Review Of The Accounting Process PDF

REVIEW OF THE ACCOUNTING PROCESS ACCOUNTING DEFINED 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, in making r...

REVIEW OF THE ACCOUNTING PROCESS ACCOUNTING DEFINED 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, in making reasoned choices among alternative courses of action. This definition stipulates the nature and purpose of accounting. An accountant provides services and furnishes quantitative information expressed in terms of money that is useful to the users of the accounting information. The information are outlined into reports called financial statements and served as a basis for making important economic decisions. The users of the accounting information are categorized as either internal or external users. External users are decision makers who have no direct access to the information provided by the operations of the company. Internal users represent the managers or the decision makers of an entity and they need the accounting information for the continued operation of their business. Examples of users and their need for accounting information as the basis for their decision making are: a. Investors are influenced with the returns from their investments and to decide whether to make additional investments, hold or sell their shares of stocks. b. Creditors/Suppliers/Lenders need accounting information to help in their decision whether to extend credit or loans being applied by businesses. c. Government and their agencies need to know if an entity is abiding the implemented government rules and regulations. d. Employees/Labor unions are interested in the stability and profitability of the company they are working with and for the assurance of their security of tenure. e. General Public and Customers need to know if the company would provide them continuity of their services and updates on improvements of their products and services. BRANCHES OF ACCOUNTING There are two main branches of accounting: Financial Accounting and Management Accounting. Financial Accounting is designed in providing accounting information for all parties external to the operating responsibility of the company. It is the process of preparing accounting reports known as financial statements that show the company’s financial performance and position to people outside the company like creditors and customers. 1  Management or Managerial Accounting is designed in providing accounting information and operational needs for use by the internal users, the management. It involves financial analysis, budgeting and forecasting, cost analysis, and evaluation of business decisions. AREAS OF ACCOUNTING Accounting is commonly misinterpreted and understood as just the recording of business transactions, known as bookkeeping. However, bookkeeping is only one of the functions of accounting while accounting is a diversified profession. Accountants can be employed in four broad or specialized areas: Public Accounting Public accounting offers accounting and related services to its clients on a fee basis. Some of the services being offered include preparation, review and audit of the company’s financial statements, tax services, and consultation involving accounting systems, mergers and acquisitions. Accountants practicing public accounting are licensed professionals known as Certified Public Accountants Private Accounting Private accounting offers accounting services for a specific company and is an important part to the success of any organization. Private accountants offer a higher level of services through familiarity with the full workings of the company’s business interests. They are concerned with the collection and analysis of financial data within a specific company. They are also involved with strategic planning and developing new products and services. Government Accounting Under Section 109, of the PD No. 1445, Government Accounting is defined as one that encompasses the process of analyzing, classifying, summarizing and communicating all transactions that are involved in the receipt and disbursement of all government funds and properties, and interpreting the results thereof. Its objectives were set to include several areas in government operations. The accounting data should show how government funds were used and should indicate the outflow and inflow of funds and the need for a study of fund management and control, if necessary. Accounting Education Accounting Education is an area of accounting that covers the upgrading, researching and teaching accounting knowledge to students, aspiring accountants or accounting professionals seeking continuous education and updates. This area is composed of accountants (Certified Public Accountants) who are into teaching, training and development, including research. Accountants in education pursue a career as a faculty member in a school, an author of an accounting book, a researcher, a trainer, or a reviewer. 2 FORMS OF BUSINESS ORGANIZATION The most common forms of business organization are the following: Sole Proprietorship Sole or Single Proprietorship is organized and owned by only one person. It is easy to form and offers complete control to the owner. However, he is also personally liable for all financial obligations and debts of his business. Partnership A partnership is formed by two or more individuals who agreed to carry on a trade or business. Each individual contributes money, property, labor or skill, and expects to share in the profits of the business. Corporation A Corporation is a more complex from of business organization as differentiated from a sole proprietorship and a partnership. It is a separate legal entity whose ownership is divided into shares of stocks. Its owners are known as shareholders. It is also subject to more legal requirements and government regulations. TYPES OF BUSINESS ACTIVITIES A business is an organization that uses basic resources (inputs) like materials and labor to provide goods or services to customers or clients. There are three major types of business: Service Business A service type of business provides services rather than products to customers or clients for a fee. Examples are salons, repair shops, hotels and restaurants, and professional firms like law and accounting. Merchandising Business This type of business is also called a trading business. Merchandising companies buy goods in salable form and sell them to their customers at a higher cost to make a profit. Examples are department stores, bookstores, appliance stores and other resellers. Manufacturing Business This type of business buys raw materials with the intention of using them in making a new product. Manufacturing companies converts these raw materials into finished products before selling them to their customers. 