements of Financial Statements
1. Assets. Are things of value that are owned and used by the enterprise in its operation. Asset
is defined as “ resources controlled by the enterprise as a result of past transactions and events
and from which future economic benefits are expected to flow to the enterprise”. Examples are
cash, accounts receivable, inventories, supplies, prepaid expenses, land , building, equipment ,
tools, intangible assets and other assets.
2. Liabilities. Are financial obligation of the business to its creditors. It represents the claim of the
creditors over the assets of the enterprise. Liabilities are defined as “ present obligations of an
enterprise arising form past transactions or events, the settlement of which is expected to result
in and outflow from the enterprise of resources embodying economic benefits”. Examples are
Accounts payable, accrued expenses, taxes payable, Loan payable , bond payable and others.
3. Owner’s Equity or Capital. Is the residual interest in the assets of the enterprise after deducting
all its liabilities. It is increased when there is Net Income or additional contribution by owner
and decreased when there is Net Loss or withdrawal by the owner. Capital is synonymous to
“Proprietorship”, “Proprietary Interest” or “Net Worth”. “Owner’s Equity”, “Partnership Equity” or
“Stockholder’s Equity” are the appropriate terms respectively for a sole proprietorship, partnership
and corporation form of enterprise.
4. Revenue. Is defined as “gross inflow of economic benefits during the period arising in the
course of ordinary activities of an enterprise when those inflows result in increase in equity ,
other than those relating to contributions”. Examples are proceeds from services rendered by
a servicing firm, income from use by other entities of the resources of the enterprises like
royalties income, rent income, interest income, etc and sale of merchandise for trading firm.
5. Expense. Are the “gross outflow of economic benefits during the period arising in the course
of ordinary activities of an enterprise when those outflows result in decrease in equity , other
than those relating to distribution to owners”. Examples are salaries expense, rent expense,
supplies expense, etc.
Net Income or Net loss. The excess of revenues over expenses is called “Net Income” while
“ Net Loss” occurs when expense exceeds the revenue.
The Financial Statements
The financial statements are the means by which the information accumulated and processed in
financial accounting are periodically communicated to the users. The objectives of financial statements is
to provide information about the financial position, performance and cash flows of the enterprise that is
vital in making a sound economic decision. There are five (5) basic financial statements as per ASC # 1
Revised 2000) namely:
1. Balance Sheet. It shows the financial position of an enterprise as of particular date. It shows
the Assets, Liabilities & Owner’s Equity thru which the enterprise’ liquidity, solvency, financial
structure and capacity for adaptation could be measured and evaluated.
2.
Income Statement .It shows the performance of the enterprise for a given period of time. This
statement present the result of operation of an enterprise, which would either be an net income
, net loss or break-even .
3.
Statement of Changes in Equity. It summarizes the changes in equity for a given period of
time. The beginning equity of the owner is increased by the additional investment and net
income. Correspondingly, it is decrease by withdrawals and not loss.
4.
Statement of Cash Flow. This provides information about cash inflows (receipts) and cash
outflows (payments) of an entity for a given period of time which are being classified into :
a) Operating Activities ; b) Investing Activities ; and c) Financing Activities.
5.
Accounting Policies and Notes to Financial Statements. This is an additional statement and
considered also as basic statement. This presents significant accounting policies that affected
the financial statements and other disclosures necessary to make the financial statements more
useful.
Users of Financial Statements:
1.
Investors. They need information to help them determine whether they should add more or
withdraw their capital investment. Stockholders are interested on information which enables them
to assess the ability of the enterprise to pay dividend
2.
Employees. They are interested on information about the stability and profitability of the
enterprise. They are interested on information which enables them to assess the ability of the
enterprise to provide remuneration , retirement benefits and employment opportunities.
3.
Lenders/ Creditors. Are interested on information which enables them to determine whether
their loans and interest thereon will be collected when due.
4.
Suppliers . They are interested on information which enables them to determine whether
amounts owing to them will be paid on maturity.
5.
Customers. They have an interest on information about the continuance of an enterprise
especially when they have a long-term involvement with or are dependent on the enterprise.
6.
Government and their agencies. These users require information to regulate the activities of
an enterprise, determine taxation policies and as a basis for national income and similar
statistics.
7.
Public. Enterprises affect members of the public in a variety of ways. For example, enterprises
make substantial contributions to the local economy in many ways including the number of
people they employ and their patronage of local suppliers. Financial statements may assist the
public by providing information about the trends and recent developments in the prosperity of
the enterprise and the range of its activities.
8.
Management. They utilize information to set goals for their organization, to evaluate results of
past economic decision and to control activities of the entity. Managers use financial information
for planning, controlling and for decision-making purposes.
(Note: 1-7 are referred to as external users, while 8 is considered internal users.)
Accounting as “ Language of Business”
The entity concept of accounting emphasize that “ business has distinct personality separate from
that of the owner”. As a separate unit, the means thru which business communicates to owner and to
various interested parties about its performance, accomplishments, status and conditions are done thru the
financial statements. This accounting reports uses distinct technical terms or accounting terminologies which
are understandable in the business world. Thus financial statements become the “bridge of communications”
between them. With the relevant quantitative information it provides to concerned parties, accounting is
said to be the “language of business entity”.
Accounting Defined
Accounting according to American Institute of Certified Accountants, is the art of recoding, classifying
and summarizing in a significant manner and in terms of money, transactions and events which are in part
or at least of financial character and interpreting the results thereof.
Accounting is a service activity. Its function is to provide quantitative information, primarily financial
in nature about economic entity that is intended to be useful in making economic decisions.
Phases of Accounting
The above definition implies the four (4) major function of accounting , namely:
Recording. Means putting into writings business transactions in chronological order, thru the double
entry bookkeeping method, in the journal and ledger books
Classifying. Is the sorting or grouping of similar transactions or items. Classification reduces the
effects of numerous transactions into useful groups or categories.
Summarizing. Is done at the end of the accounting period thru the preparation of Financial
Statements or financial reports
Interpreting. It is the analytical portion of accounting. Financial Statement will be meaningful and
Beneficial to management if duly analyzed and interpreted.