3 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) Generally accepted accounting principles are a common set of accounting principles, standards and procedures that must be followed when preparing financial statements. Because it is important that all who will receive accounting reports be able to interpret them, a set of practices were developed that will provide guidelines for financial accounting. The term used to describe these practices is generally accepted accounting principles (GAAP). Generally accepted accounting principles encompass the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time. These “principles” are not like the unchangeable laws of nature found in chemistry or physics. They are developed by accountants and businesses to serve the needs of decision makers, and they can be changed or altered as better methods are developed or as circumstances change. A few examples of these generally accepted accounting principles are: 1. Business Entity Concept Under the business entity concept, the activities of a business are recorded separately from the activities of the owner or owners. This concept is important because it limits the economic data in the accounting system to data related directly to the activities of the business. Thus, the accountant for a business with one owner (a proprietorship) would record the activities of the business only, not the personal activities, property, or debts of the owner. 2. Going Concern or Continuity Assumption To prepare financial statements for an accounting period, the accountant must make an assumption about the ability of the business to continue. Specifically, the accountant assumes that unless there is evidence to the contrary, the business entity will continue to operate for an indefinite period. This method of dealing with the issue is called the going concern or continuity assumption. The justification for all the techniques of income measurement rests on this assumption of continuity. 3. Time Period Assumption The operating results of any business cannot be known with certainty until the company has completed its life span and ceased doing business. But financial reports covering shorter time periods are needed because external decision makers require timely accounting information to satisfy their analytical needs. Because of this, businesses have imposed the time-period assumption, requiring that changes in a business’s financial position be reported over a series of shorter time periods like annually, semi-annually, quarterly or monthly. An annual accounting period is the most common which can be a calendar year or a fiscal year. Example: January 1, 2017 to December 31, 2017 is a calendar year; July 1, 2017 to June 30, 2018 is a fiscal year. 4 4. Unit-of-Measure Assumption The unit-of-measure assumption specifies that accounting should measure and report the results of a business’s economic activities in terms of a monetary unit such as the Philippine peso. The assumption recognizes that the use of a standard monetary unit throughout all financial statements is an effective means for aggregating and communicating accounting information. It is a standard practice to ignore changes in the purchasing power of a peso. ACCRUAL BASIS AND CASH BASIS OF ACCOUNTING The difference between accrual basis and cash basis of accounting lies in the timing of when is revenues and expenses are recognized and incurred when recorded in the books. Under the cash basis of accounting, revenues are recognized and recorded when cash is received or collected and expenses when cash is paid. No adjusting entries are needed in this method of accounting. Under the accrual basis of accounting, revenues are recognized and recorded when earned regardless of when cash is received or collected. Expenses incurred are recorded whether or not cash is paid. Adjusting entries are needed under this method to update the account balances at the end of the accounting period. THE ACCOUNTING CYCLE The accounting cycle, also known as the accounting process, refers to a series of steps accountants perform during an accounting period for the orderly accumulation, reporting and interpretation of data pertaining to the financial operations of the business. The functions of accounting can be summarized as the recording, classifying, summarizing and interpreting of business data. The first three functions represent the process by which accounting information is developed. These steps are applied in accordance with generally accepted accounting principles and practices developed by the accounting profession. The interpreting function involves the use of analytical techniques and procedures as a base for management decisions. The steps in the accounting cycle include the following: 1. Documentation 2. Journalizing 3. Posting 4. Preparation of the trial balance 5. Compilation of data needed for adjustments 6. Preparation of the worksheet 7. Preparation of the Financial Statements 8. Adjusting entries are journalized and posted to the ledger 9. Closing entries are journalized and posted to the ledger 10. Preparation of the post-closing trial balance 11. Reversing entries are journalized and posted to the ledger 5  The first three steps constitute the recording phase of accounting. The summarizing phase begins with the trial balance preparation up to the post-closing trial balance. Reversing entries prepared on the first day of the next accounting period is considered to be an optional step. RECORDING PHASE Accounting is based on a double entry system which means that a business transaction has a dual effect when recorded. Business transactions are recorded in at least two accounts. Documents are needed to serve as a basis for recording the transactions. The two books of accounts where transactions are recorded are the journal and the ledger. The double-entry accounting system has specific rules of debit and credit for recording the transactions in the accounts. Debit is the left side of an account while credit is the right side. To summarize the rules of debit and credit: Debit: Credit:  Increases in assets  Decreases in assets  Decreases in liabilities  Increases in liabilities  Decreases in equity/capital  Increases in equity/capital  drawings  investments  decrease in revenue  increase in revenue  increase in expense  decrease in expense Applying the rules of debit and credit, transactions are first recorded in the book of original entry called the general journal and the process is known as journalizing. The chart of accounts should show the elements of the financial statements which shall be used in recording the transactions. Special journals are sometimes used by businesses that are designed for recording a single type of transaction that occurs frequently. The format and the number of special journals used will depend on the nature of the business. The most common special journals include the cash payments journal, cash receipts journal, revenue/sales journal and the purchases journal. The general journal will be used for entries that cannot be recorded in the special journals such as adjusting and closing entries. The information from the journal is then transferred to the book of final entry called the general ledger and the process is called posting. The ledger is a complete listing of all the accounts as found in the chart of accounts of a business. The purpose of this process is to classify the effects of transactions on the elements of the financial statements. Businesses may have control accounts and subsidiary ledgers that will show their balances are the same. Subsidiary ledger is a group of related accounts showing the details of the balance in the control account. Examples of control accounts are Accounts receivable and Accounts payable accounts. 6 SUMMARIZING PHASE After all the transactions are posted in the ledger, the account balances are then computed and must show the normal balances of each individual account. The preparation of the trial balance will mathematically prove the equality of the debit and credit balances of each account but will not give the assurance that no errors have been made during the journalizing and posting process in case the total debit and credit amounts are shown as equal. Inequality in the debit and credit totals would automatically prove the presence of an error. The most common examples of errors showing inequality of total debit and credit amounts are transposition and slide. Transposition is the erroneous rearrangement of writing an amount like P 1,250 written as P 1,520. Slide is an error in which the whole amount is moved one or more spaces to the right or the left, like P 1,000 written as P 100 or P 10,000. At the end of the accounting period, some of the account balances presented in the trial balance are not yet updated and may require adjustments before financial statements are prepared. Data for adjustments are then compiled for such updating. The types of accounts that require adjustment are as follows: 1. Prepaid Expenses – These are expenses paid by the business in advance; or these are expenses already paid in cash by the business but the expenses are not yet incurred or only a portion of the amount paid was used up as expense. Prepaid expenses are also termed as deferred expenses. There are two methods of accounting for prepaid expenses: a. Asset method – if at the date of payment, the business debited an asset account. The pro-forma adjustment is: Expense Account xxx Compute used or expense Asset Account xxx portion b. Expense method – if at the date of payment, the business debited an expense account. The pro-forma adjustment is: Asset Account xxx Compute unused or asset Expense Account xxx portion To illustrate, assume that Lakers Company is using a monthly accounting period. On January 1, 2017, the company paid P 30,000 representing 3-month rent beginning January 1, 2017. The company adjusts and closes its books every month. The entry to record the prepayment and the adjusting entry at the end of the month will be: 7  Asset Method Expense Method 2017 Jan 1 Prepaid Rent 30,000 Rent Expense 30,000 Cash 30,000 Cash 30,000 31 Rent Expense 10,000 Prepaid Rent 20,000 Prepaid Rent 10,000 Rent Expense 20,000 Since P 30,000 is for 3 months, the monthly rent is P 10,000. For January, the used or expense portion is one month or P 10,000; therefore the unused or asset portion will be two months or P 20,000 as of January 31. Regardless of which method a business used in any particular case, the amount reported as expense in the income statement and the amount reported as asset in the balance sheet will be the same. Both methods of accounting for prepayment are acceptable although most companies employ the expense method due to its simplicity. A business must also use a method consistently for a particular type of prepayment, say asset method for rent while expense method for supplies. 2. Unearned Revenues – These are revenues collected or received by the business in advance; or these are revenues already collected in cash by the business but the revenues are not yet earned or only a portion of the amount received was earned or became revenue. Unearned revenues are also termed as deferred revenues. There are two methods of accounting for unearned revenues: a. Liability method – if at the date of collection, the business credited a liability account. The pro-forma adjustment is: Liability Account xxx Compute earned or income Revenue Account xxx portion b. Revenue method – if at the date of collection, the business credited a revenue account. The pro-forma adjustment is: Revenue Account xxx Compute unearned or liability Liability Account xxx portion To illustrate, assume that Miami Company is using a monthly accounting period. On January 1, 2017, the company collected or received P 30,000 representing 3-month rent beginning January 1, 2017. The company adjusts and closes its books every month. The entry to record the advance collection and the adjusting entry at the end of the month will be: 8  Liability Method Revenue Method 2017 Jan 1 Cash 30,000 Cash 30,000 Unearned Rent 30,000 Rent Income 30,000 31 Unearned Rent 10,000 Rent Income 20,000 Rent Income 10,000 Unearned Rent 20,000 Since P 30,000 is for 3 months, the monthly rent is P 10,000. For January, the earned or income portion is one month or P 10,000; therefore the unearned or liability portion will be two months or P 20,000 as of January 31. Regardless of which method a business used in any particular case, the amount reported as income in the income statement and the amount reported as liability in the balance sheet will be the same. Both methods of accounting for unearned or deferred revenues are acceptable although most companies employ the revenue or income method due to its simplicity. A business must also use a method consistently for a particular type of unearned or deferred revenue, say liability method for rent while income or revenue method for subscription. 