CHAPTER 2
ANALYSIS OF BUSINESS TRANSACTION, ACCOUNTING EQUATION
AND THE RULE OF DEBIT AND CREDIT
Business Transaction
Business transactions are the economic activities of a business which can be measured and expressed in
terms of money. Business transactions are exchanges of equal monetary values, meaning for every value received,
another value is given away as an exchange. This is the “give and take” process of accounting as expressed in an
equation “Value Received = Value Parted”.
Account Titles
Account Titles are identifications or brief descriptions of items that fall to some kind, class or nature. In
recording business transactions, the elements of financial statements are to be assigned with their individual names
called “account titles”
Classification of Account Titles:
a) Balance Sheet Accounts- (financial position), referred to as real accounts
b) Income Statement Accounts- (performance), referred to as nominal or temporary Accounts
BALANCE SHEETS ACCOUNTS
ASSETS-are classified only into two, namely current assets and non-current assets.
Current Assets- refer to all assets that are expected to be realized, sold or consumed within the enterprise’s normal
operating cycle. Operating cycle is the interval of time from the date of acquisition of merchandise inventory; sell
inventory to customers and the ultimate collection of cash from the sale.
Cash- the account title used to describe money, either in paper or in coins and money substitutes like checks,
Postal money orders, bank drafts and treasury warrant. “Cash on Hand” is the account title used
when
Cash is
within the premise of the business and “Cash in Bank” if deposited in the bank.
Petty Cash Fund- the account title for money placed and set aside for petty or small expenses. This exist
when
Business used the imprest system of keeping cash.
Notes Receivable- this is a promissory note that is received by the business from the customer arising from
rendering of services, sale of merchandise, etc.
Accounts Receivable- the account title for amounts collectible arising
customer
or client on credit, or sale of goods to customers on accounts.
from services rendered to a
Allowance for Bad Debts- this is an “asset offset” or a “contra-asset” account. It provides for possible
losses
from uncollected accounts. Though this is not actually an asset, it is classified as such because it
is
shown as a deduction from the Accounts Receivable which is a Current Asset Account.
Accrued Interest Income- the amount of interest earned on a Notes Receivable which is not yet collected.
(If
the note is interest-bearing)
Advances to Employees- the account title for amounts collectible from employees for allowing them to
make
cash advances which are deductible against their salaries or wages.
Inventories- are assets which are: held for sale in the ordinary course of business; in the process of
production
for such sale; or in the form of materials or supplies to be consumed in the production process or
in the
rendering of services.
Prepaid Expenses- account title for expenses that are paid in advance but are not yet incurred or have not
yet
expired such as Prepaid Rental, Prepaid Insurance.
Unused Supplies- an account title for cost of stationery and other supplies purchased for use but are left
on
hand and still unused.
Non-Current Assets.- are all other assets not classified as current assets.
Property and Equipment- are tangible assets which are held by an enterprise for use in production or
supply
of goods and services, for rental to others, or administrative purposes, and are expected to be
used
during more than one period .
Land- an account title for the site where the building used as office or store is constructed.
Building- account title for a finished construction owned by the business where operations and transactions
took place.
Equipment- includes calculators, typewriters, adding machine, computers, steel filing cabinets and the like.
If
these are used in the office, the account title is “Office Equipment” and if used in the store, “Store
Equipment”. Trucks, jeeps, vans, automobiles and other kinds of motor vehicles bear the account
title
as “Transportation Equipment” and if some vehicles are used exclusively for delivering goods, the
account title is “Delivery Equipment”
Furniture & Fixtures- includes chairs, tables, counters, display cases and the like.
Accumulated Depreciation- this is an “asset offset” or “contra-asset” account. This is called a “Valuation
Account” which is shown as a deduction from property and equipment or cost of the fixed assets.
LIABILITIES- are classified only into two, namely: current liabilities and non-current liabilities.
Current Liabilities- are financial obligations of the enterprise which are (a) expected to be settled in the normal
course of the operating cycle, (b) due to be settled within one year from the balance sheet date.
Accounts Payable- an account title for a financial obligation of an enterprise that constitutes an oral or
verbal
promise to pay.
Notes Payable (short -term) - same as Accounts Payable in nature but only the obligation is evidenced
by a
promissory note. The enterprise is the one who issued the note.
Accrued Expenses- these are expenses incurred by the enterprise but are not yet paid. This normally
occurs
when the accounting period ended such as rent, salaries, interest, taxes payable, etc.
SSS Premium Payable- refers to the amount due and payable by the enterprise to the
Social Security
System. This is composed of both employer and employees’ shares of SSS contributions.
Pag-ibig Premium Payable- refers t the amount due and payable by the enterprises to Home Development
Mutual Fund. This is composed of both employer and employees’ shares of Pag-ibig contributions.
Withholding Tax Payable- refers to the amount due and payable by the enterprise to the Bureau of Internal
Revenue for the tax withheld from employees.
Pre-collected or Unearned Income- this is an account title for an income collected or received in advance
and
are not yet considered as “earned”
Non-current liabilities- are financial long term obligations of an enterprise which are due and payable for more
than
one year. This usually occurs in a corporate form of business organization.
Notes Payable (long term)- same nature with that of Notes Payable 9short-term) but only, this requires
payment for more than a year.
Mortgage Payable- a financial obligation of the enterprise which requires a fixed or tangible property to be
pledged as a collateral to ensure payments.
OWNER’S EQUITY
Capital- this is the center of the owner’s concern because this may increase or decrease at anytime as a
result
of business operations. In the normal course of operation, owner’s equity will be increased by
“income”
and decrease by “ expenses”.
Withdrawal (Drawing or Personal)- refers to the amount or cash value of the property that the owner
has
invested in the enterprise but later withdrawn for personal use.
Income & Expense summary- this is a temporary account created at the end of the accounting period
where
Income and Expenses are temporarily closed to this account.
INCOME STATEMENT ACCOUNT
INCOME or REVENUE
Sales- in general, this represent revenue derived from the sale of merchandise.
Service Income- in general , this is the account title used for all types of income derived from rendering of
services. Sometimes the account title used is “Service Revenue”. Other specific income account
titles
used are:
Professional Income- the account title generally used by professionals for income earned from the
practice of
their profession or may be specified as “Accounting or Auditing Fees Income” for accountants,
Legal
Fees Income” for Lawyers, “Dental Fees Income” for Dentists, “Medical Fees Income” for doctors,
etc.