3. Accrued Expenses – These are expenses incurred in one period but remain unrecorded and unpaid as of the end of the period. They are also called accrued liabilities or unrecorded expenses. The pro-forma adjustment is: Expense account xxx Liability account xxx For example: A company’s accounting period is monthly, January 1-31, 2017. All expenses incurred during the month of January must be recorded in January. Let us say, telephone bill for the month of January amounting to P 5,000 will be paid on February 5, 2017, the adjusting entry will be: 2017 Jan 31 Utilities Expense 5,000 Utilities Payable 5,000 So, since we are using the accrual basis of accounting, the question is when did the company incur the expense? The answer of course is for the month of January, therefore we will record the expense in January. And since this will still be paid in February, we will record a liability in January. 9  Another example is, assume a small business is paying a total of P 10,000 for the wages of its employees for a 5-day work week. Payday is every Friday. Accounting period is monthly. The Wages Expense during the month of March is shown below: Wages Expense Mar. 5 10,000 12 10,000 19 10,000 26 10,000 40,000 If March 26 is a Friday, then the last day of the month (March 31) falls on a Wednesday. Therefore the adjusting entry to be made will be: Mar. 31 Wages Expense 6,000 Wages Payable 6,000 If financial statements are prepared on March 31, the Wages Expense to be shown in the income statement totaled P 46,000 and the balance sheet will show Wages Payable amounting to P 6,000. 4. Accrued Revenues – These are revenues earned in one period but remain unrecorded and not received as of the end of the period. They are also called accrued assets or unrecorded revenues. The pro-forma adjustment is: Asset account xxx Revenue account xxx For example: ABC Company’s accounting period is monthly, August 1-31, 2017. All revenues earned during the month of August must be recorded in August. If the company is in the business of renting apartments and one of its tenants has not paid the August rent for P 8,000, then the adjusting entry of ABC Company will be: 2017 Aug. 31 Rent Receivable 8,000 Rent Revenue 8,000 10  5. Depreciation of Property, Plant and Equipment Physical resources that are owned and used by a business which are permanent in nature or have a long useful life are called fixed assets or plant assets. Examples are land, building, equipment, trucks, automobiles, a computer, store fixtures, or office furniture. These assets help generate income for the business. Therefore it is important and proper that a portion of the asset be recorded as expense in each accounting period. Fixed assets, with the exception of land have limited useful lives and as such are subject to depreciation. Depreciation is the systematic allocation of the cost of the fixed asset over its useful life. Depreciation is not a process of asset valuation. The pro-forma adjustment for depreciation is: Depreciation Expense – Name of asset xxx Accumulated Depreciation – Name of asset xxx There are different methods of computing depreciation. We will discuss here only the simplest and the most commonly used method which is the straight-line method. This method will result into equal periodic charges for depreciation. Also take note that in the adjusting entry for depreciation, the account credited is the account Accumulated Depreciation. This is a contra- asset account which will be deducted from the related fixed asset account in the balance sheet. The credit is not made directly to the fixed asset account in order to preserve the original cost of the fixed asset in the balance sheet. To illustrate, assume that on January 1, 2017, Knicks Company bought a delivery truck for a total cost of P 500,000. Its estimated life is 10 years and the estimated residual value is P 50,000. The company is using the straight-line method of computing depreciation and it is using an annual accounting period. The entries of Knicks Company for the above transactions are: 2017 Jan 1 Delivery Truck 500,000 Cash 500,000 To record the purchase of delivery truck The adjusting entry on December 31, 2017: 2017 Dec 31 Depreciation Expense-Delivery Truck 45,000 Accumulated Depreciation-Delivery Truck 45,000 11 Computations will be: Annual depreciation = Cost – Residual Value Estimated Life = P 500,000 – 50,000 10 = P 45,000 =========== Other computation for straight-line method is: Annual depreciation = (Cost – Residual Value) x Depreciation Rate = (P 500,000 – 50,000) x 10% = P 45,000 ========== The depreciation rate can be computed by getting the reciprocal of the life. Example: 10 years is equal to 1/10 or 10%. The balance of the Depreciation Expense account is shown in the income statement. In the balance sheet as of December 31, 2017, the carrying amount or the book value of the asset is P 455,000, as shown below: Delivery Truck P 500,000 Less Accumulated Depreciation 45,000 Carrying amount or Book value P 455,000 The depreciation of the fixed asset will be recorded at the end of each year (for ten years). The same adjusting entry will be recorded for 10 years. Assuming a balance sheet will be made on December 31, 2022: Delivery Truck P 500,000 Less Accumulated Depreciation 270,000 Carrying amount or Book value P 230,000 At the end of ten years, the Accumulated Depreciation account will have a balance of P 450,000. At this point, the book value of the asset will be equal to the residual value of P 50,000. 12  6. Uncollectible accounts – these are estimated amounts due from customers that may no longer be collected and are considered to be as bad debts. The allowance method estimates the amount of uncollectible accounts receivable and will be recorded as an adjusting entry at the end of the accounting period and follows the matching principle. The pro-forma adjustment is: Doubtful Accounts Expense xxx Allowance for Doubtful Accounts xxx Since the loss is an estimate only and the specific customer cannot be identified at this point, the Accounts Receivable may not be credited. Instead a contra asset account, Allowance for Doubtful Accounts, is credited. The Doubtful Accounts Expense is also called Bad Debts Expense or Uncollectible Accounts Expense. The Allowance for Doubtful Accounts is also called Allowance for Bad Debts or Allowance for Uncollectible Accounts. The estimate of uncollectible amount at the end of the accounting period is based on past experience and forecasts of the future. This is computed based on the Accounts Receivable balance wherein: a. Single rate is applied to outstanding accounts receivable or b. Aging of accounts receivable where accounts are classified according to how long they remain outstanding The computation for the estimated Doubtful Accounts Expense is shown as: Required ending balance of Allowance for Doubtful Accounts P xxx Allowance for Doubtful Accounts before adjustment *add if debit balance/deduct if credit balance) xxx Doubtful Accounts Expense for the period P xxx ========== As an example, the following accounts were found in the ledger of Cavs Red Enterprises on December 31 of the current year: Debit Credit Accounts Receivable 187,520 Allowance for Doubtful Accounts 10,680 Net Sales 4,272,000 The estimated doubtful accounts at the end of the current year is 10% of the outstanding Accounts Receivable. The adjusting entry on December 31 is as follows: Doubtful Accounts Expense 8,072 Allowance for Doubtful Accounts 8,072 13  Required ending balance of Allowance for Doubtful Accounts P18,752 (10% x P 187,520) less credit balance of allowance before adjustment 10,680 Doubtful Accounts Expense for the period P 8,072 ============== 7. Merchandise Inventory– these represents good on hand and available for sale in the ordinary course of the business. If the company is using the periodic inventory system, adjusting entries are required to replace or remove the beginning balance of the merchandise inventory with the balance at the end of the accounting period. The adjusting entries to record the replacement of the beginning merchandise inventory balance and to enter the ending inventory balance would be: Income Summary xxx Merchandise Inventory xxx To close the beginning inventory Merchandise inventory xxx Income Summary xxx To record the ending inventory Under the perpetual inventory method, purchases and sale of goods are recorded in the merchandise inventory account and the cost of goods sold account. As a result, the balances of the merchandise inventory and the cost of goods accounts are always updated. After all the adjustments are compiled, the next step is the preparation of the worksheet. This is an optional step in the accounting cycle. However, it is useful in showing the flow of the accounting information from the unadjusted trial balance to the adjusted trial balance and in analyzing the impact of such adjustments on the financial statements. A worksheet is a working paper prepared by an accountant to facilitate the preparation of the financial statements. After the completion of the worksheet, financial statements are prepared and serve as the primary means of communicating important accounting information to users. These are accounting reports that quantify the financial strength, performance and liquidity of a business. Financial statements represent the final output in the work of an accountant. They include Statement of Comprehensive Income, Statement of Changes in Equity, Statement of Financial Position, the Cash Flow Statement and Notes to the Financial Statements. The Statement of Comprehensive Income, also known as the Profit and Loss Statement, presents the income, expenses and the operating result (profit or loss) during an accounting period. The Statement of Changes in Equity shows the summary of changes (increases or decreases) affecting the equity of the owner/s during an accounting period. 14  The Statement of Financial Position, also known as the Balance Sheet, shows the financial condition of the business as of a specific date. It helps the users in assessing the financial soundness of business in terms of liquidity risk, financial risk, credit risk and business risk. The Cash flow Statement presents the movement of cash (input and output) over a period and is classified as either under operating, financing or investing activities. The Notes to the Financial Statements are an integral part of an entity’s financial statements. They are for complying with the full disclosure principle. The adjusting and closing entries are entries prepared and posted in the ledger at the end of the accounting period. The adjusting entries are prepared after the data for adjustments are compiled and presented in the worksheet. Accounts in the ledger are classified as nominal or temporary accounts and real or permanent accounts. Nominal accounts include revenue, expense, owner’s drawing and income summary accounts. Real or permanent accounts include the assets, liability and the owner’s equity (capital) accounts. Closing entries are prepared to reduce the nominal account balances to zero on the general ledger. The revenue and expense account balances are transferred to the Income Summary account. The Income Summary balance is then transferred to the owner’s equity or capital account. A credit balance in the Income Summary indicates the profit while a debit balance indicates a net loss. The owner’s drawing account is also transferred in the owner’s capital account. The following entries show how the closing process is made: 1. Revenue xxx Income Summary xxx To close revenue accounts 2. Income Summary xxx Expenses xxx To close expense accounts *3. Income Summary with a credit balance: Income Summary xxx Owner’s Capital xxx To close income summary account *Income Summary with a debit balance: Owner’s Capital xxx Income Summary xxx To close income summary account 4. Owner’s Capital xxx Owner’s Drawing xxx To close drawing account 15  The post-closing trial balance is a list of accounts and their balances after the closing entries have been journalized and posted to the ledger. It includes all the real accounts since the nominal account balances have been reduced to zero. The purpose of the post-closing trial balance is to verify that all nominal accounts have been closed properly and the total debits and credits in the accounting system are equal after the closing process. Reversing entries are journal entries prepared on the first day of the next accounting period which