Rental Income- for income earned on buildings, space or other properties owned and rented out by the
business as the main line of its activity.
Interest Income- for income received by the business arising from an amount of money borrowed by a
customer and is usually covered by a promissory note. This is typical in a lending institutions.
Miscellaneous Income- for income earned by the business which is not the main line of its activity and
could
not be clearly classified.
EXPENSES
Cost of Sales or Cost of Goods Sold - cost to produce and sell the goods.
Rent Expense- for the amount paid or incurred for use of property or premises.
Repairs and Maintenance- for expenses incurred in repairing or servicing the buildings, machineries,
vehicles,
equipment, etc., which are owned/used by the business.
Office Supplies Expense- the stationery, envelopes, clips, fastener, etc, used in the office will bear the
account
title as “Office supplies”; if use in the store “Store supplies”.
Salary Expense- for compensation given to employees of a business. It may be specified as “Office
Salaries”,
Salesman’s Salaries”, etc.
Bad Debts- for the anticipated loss that the business may incur arising from uncollectible accounts.
Depreciation Expense- the allocated expired portion of the cost of property and equipment or fixed
assets.
Taxes and Licenses- for the amount paid for business permits, licenses and other government dues except
the
Income Tax paid which is not allowable by law as a deduction.
Insurance Expense-account title for the expired portion of the insurance premium paid.
Utilities Expense- the account title for telephone, light and water bills. Also included is gasoline, lubricants &
oil.
SSS contribution- account title for the employer’s share on SSS contribution.
Philhealth Contribution- the account title used for the employer’s share on Medical Care contribution.
Pag-ibig contribution- the account title used for the employer’s share on Pag-ibig contribution.
Miscellaneous Expense - Any amount paid as expense which is not significant enough to warrant a
particular
classification.
The Account
An account is an accounting device use to summarize the effect of changes in Assets, Liabilities and
Owner’s Equity. The simplest form of the account is known as the “T- Account”. A T-account is divided into two
sides, the left side-hand is called the “debit side” and the right –hand side is called the “credit side”. The left-hand
side or debit side shows the value received while the right –hand or credit side shows the value parted with of
transaction analysis.
ACCOUNT TITLE
Left-Hand Side
or
Debit side
Is for
Value Received
Right –Hand Side
or
Credit Side
is for
Value Parted With
Thus, an amount entered on the left-hand side of the account is called a “Debit Entry” while the amount
entered on the right –hand side is called a “credit entry”. The abbreviation of debit and credit are: Dr. and Cr.
respectively.
Account Balance
The difference between the total debit and total credit of an account is called an “Account Balance”. If the
total of the debit side exceeds the total of the credit side, the account is said to be in a “Debit Balance”. Conversely,
if the total of the credit side exceeds the total of the debit side, the account is said to be in a “Credit Balance”. If the
debit total equals with that of the credit total, the account is said to be “In-Balance” or “Closed Account”.
Principle of Debit and Credit- Double Entry System
Accounting is based on a double-entry system , which means that the dual effect of a business transaction
is recorded. Note that in every business transaction, there is always the value received and a value parted . To
record , the value received is debited and the value parted with, is credited. The word “double” means at least “
two” accounts is affected for every transaction with the total debits equal to the total credit. Thus, the equation
is always maintained as follows:
Value Received = Value Parted With
or
Debit = Credit
Accounting Equation
The accounting equation is the most basic tool of accounting. 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 the assets must always equal liabilities and owners’ equity which also implies that the Assets of the business
was provided by the creditors and the owners. The basic accounting model is:
ASSETS= LIABILITIES + OWNER’S EQUITY
Considering that owner’s equity is affected by Income, Expense and Drawing Accounts, the accounting
equation is expanded and restated as follows:
ASSETS = LIABILITIES + OWNER’S EQUITY (+income- Expense – Drawing)
Normal Balances of Accounts
The Accounting Equation, ASSETS = LIABILITIES + OWNERS’S EQUITY reflects the normal balance of
the three Accounting Values. This means that the left side of the equation which is assets, normally has a debit
balance while the right side of the equation, Liabilities & Owners Equity normally has a credit balance.
Rules of Debit and Credit
Additions and subtractions in the recording process are done by “side positioning”. Account with normal
balance of debit, such as Asset, is increased by entering the amount on the debit side and is decreased by entering
the amount on the credit side. Account with normal balances of credit such as Liabilities & Owner’s Equity are
increased by entering the amount on the credit side, while it is being decreased if entered on the debit side . Thus
the rule of debit and credit is stated as follows:
ACCOUNT
NORMAL BALANCE
TO INCREASE
DEBIT
CREDIT
CREDIT
CREDIT
DEBIT
DEBIT
DEBIT
CREDIT
CREDIT
CREDIT
DEBIT
DEBIT
ASSETS
LIABILITIES
OWNER’S EQUITY
REVENUE
EXPENSES
DRAWINGS
TO DECREASE
CREDIT
DEBIT
DEBIT
DEBIT
CREDIT
CREDIT
Financial Transaction Worksheet
A financial transaction worksheet is a form used to analyze the effect of business transaction to the
assets, liabilities or owner’s equity of the business entity. Every business transaction may either increase or
decrease the assets, liabilities and/or owner’s equity without affecting the equality of the accounting equation.
Under the double entry system, the equality of the basic accounting model, Asset = Liability + Owner’s Equity is
always maintained.
Effects of Transactions
A business transaction has a dual but self-balancing effect on the accounting equation . The effect of a
transaction to the equation may be grouped into nine types as follows:
1)
2)
3)
4)
5)
6)
7)
8)
9)
Increase in Assets= Increase in Liabilities
Increase in Assets= Increase in Owner’s Equity
Increase in One Asset= Decrease in another Asset
Decrease in Assets = Decrease in Liabilities
Decrease in Assets = Decrease in Owner’s Equity
Increase in Liabilities = Decrease in Owner’s Equity
Increase in One Liability = Decrease in another Liability
Increase in Owner’s Equity = Decrease in Liabilities
Increase in One Owner’s Equity = Decrease in another Owner’s
CHAPTER 3
RECORDING BUSINESS TRANSACTION
ACCOUNTING CYCLE
The accounting cycle refers to a series of sequential steps or procedures performed to accomplish the
accounting process. The steps of Accounting Process is as follows:
Step 1 Identification of Events to be Recorded
Step 2 Transactions are Recorded in the Journal
Step 3 Journal Entries are posted to the Ledger
Step 4 Preparation of a Trial Balance
Step 5 Preparation of the Worksheet including Adjusting Entries
Step 6 Preparation of the Financial Statements
Step 7 Adjusting Journal Entries are Journalized and Posted
Step 8 Closing Journal Entries are Journalized and Posted
Step 9 Preparation of a Post-closing Trial Balance
Step 10 Reversing Journal Entries are Journalized and Posted
1. Transaction analysis- is the first step of the accounting cycle. The basic steps in analyzing transactions are:
1. Identify the transaction from source documents ( e.g. sales invoice, cash register tapes, official
receipts, bank statements….etc.)
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.
2. Transaction are journalized- is the second step of the accounting cycle.
Recording involves the writing down of business transaction in a systematic manner and in order
of their occurrence in the Journal. A journal is a chronological record of entity’s transaction. It is also called
the book of original entry. Journalizing is the process of recording transaction. The simplest journal is the
General
Journal. Other kind of journal is the Special Journal.
A general journal have the following standard contents: date column, particulars posting
reference(P.R.), debit column and credit column. Shown below is the formation of a simple journal entry:
Year
Month
Day
Particulars
PR
Debit item
Credit item
Explanation of the
Nature of transaction
Debit
1,750.35
Page no.
Credit
1,750.35
In journalizing, the rules of double-entry system are observed in each transaction. The value
received is debited while the value parted is credited. The sum of the debits for every transaction equals
the sum of the credits; and the equality of the accounting equation is always maintained.
Opening Entry is the first entry made in the general journal such as the recording of the initial
investment of the owner who for the first time engage into business.
Other set of books used by the business is a ledger, which has two kind: the General Ledger
and the Subsidiary ledger. A General ledger is the “reference book” of accounting system and is used to
classify and summarize transactions. A ledger is a “group of accounts” called the book of final entry.
It is in this book where transaction that were recorded in the journal are transferred for final recording.
The accounts in the general ledger are classified into two general groups:
1. Balance Sheet or permanent accounts (assets, liabilities and owner’s equity). Sometimes
called real account.
2.
Income Statement or temporary account (income and expenses) . Sometimes called
nominal account.
Each account has its own record in the ledger. Every account in the ledger maintains the basic
format of the T-account. The left- hand side is called a debit while the right side is called credit. Each side
has the column for the : date, Particulars, Folio or Journal Reference and the money column. A ledger
organizes information by account. Shown below is the format of a T – account in a general ledger:
Year
Month
Particulars
Day
ACCOUNT TITLE
F
Debit
Year
Month
Particulars
Day
Page No.
F
Credit
Chart of Accounts is a list of all the accounts and their account numbers in the ledger. It shows
account titles which are arranged in the financial statement order, that is, Asset, Liabilities, Owner’s Equity,
Income and Expenses. Presented below is the chart of accounts of Royal Blue Services:
Royal Blue Services
Chart of Accounts
ASSETS
Page
No.
Account
No.
INCOME
Page
No.
Account
No.
1
2
3
4
5
6
7
8
9
111
112
113
114
115
116
117
118
119
Cash
Accounts Receivable
Supplies
Prepaid Rent
Prepaid Insurance
Service Vehicle
Accumulated Depreciation
Office Equipment
Accumulated Depreciation
19
441
20
21
22
23
24
25
551
552
553
554
555
556
10
11
12
13
14
15
221
222
223
224
225
226
LIABILITIES
Notes Payable
Accounts Payable
Salaries Payable
Utilities Payable
Interest Payable
Unearned Service Fee
26
27
28
557
558
559
16
17
18
331
332
333
OWNER’S EQUITY
Royal, Capital
Royal, Drawing
Revenue and Expense Summary
Service Income
EXPENSES
Salaries Expense
Supplies Expense
Rent Expense
Insurance Expense
Utilities Expense
Depreciation ExpenseService Vehicle
Depreciation ExpenseMiscellaneous Expense
Interest Expense
3. Posting -is the third step of the Accounting Cycle.
Posting is the process of transferring entries from the journal to the ledger. The transfer of entries
from the journal to the ledger is actually the sorting process or “classifying aspect of accounting” as each
value is place according to its kind, class or nature.
In posting, debits in the journal are posted as debits in the ledger, and credits in the journal as
credits in the ledger. The following are the steps in posting:
1. Transfer the date of the transaction from the journal to the ledger.
2. Transfer the page number from the journal to the journal references (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.
Footing is the process of adding each of the two amount columns of an account or item in the
general ledger and finding their balances thereof. If the account is a credit balance, meaning credit total is
greater than debit total, the difference is placed in the credit column. If the account is debit balance,
meaning debit total is greater than the credit total, the difference is placed in the debit column.
After footing, those accounts with a “debit” or “credit” balances are said to be accounts with “open
balances” or referred to as “open accounts”.
4. Trial Balance Preparation - is the fourth step of the Accounting Process
After footing, accounts in the ledger with open balances are listed down with their respective
balances, in a summary report called Trial Balance. This is done to check the mathematical accuracy in
posting and footing and to verify the equality of debits and credit in the ledger at the end of each accounting
period . But the equality of debit and credit does not signify the absence of any error at all.
The following is the procedures in the preparation of a trial Balance:
1. List the account titles in the General Ledger with “open balances ” following the sequences of
filing the accounts in the ledger.
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 and “double rule” if total debits equal total credits.
A trial balance is of two forms: “Trial Balance of Balances” and “Trial Balance of Totals”. Shown
below is the trial balance of Royal Blue Services.
Royal Blue Services
Trial Balance
May 31, 2012
Cash
Accounts Receivable
Supplies
Prepaid Rent
Prepaid Insurance
Service Vehicle
Office Equipment
Notes Payable
Accounts Payable
Utilities Payable
Unearned Service Revenue
Royal, Capital
Royal, Drawings
Service Income
Salaries Expense
Utilities Expense
Total
P
DEBIT
44,400
24,000
36,000
16,000
28,800
840,000
120,000
CREDIT
P 420,000
106,000
2,800
20,000
500,000
28,000
124,800
27,600
8,800
P 1,173,600
========
_________
P 1,173,600
=======
Errors in the Trial Balance
The trial balance is said to be a control device that help detect and minimize accounting errors. The
inequality of the totals of the debit and credit indicates that an error and/ or omissions have been committed .