reverses certain types of adjusting entries immediately made in the preceding period. The adjusting entries that may be reversed include the accruals, prepaid expense using the expense method and unearned revenue using the revenue method. This step is an optional procedure and is useful to simplify record keeping in the next accounting period. The rule to follow is all adjusting entries that increase an asset or liability will be reversed. Whether reversing entries are made or not, the same result is achieved. The following show reversing entries that are made on the first day of the next accounting period: 1. Prepaid expense using expense method Expense xxx Prepaid Expense/Asset xxx 2. Unearned revenue using revenue method Unearned Revenue xxx Revenue xxx 3. Accrued expense Payable xxx Expense xxx 4. Accrued Revenue Revenue xxx Receivable xxx 16  THE ACCOUNTING PROCESS Business Transactions Reversing entries Documentation Journalizing Post- closing trial - General journal balance preparation - Special journals Journalizing and Posting posting of adjusting - General ledger and closing entries - Subsidiary ledgers Financial statements Trial Balance preparation preparation Work sheet Adjustments preparation 17 MERCHANDISING BUSINESS The activities of a service business differ from that of a merchandising business. A service business earns revenue by rendering services to customers or clients. The revenue activities of a merchandising business involve the buying and selling of goods or merchandise to its customers. However, except for the merchandise related accounts, the accounting cycle for both types of business activities are the same. Because of the differences in their revenue activities, the general format of the condensed statements of comprehensive income of service and merchandising companies are illustrated below: Service Business Merchandising Business Service Revenue P xxx Sales P xxx Less Operating Expenses xxx Less Cost of Merchandise Sold xxx Net Income xxx Gross Profit xxx Less Operating Expenses xxx Net Income xxx INVENTORY SYSTEMS The two main types of inventory systems are the periodic inventory system and the perpetual inventory system. Companies that sell goods of low unit value or inexpensive items use the periodic inventory system. The periodic system relies upon the physical count of the inventory to determine the ending inventory balance. Merchandise bought intended for sale are recorded in the Purchases account. The balance in the Purchases account is then added to the beginning balance of the inventory account to arrive at the cost of merchandise available for sale. When a physical inventory count is done, the amount of the ending inventory balance will then be deducted from the cost of merchandise available for sale to arrive at the cost of merchandise sold. Sale of merchandise is recorded in a revenue account, Sales. However, the cost is not recorded. Under the perpetual inventory system, purchases and sale of merchandise is recorded in the Merchandise Inventory account and the Cost of the Merchandise sold account. This system is used by companies that sell goods of high unit value like automobiles, jewelry, and other large home appliances. The business keeps track of its cost of merchandise sold on a continuous basis, thus, at any given time, there is an estimate of the company’s inventory level. At the end of the accounting period, an actual count is taken on the number of units still on hand and is compared with the records showing the ending inventory balance. VALUE ADDED TAX Value Added Tax (VAT) is a type of sales tax which is levied on the consumption on the sale of goods, services or properties, as well as goods imported in the Philippines. A 12% value added tax rate is levied on goods and is recorded as a separate account in recording the sale and purchase transactions. It is an indirect tax that is passed on to the buyer 18 and is added to the selling price. The amount paid by the customer, known as the invoice price, will include the selling price and the 12% value added tax. Output Vat refers to the value added tax the seller passed on to the buyer and is classified as a liability account. Input Vat refers to the value added tax the buyer paid on the purchase. The excess of output tax over input tax is the Value added tax due and payable to the Bureau of Internal Revenue and is to be remitted by the company within 25 days of the following month. The following transactions illustrate the accounting for value added tax using the periodic system: Mar 5 A Company sold merchandise to B Company for cash, P 22,400 vat inclusive. A Company B Company Cash 22,400 Purchases 20,000 Sales 20,000 Input tax 2,400 Output tax 2,400 Cash 22,400 Mar 6 A Company sold merchandise to X Company, P 28,000 vat inclusive. A Company X Company Accounts Receivable 28,000 Purchases 25,000 Sales 25,000 Input tax 3,000 Output tax 3,000 Accounts Payable 28,000 Mar 9 A Company issued a credit memorandum to X Company for defective merchandise returned sold on March 6, invoice price P 2,800 A Company X Company Sales returns and allowances 2,500 Accounts Payable 2,800 Output tax 300 Purchase ret. and allow. 2,500 Accounts Receivable 2,800 Input tax 300 Mar 15 A Company collected amount due from X Company A Company X Company Cash 25,200 Accounts Payable 25,200 Accounts Receivable 25,200 Cash 25,200 SPECIAL JOURNALS We have used the general journal to record all types of business transactions. However, as the transactions of a company increase, there is a need to change to a more efficient and timesaving manner. Accountants have developed an accounting system for an orderly and effective processing of data. They have developed special journals. Each special journal records one particular type of transaction that occurs frequently, such as sales on account, cash receipts, purchases on account, or cash disbursements. 19 The special journals are designed to systematize the original recording of major recurring types of transactions. The number and format of the special journals actually used in a company depend primarily on the nature of the company’s business transactions. The special journals illustrated on this chapter are the sales, cash receipts, purchases, cash disbursements journals.  The Sales Journal is used to record all sales of merchandise on account (on credit).  The Cash Receipts Journal is used to record all inflows or receipts of cash into the business.  The Purchases Journal is used to record all purchases of merchandise and other items on account (on credit).  The Cash Payments Journal is used to record all payments (or outflows) of cash by the business. Although we use all these four special journals, the General Journal is still needed. The General Journal is used to record all transactions that cannot be recorded in any one of the special journals. All five of these journals are books of original entry. If a transaction is recorded in the journal, it is posted to the ledger and made part of the accounting records. Therefore, if a transaction is recorded in a special journal, it should not be recorded in the general journal because this would record the transaction twice. Since the journal entries are posted to the ledger accounts, the posting reference column in the ledger should indicate the source of the posting. The following abbreviations are used for the five journals: Journal Transactions Abbreviation Sales Journal Merchandise sold on account S Cash Receipts Journal Cash receipts from all sources CR Purchases Journal Merchandise and other items purchased on account P Cash Payments Journal Cash payments for various purposes CD General Journal Any transaction that is not included in the special G journals. CONTROL ACCOUNTS AND SUBSIDIARY LEDGERS A control account is an account in the general ledger that shows the total balance of all the subsidiary accounts related to it. An example of a control account is the general ledger Accounts Receivable account, which summarizes all of the amounts owed to the company. The subsidiary ledger accounts show the details supporting the related general ledger control account balance. The company may use subsidiary accounts for receivables to send out customer statements. They may use the subsidiary accounts for payables to determine the amount payable to each supplier. These accounts are normally arranged alphabetically by the name of the customer or supplier. The sum of the subsidiary accounts in a subsidiary ledger should agree with the balance in the related general ledger control account when the company prepares the financial statements. 20  A subsidiary ledger, then, is a group of related accounts showing the details of the balance of a general ledger control account. The subsidiary ledger is separated from the general ledger in order to relieve the general ledger of a mass of details and thereby shorten the general ledger trial balance. Also, having separate ledger promotes a division of labor. SCHEDULE OF ACCOUNTS PAYABLE A schedule of accounts payable is prepared to make certain that the total of the balances in the subsidiary ledger accounts agrees with the control account. SCHEDULE OF ACCOUNTS RECEIVABLE A schedule of accounts receivable is prepared to ensure that the total of the balances in the subsidiary ledger account agrees with the control account. This schedule is merely a listing of open account balances. 21  EXERCISES 1-1 On December 31, 2019, Jag Company had total assets of P 640,000 and total liabilities of P180,000. During 2020, the company had total revenues of P 560,000 and total expenses of P 460,000. Also during 2020, the owner withdrew P 60,000. On December 31, 2020, total assets were P 840,000. _________________ 1. Compute the owner’s equity on December 31, 2019 _________________ 2. Compute the net income for the year 2020. _________________ 3. Compute the total liabilities on December 31, 2020. _________________ 4. Compute the owner’s equity on December 31, 2020. 1-2 On March 1, 2020, Anthony Davis started his business, Davis Laundry Services, by investing cash of P 140,000. During the month, he earned service revenue on account, P 100,000. He also paid utilities expenses amounting to P 7,000; wages of P 20,000 and rent expense for the month of P 12,000. He later collected partially the account of customers amounting to P 30,000. At the end of the month, he received a bill for advertising for the month of March payable in April, amounting to P 10,000. _________________ 5. Compute the owner’s equity on March 31, 2020 _________________ 6. Compute the total assets on March 31, 2020 _________________ 7. Compute the total liabilities on March 31, 2020. _________________ 8. Compute the net income for the month of March 2020 1-3 During the current year, the assets of Clipper’s Company increased by P 232,000 and the liabilities decreased by P 54,000. If the owner’s equity in the business is P 620,000 at the end of the year, how much is the owner’s equity at the beginning of the year? 1-4 The balance sheet of Miami Company shows owner’s equity of P 680,000, which is equal to 2/3 of the amount of total assets. What is the amount of total assets? Total liabilities? 1-5 The following data relates to Warriors Company: Withdrawals by the owner P 56,000 Total revenues during the year 308,000 Owner’s equity, January 1 220,000 Additional investments 94,000 Total expenses during the year 232,000 How much is the owner’s equity at the end of the year? 22 1-6 Given are the following selected data of Thunder Repair Service Company Revenue from professional services rendered for cash P 490,000 Revenue from professional services rendered on account 160,000 Additional investment by the owner 104,000 Cash collected from account customers 230,000 Operating expenses incurred on account 48,000 Operating expenses incurred for cash 140,000 Cash withdrawn by the owner 76,000 Compute for the net income of the company. 1-7 You are given the following data: December 31, 2019 December 31, 2020 Assets P 520,000 P 670,000 Liabilities ? 300,000 During 2020: Net loss, P 20,000; Additional investment, P 35,000; Drawings, P 60,000 Compute for the beginning balance of liabilities. 23 1-8. The following trial balance did not balance. JERRY WEST, CPA Trial Balance December 31, 2020 Debit Credit Cash 28,400 Accounts receivable 22,310 Supplies 30,000 Office equipment 50,000 Accounts payable 46,600 Jerry West, Capital 90,000 Jerry West, Drawing 8,000 Professional fees 42,660 Salaries expense 24,000 Advertising expense 9,100 Rent expense 4,000 Utilities expense 5,000 Miscellaneous expense 1,000 181,810 179,260 The following errors were detected: 1. Cash received from a customer on account was debited for P 4,700 and Accounts Receivable was credited for the same amount. The actual collection was for P 7,400. 2. The purchase of a computer on account for P 23,400 was recorded as a debit to supplies for P 23,400 and a credit to Accounts payable for P 23,400. 