There are cases too where errors and omissions are committed yet the trial balance total are equal.
The following cases would result to the inequality of trial balance :
1. Errors in preparing the trial balance
1. Incorrect addition of the debit and/or credit column
2. Incorrect recording of the account amount on the trial balance
* transposition
* slide
3. A debit balance was recorded on the trial balance as credit ; or a
credit balance was recorded on the trial balance as debit.
4. Omission of the entire amount on the trial balance
2. Errors in determining the account balances:
1. Incorrect computation of balance (addition and/or subtraction process)
2. A balance was entered in the wrong balance column
3. Error in posting a transaction to the ledger
1. Omission of a debit or credit posting
2. A debit entry was posted as a credit or vice versa.
3. Incorrect amount was posted to the account.
The following are errors and omissions committed that will still result to equality of the totals of debit and
credit
of trial balance:
1.
2.
3.
4.
5.
6.
Failure to record transaction in the journal
Both debit and credit of journal entry may not have been posted in the ledger.
Recording the same transaction more than once.
Recording an entry but with the same erroneous debit and credit amounts
Correct journal entry amount may have been posted to a wrong account.
Inappropriate use of account title in the journal that was carried to posting in the
ledger.
The following is the suggested approach to locate an error in the trial balance:
1. Check the addition of the debit and credit column of the trial balance;
2. Check whether the corresponding amount of each of the listed account in the trial balance are
posted in their proper normal balance column. If still out of balance then,
3. Determine the difference between the debit and credit totals
a. If the amount of difference is 1, 10, 100 or 1,000, it might be an error in addition;
b. If the amount of difference is 9 or a multiple of 9, a transposition error was committed,
meaning the orders of figures written are reversed. For example 36 was written as 63;
c. If the amount of difference is divisible by 2 it might be an error in listing the account
balance. A debit amount was listed in the credit column of the trial balance and vice versa;
d. If the amount if difference is divisible by 9 ( can be divided by 9) it indicates a slide or
misplacement of decimal point. For example, P 2,500 was incorrectly written as P 250
(Note : step a to d could not be applied if there are two or more errors being committed
simultaneously.)
4. Compare the accounts and amounts in the trial balance with that in the ledger. Be sure no account
is omitted and amounts are correctly carried to its appropriate column.
5. Re compute the balance of each ledger account.
6. Trace all postings from the journal to the ledger accounts.
CHAPTER 4
WORKSHEET AND FINANCIAL STATEMENTS
Worksheet is a summary device used by an accountant to facilitate the preparation of Financial
Statement. It is a working paper in the form of columnar sheet used as a tool or bridge connecting the Trial Balance
and Financial Statement.
Worksheet Preparation including the adjusting entry is the fifth step of the accounting cycle.
PROCEDURES FOR PREPARING THE WORKSHEET (10-column worksheet)
Step 1- Write the complete heading on the center of the uppermost of the columnar sheet: the name of
the business on the first line, title of the report on the second line, which is “Worksheet” , and period
covered on the third line.
Step 2- Copy the trial balance “as is” to the trial balance section of the worksheet, then total the amounts
and double rule;
Step 3- Enter the adjusting entries in the adjustment columns and total the amounts;
Step 4- Enter the adjusted amounts in the Adjusted Trial Balance section of each account. The adjusted
trial balance amount is determined by combining the trial balance and the adjustment figures. When
extending amounts from the trial balance to the adjusted trial balance, the following points are observed:
•
ADD when the type of adjustment (debit or credit) is the same as the trial balance.
•
SUBTRACT when the type of adjustment (debit or credit) is different from the Trial
Balance.
Step 5- Extend the “ Real Accounts” (asset, liability & owner’s equity account) to the Balance Sheet section
observing the debit and credit balances of account appearing in the Adjusted Trial Balance.
Step 6- Extend the “Nominal Accounts”( income and expense account) to the Income Statement section
observing the debit and credit balances of accounts appearing in the Trial Balance.
Step 7- Foot the debit and credit money column of the Income Statement and Balance Sheet and place the
totals on their respective columns in the same line with the double ruled total of the trial balance.
Then it could be observed that : a) the amount of the debit and credit columns of both Income
Statement and Balance Sheet are not equal; B) the amount of difference between the debit and
credit of the Income Statement section is exactly the same with the amount of difference between
the debit and credit of the balance sheet; and c)the “the same amount” of difference between the
debit and credit of both the Income Statement and Balances Sheet section represents either “Net
Income “ or Net Loss” .
Step 8- Enter the amount of difference in the columns of both the Income Statement and Label it “ Net
Income” if the credit column of the Income Statement section is greater than the debit. If the debit column
of the Income Statement section is greater than the credit, label it “Net Loss”.
Step 9- Total the debit and credit columns of both the Income Statement and Balance Sheet and double
rule the amounts , which then have equal balances.
NOTE: Omit step no. 4 if an 8-column worksheet is prepared. For a “simple worksheet” or 6-column
worksheet, step no. 3
and 4 is omitted.
FINANCIAL STATEMENTS
Basically , the end product of an accountant are the Financial Statements. Financial Statements provide
information about the result of operation, financial position, and cash flows of an enterprise that is useful to various
interested parties in making economic decisions. A complete set of financial statements includes the following
components:
1. Balance Sheet
2. Income Statement
3. Statement of Changes in Equity
4. Cash Flow Statement; and
5. Accounting Policies and Notes to Financial Statements.
The preparation of Financial Statement is the sixth step of the accounting process.
With the completion of the worksheet, it is easier to prepare the financial statement for the account
balances have been extended to the appropriate income statement and balance sheet column. So , if we are to
prepare the Income Statement , we just refer to the Income Statement section of the worksheet and if we are to
prepare the Balance sheet, we just take a look at the Balance Sheet section of the worksheet. Of course, we need
to follow the standard format of these statements.
INCOME STATEMENT
The Income Statement is a statement which shows the performance of the enterprise for a given period
of time. It shows the summary of the revenues earned and expenses incurred for that period of time. An income
statements maybe presented using a “single step” or “multiple step” forms. The single- step form is commonly
used in a service concern, where Expenses are deducted from Revenues to arrive at the “Net Income” or “Net
Loss”. The multiple-step form is often used in a “merchandising” and “manufacturing concern”.
Below is a Single-Step Form Income Statement of Royal Services for the month ended, May 31, 2008
Royal Blue Services
Income Statement
For the month ended, May 31, 2012
Revenues
Service Income
Expenses
Utilities expense
Salaries Expense
Rent Expense
P 143,400
P 8,800
1,200
8,000
Supplies Expense
Insurance Expense
Depreciation Expense-Service vehicle
Depreciation Expense- Office Equipment
Interest Expense
6,000
2,400
8,000
2,000
7,000
Net Income
P 73,400
P 70,000
=====
STATEMENT OF CHANGES IN EQUITY
The Statement of Changes in Equity summarizes the changes that occurred in owner’s equity. It is arrived
at by adding to the Beginning Owners Equity balance, any Additional Investment and Net income for the period and
deducting thereof withdrawals by the owner and net loss for the period. The beginning balance and additional
investments are taken from the owner’s capital account in the general ledger. The net income or net loss comes
from the income statement while the withdrawals from the balance sheet column of the worksheets.
Royal Blue Services
Statement of changes in Equity
For the Month Ended, May 31, 2012
Royal, Owner’s Equity, 5/1/2012
Add: Additional Investment
Net Income
Total
Less: Withdrawals
Royal, Owner’s Equity, 5/31/2012
P 500,000
P
0
70,000
70,000
570,000
28,000
P 542,000
======
BALANCE SHEET
The balance sheet 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 .With the balance sheet the company’s liquidity, financial
flexibility , solvency and stability could be evaluated. Liquidity refers to the availability of cash in the near future
after taking account of the financial obligation 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 unexpected needs and opportunities.
Solvency refers to the availability of cash over the longer term to meet financial commitments as they fall due.
The balance sheet can be presented in two forms, “account form” or “report form”. The report form simply
lists assets, followed by the liabilities then by the owner’s equity in vertical sequence. The account form lists the
asset on the left and the liabilities and owner’s equity on the right side which is patterned after the accounting
equation, Assets= Liabilities
Shown below is the “Report form” balance sheet of Royal Blue Services as of May 31, 2012:
Royal Blue Services
Balance Sheet
As of May 31, 2012
Assets
Current Assets:
Cash
Accounts Receivable
Supplies
Prepaid Rent
Prepaid Insurance
P 44,400
34,600
30,000
8,000
26,400
Property and Equipment:
Service Vehicle
Less: Accumulated Depreciation
P 840,000
8,000
Office Equipment
Less: Accumulated Depreciation
P 120,000
2,000
P 143,400
832,000
118,000
950,000
Total Assets
P
1,093,400
========
P
551,400
Liabilities
Current Liabilities:
Notes Payable
Accounts Payable
Salaries Payable
Utilities Payable
Interest Payable
Unearned Service Revenues
P 420,000
106,000
3,600
2,800
7,000
12,000
Owner’s Equity
Royal, Capital
542,000
Total Liabilities and Owner’s Equity
P 1,093,400
=======
STATEMENT OF CASH FLOWS
Statement of Cash Flow 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. It shows the net increases or decreases 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.
Royal Blue Services
Statement of Cash Flow
For the month ended, May 31, 2012
Cash Flows for 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 in) operating activities
P 120,800
( 10,000)
( 27,600)
( 16,000)
( 28,800)
( 6,000)
Cash Flows from Investing Activities:
Payments to acquire service vehicle
Payments to acquire office equipment
Net cash provided by (used in) investing activities
P( 840,000)
( 30,000)
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 22,400
(870,000)
P 500,000
420,000
( 28,000)
892,000
P 44,400
____0___
P 44,400
======
CHAPTER 5
COMPLETING THE ACCOUNTING CYCLE
ADJUSTMENTS ARE JOURNALIZED AND POSTED
Following the preparation of the financial statements is the seventh step in the accounting process which
is to journalize and post the adjustments as the closing entries are made. This will bring the ledger into
agreement with the data reported in the financial statements. The adjusting entries to be journalized and posted are
those that was prepared and reflected in the worksheet.
CLOSING ENTRIES ARE JOURNALIZED AND POSTED
The preparation of closing entries in the General Journal and posting it to the General Ledger is the
eight step of the Accounting Process. It is prepared at the end of the period to bring all temporary or income
statement account to “zero” balance. Accounts with zero balance is said to be closed .
Closing entries are prepared to effect the result of its operation to Capital.Net Income is added to capital
while net loss will be deducted from capital. Closing entry simply transfer temporary accounts to the capital
accounts . A summary account- Revenue & Expense Summary or Income Summary or Income & Expense
Summary – is used to close the income and expense account.
To close an account, nominal account with debit balance will be credited by the amount equal to its debit
. Likewise, nominal account with credit balance will be debited by the amount equal to its credit .
Basically , there are four closing entries to be prepared, as follows:
1.
2.
3.
4.
Closing all revenue accounts to Revenue and Expense Summary account;
Closing all expenses accounts to Revenue and Expense Summary account;
Closing Revenue and Expense Summary account to Capital account ; and
Closing Drawing account to Capital account.
PREPARATION OF A POST-CLOSING TRIAL BALANCE
The ninth step in the Accounting Process is the preparation of a Post-Closing Trial Balance.
After the closing entries have been posted , all nominal accounts will have a zero balance, while all
real accounts (Balance sheet account) will have an “open balances”. Of the accounts with “open balances” in the
general ledger, a trial balance is prepared purposely to prove the equality of the debit and credit amounts. This
final trial balance is called a Post- Closing Trial Balance which is defined as “ balance sheet in a trial balance
form” as it contains the list of the Balance Sheet accounts with open balances.
The worksheet may be referred to in the preparation of the Post-Closing Trial Balance. The Balance Sheet
section of the worksheet shows the real accounts that comprise the post-closing trial balance except that the capital
balance as per worksheet should be added by the net income and deducted by the amount of drawing.
Presented below is the post-closing trial balance of Royal Blue Services :
Royal Blue Service
Post –Closing Trial Balance
May 31, 2012
Cash
Accounts Receivable
Supplies
Prepaid Rent
Prepaid Insurance
Service Vehicle
Accumulated Depreciation
Office Equipment
Accumulated Depreciation
Notes Payable
Accounts Payable
Salaries Payable
Utilities Payable
Interest Payable
Unearned Service Revenues
Royal, Capital
Total
P
44,400
34,600
30,000
8,000
26,400
840,000
P 8,000
120,000
2,000
420,000
P 1,103,400
=======
106,000
3,600
2,800
7,000
12,000
542,000
P 1,103,400
=======
REVERSING ENTRIES
Preparing the reversing entries is the tenth and last step of the Accounting Process.
Reversing entries are prepared on the first day of the succeeding accounting period. It is a journal entry
which is the exact opposite of a related adjusting entry made at the end of the period. It is made to simplify the
recording of regular transactions in the next accounting period.
The adjusting entries that can be reversed are as follows:
1. Prepaid Expense (expense method)
3.
2. Unearned Revenues ( income method)
4.
Accrued Expense
Accrued Revenues
CHAPTER 6
ADJSUTING ENTRIES
Adjusting entries are prepared at the end of accounting period to bring records or balances of accounts
updated and to properly match income against expense during the period. It is called “end of the period
adjustments”.
The following are the usual items which require adjusting entries at the end of an accounting period:
1. Accruals
a. Accrued Expense
b. Accrued Income
2. Deferrals
a. Prepayment of Expenses
b. Pre-collection of Income
3. Provision for Depreciation of Fixed Assets
4. Provision on for Estimated Doubtful Accounts (Bad Debt)
5. Adjustments on Inventories
6. Correction of erroneous Journal Entries
ACCRUALS
A. Accrued Expense- This is an expense already incurred by the business but not yet paid at the end of the period.
To recognize the expense at the end of the period though not yet paid, adjusting entry shall be prepared as follows:
Expense
Accrued Expense
xx
xx
Failure to prepare the adjusting entry will overstate the Net Income, Liability will be understated while Owner’s
Equity will be overstated.
Example: Office rental for the month of December were incurred but not yet paid as of December
31,2012, P 5,000
The adjusting entry that should be prepared on December 31, 2012 to record the Rent Expense incurred and
recognize the corresponding liability account is as follows:
Rent Expense
P 5,000
Accrued Rent expense
P 5,000
To set-up unpaid rental for the month of December 2012.
b. Accrued Income- This is an income already earned by the business but not yet collected at the end of the
period. To
record the income actually earned during the period though not yet collected , an adjusting entry should be
prepared as follow:
Accrued Income
Income
xx
xx
Failure to prepare the adjusting entry will understate the Net Income, Assets as well as the Owner’s Equity.
Example: The business received a P15,000 6%-90 day note from a customer dated December 5, 2012.
The adjusting entry that should be prepared on December 31, 2012 to record the interest income actually
earned from December 5 to December 31 and to recognize the corresponding receivable account will be
as
follows:
Accrued Interest Income
Interest Income
To record interest earned from Dec 5 to Dec 31.
(15,000 x 6% x 65/360)
P 65
P 65
DEFERRALS:
Prepayments of Expenses
Prepaid Expense- This is an expense already paid but not yet incurred. There are two methods that can be used
in
recording prepayments:
1. Expense Method-under this method, an expense account is debited upon payment of the prepaid
expense.
2.Asset Method- under this method, an Asset Account is debited upon payment of a prepaid expenses.
The adjusting entries that should be prepaid at the end of accounting period to split-up the real account
and
nominal account are as follows:
If Expenses Method is used:
Prepaid Expense
Expense
xx
xx
If Asset Method is used:
Expense
Prepaid Expense
xx
xx
Example: On May1, 2012, a one-year comprehensive insurance coverage on the service vehicle was paid,
P
12,000.
Expense Method:
Using the Expense Method, the entry to record the prepayments on May 1, 2012 is as follows:
Insurance Expense
P12,000
Cash
To record payment of one-year insurance
coverage effective May 1, 2012 to May 1, 2013.
P 12,000
By December 31, 2012, adjusting entry to set-up the asset portion (Insurance Account) representing 4
months period covering January 1, 2013 to May 1, 2013, shall be prepared as follows:
Prepaid Insurance
Insurance Expense
To record the unexpired portion of insurance
premium.
P 4,000
P 4,000
With the above adjusting entry, Insurance Expense will have a balance of P8, 000 while Prepaid Insurance
will
have P4,000 balance as of December 31, 2012.
Asset Method
Using the Asset method, the entry to record the prepayments on May 1, 2012 is as follow:
Prepaid Insurance
Cash
To record payment of one-year insurance
coverage effective May 1, 2012 to May 1, 2013.
P 12,000
P 12,000
On December 31, 2012, adjusting entry to recognize the expense portion representing 8- months period
from
May 1, 2012 to
December 31, 2012 should be prepared as follows:
Insurance Expense
Prepaid Insurance
To record the expired portion of the insurance
premium
P 8,000
P 8,000
With the above adjusting entry, Prepaid Insurance account will be reduced to its correct balance of P4,000
while Insurance Expense will have a balance of P 8,000.
Pre-collection of Income
Pre-collected Income- is an income already collected by the business but not yet earned at the end of the
period.
Like the prepaid expenses, there are two methods of accounting for pre-collections, as follows:
1. Income Method- Under this method, an Income account is credited upon collection or receipt of cash.
2. Liability Method- Under this method, a Liability account is credited upon collection or receipt of cash.
The adjusting entries that should be prepaid at the end of accounting period to split-up the real account and
nominal account are as follows:
If Income Method is used, the adjusting entry will be as follow:
Income
Unearned Income
xx
xx
Failure to prepare the above adjusting entry will overstate the Net Income, understate the liability while
Owner’s Equity will be overstated.
If Liability Method is used, the adjusting entry will be as follow:
Unearned Income
Income
xx
xx
Failure to record the above adjustment will understate the Net Income, overstate the liability while Owner’s
Equity will be understated.
Example: On Nov.1, 2012, the company received P 15,000 from customer for services to be rendered
during the month of November, December and January.
Income Method:
Using the Income Method, the entry to record the receipt of cash on Nov. 1, 2012 is as follows:
Cash
Service Income
To record receipt of service Income
to be rendered for Nov.
Dec. & Jan.
P 15,000
P 15,000
By December 31, 2012, adjusting entry to set-up the unearned or liability portion should be prepared, as
follows:
Service Income
Unearned Service Income
To record the unearned portion of the
service income collected in advance
P 5,000
P 5,000
With the above adjusting entry, Service Income will have a balance of P 10,000 representing the November
&
December earned Service Income while Unearned Service Income will have a balance of P 5,000
representing the month of January advance collection.
Liability Method
Using the liability method, the entry to record the collection of the 3 month Advance Service Income on
Nov.
1 is as follows:
Cash
P 15,000
Unearned Service Income
To record the collection of Service
Income for the month of Nov., Dec. & Jan
P 15,000
On December 31, 2012, adjusting entry should be made to record the earned
representing the month of November and December as follows:
Unearned Service Income
Service Income
To record the earned portion of the Service
Income collected in advance.
Service
Income
P 10,000
P 10,000
With the above adjusting entry, Unearned Service Income will have a balance of P 5,000 while Service
Income will have a balance of P 10,000.
Note that after posting the adjusting entry, the Income Method or Liability Method will yield the same
balances , P 10,000 for Service Income while P 5,000 for Unearned Service Income.
PROVISION FOR DEPRECIATION OF FIXED ASSETS
All fixed assets or property and equipment when acquired, are capitalized or treated as an asset not as an
expense. But considering that fixed assets help generate income for the entity, a portion of the cost of the assets
should be reported as expense in each accounting period. “Depreciation Accounting” requires the allocation of the
cost to its estimated useful life. The estimated amount allocated to any one accounting period is called depreciation
expense. All fixed asset except Land is subject for depreciation.
There are several methods of determining depreciation. The Straight -line method is commonly used
because of its simplicity . This is computed by the formula presented below:
Depreciation Expense = Cost- Salvage Value
Estimated useful life
where,
Cost- represent the amount an entity paid to acquire the depreciable asset.
Estimated salvage value – is the amount that the asset can probably be sold for at the end of its
estimated useful life.
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.
The adjusting entry for depreciation is presented below:
Depreciation
Accumulated Depreciation
xx
xx
Accumulated Depreciation Account is a balance sheet account, a contra-account to the fixed asset
account. The book value of the property and equipment is obtained by deducting accumulated depreciation from
its cost.
Failure to record the adjusting entry will overstate the Net Income, the Asset as well as the Owner’s Equity.
Example: Acquired Office Equipment costing P 350,000 on June1, 2012 which is expected to last 5 years
with
P 50,000 salvage value.
The annual depreciation is P 60,000 computed as follows:
Annual Depreciation =
P 350,000 – P 50,000 =
5 years
P 60,000
However, the adjusting entry on December 31, 2012 should be as follow:
Depreciation Expense- Office Equipment
Accumulated Depreciation- Office Equipment
To record depreciation covering 7 months
period, from June 1 to Dec. 31.
P 35,000
P 35,000
PROVISION FOR DOUBTFUL ACCOUNTS
Offering credit terms to customers is normal to any business entity. Some of these account may not be
collected thus, there is a need to reflect these as charges against revenue. Doubtful Accounts or Bad Debts is the
anticipated loss recognized for the estimated uncollectible accounts in the current period. Estimates of uncollectible
accounts may be based on the ff:
a. credit sales for the period (gross sales or net sales)
b. Aging of Account Receivable
c. The balance of the valuation account is “increased to“ a desired new balance.
d. The balance of the valuation account is “increases by” a desired amount.
Below is the adjusting entry to record for the provision for Doubtful Accounts:
Doubtful Account
Allowance for Doubtful Account
P xx
P xx
Allowance for Doubtful Account is a contra asset account. This is to be deducted from Accounts Receivable
Account, to obtain the Net Realizable Accounts Receivable.
If the accounts proves to be definitely uncollectible, the appropriate amount is written off against the contra
account with the following entry:
Allowance for Doubtful Account
Accounts Receivable
P xx
P xx
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 receivable.
Failure to record the doubtful accounts adjusting entry will overstate the Net Income, the Assets as well
as the Owner’s Equity.
Example: The company has a total credit sales of P1, 000,000 with Accounts Receivable Balance of P
300,000 and Allowance for Doubtful Account Balance of P 20,000. Assume that Doubtful
Accounts
is estimated to be 1% of credit sales.
The adjusting entry by December 31, 2004 should be as follow:
Doubtful Accounts
Allowance for Doubtful Accounts
To record provision for doubtful Account.
(P1,000,000x .01)
P 10,000
P 10,000
After the above adjusting entry, Allowance for Doubtful Account will have a balance of P30,000 while Net
Realizable Accounts Receivable will have a balance of P 270,000 ( P 300,000 – P 30,000 ).
Case II. The same data above except that the management has decided to increase the balance of the
valuation account to P 25,000.
The provision for doubtful account for the period should be equal to P 5,000
Desired new balance of Allowance for Doubtful Account
Less: Balance of Allow. for Doubtful Acct before Adjustment
Estimated Doubtful Account for the period
computed as follows:
P 25,000
20,000
P 5,000
=====
The adjusting entry should be:
Doubtful Account
Allowance for Doubtful Account
P 5,000
P 5,000
After the adjusting entry, the Allowance for Doubtful Account will have a balance P 25,000 while
Net
Realizable Value of P 275,000 (300,000- 25,000).
Case III. The same data above, except that the management has decided to increase the valuation account
by
P 6,000.
The adjusting entry should be:
Doubtful Account
Allowance for Doubtful Account
P 6,000
P 6,000
After the adjusting entry, the Allowance for Doubtful Account will have a balance P 26,000, while the
net realizable value of 274,000 (300,000-26,000)
Case IV. The same data above, except that the management has decided to increase the valuation
account
by 5% of the outstanding Accounts Receivable.
The adjusting entry should be:
Doubtful Account
Allowance for Doubtful Account
P 15,000
P 15,000
After the adjusting entry, the Allowance for Doubtful Account will have a balance P 35,000, while net
realizable value of 265,000.