3. Services were performed on account to a client for P 8,900. Accounts receivable was debited for P 8,900 while Professional fees was credited for P 890. 4. A debit posting to Salaries expense of P 6,000 was omitted. 5. A payment on account for P 2,060 was credited to Cash for P 2,060 but debited to Accounts payable for P 2,600. 6. The withdrawal of P 5,000 cash by the owner for his personal use was debited Salaries expense. 7. Utilities expense of P 2,500 was posted as a credit rather than a debit. 8. The balance of Advertising expense is P 4,100 but it was listed as P 9,100 on the trial balance. Required: Prepare a corrected trial balance. 24 1-9 Given the following independent cases, answer the following: 1. On June 1, 2020, ABC Company collected a total of P 43,200 as payment in advance of a one-year subscription contract to a monthly magazine from a client beginning June 1, 2020. Give the entries needed to record (a) the receipt of the subscription fees and (b) to adjust the accounts on December 31, 2020 using the liability method and the revenue method. 2. Sincere Company incurs salaries at the rate of P 12,600 per day. It pays the employees every Saturday for a 6 day work-week. The last payday was January 27. Give the adjusting entry on January 31. 3. Gonzales and Mendoza, a law firm, performed legal services in late December, 2020 for clients. The P 42,000 of the services will be billed to the clients in January, 2021. Give the adjusting entry that is necessary on December 31, 2020 if the financial statements are prepared at the end of each month. 4. Assume that a company acquires a building on January 1, 2020 at a cost of P 1,410,000. The building has an estimated useful life of 25 years and an estimated residual value of P 150,000. What adjusting entry is needed on December 31, 2020 to record the depreciation for the entire year? 5. Give the adjusting entries needed as of December 31, the last day of the current year. Show your computations after each entry. (a) The balance of the supplies account is a debit of P 14,125. The inventory of supplies on December 31 amounts to P 4,220. (b) The insurance expense account has a debit balance of P 46,800 which represent a one- year insurance premium paid in advance on October 1. (c) The balance of the prepaid rent account is a debit of P 27,000 which represent a 6- month rent received in advance on October 15. (d) The taxes expense account includes a debit of P 64,800 which represent an advance payment of taxes for one year beginning April 30. (e) The advertising expense account includes a debit of P 111,072 which represent the cost of an advertising contract to publish the company ad in 52 consecutive issues of weekly magazine. As of December 31, advertisements had appeared in 32 issues already. (f) The balance of the equipment account is a debit of P 235,200 which represent the cost of office equipment purchased at the beginning of the year. This equipment was estimated to have a life of 15 years with a residual value of P 9,600. (g) An automobile was acquired on July 1 at a cost of P 720,000. This automobile was estimated to have a life of 8 years with a residual value of P 90,000. 25 6. Give the adjusting entries needed as of December 31, the end of the current fiscal year. Show your computations after each entry. (a) The rent revenue account showed a credit balance of P 48,000 which represent a 6- month rent received in advance from a tenant on October 31. (b) The balance of the unearned commissions account is a credit of P 35,100 which represent commissions received in advance for selling one dozen computer sets. As of December 31, only 5 computer sets were sold. (c) Service fees of P 264,000 were collected for one year in advance on April 1. These are credited to Unearned Service Fees when received. (d) Subscriptions income has a credit balance of P 14,040 which represent a one-year subscription to a monthly magazine received in advance on May 31. (e) The company pays a total of P 90,000 every Friday for a 5-day work week ending Friday. Assume that the last day of the year falls on a Wednesday. (f) The company had rendered services to a client towards the end of December. The bill for P 14,100 will be sent in January of the following year. 1-10 Prepare the adjusting entries on December 31, 2020, the end of the annual accounting period, on the following independent data. Show your computations after each entry. 1. The Insurance Expense account had a debit balance on December 31, 2020 of P 72,000 representing premium for a 2-year fire insurance policy effective October 1, 2020. 2. Rent Income was credited for P 58,500 on November 1, 2020 representing 9 months rent collected in advance. 3. Machinery per general ledger on December 31, 2020 shows a balance of P 558,000. Machinery acquired during the year was P 78,000 on March 1, 2020. All machinery is to be depreciated at the rate of 25% per annum. 4. As of December 31, 2020, commissions already earned but not yet collected amounted to P 18,000. 5. Supplies costing P 18,000 bought during the period was debited to the Supplies account. Of the amount, P 8,000 were consumed during the year. 6. Unearned Subscriptions account showed a credit balance of P 76,000 per general ledger on December 31. Of this, 40% had been actually earned during the period. 7. On December 31, 2020 a 60-day, 9% Notes Payable has a balance of P 360,000 per general ledger. The note was issued on December 5, 2020. No interest has been taken on this note. 8. Fees Collected in Advance has a balance of P 600,000 of which 60% has been earned. 26  9. Notes Receivable has a balance of P 300,000 received from a customer in settlement of an open account on November 16, 2020. The note is a 90-day, 12% note. No interest has been taken on this note. 10. The Prepaid Insurance account has balance of P 105,000 on December 31, 2020. The balance represented two fire insurance policies acquired during 2020. The first policy, Policy I for P 60,000 was acquired on March 1, 2020 and the second policy, Policy II was acquired on August 1, 2020 for P 45,000. Policy I is payment for a 2-year plan while Policy II is for a one-year plan. I-11. Compute for the missing items as indicated by a letter below. Beginning Net Ending Cost of Gross Operating Net Sales Inventory Purchases Inventory Goods Profit Expenses Income sold (Net Loss) 175,000 A 85,000 60,000 B 90,000 C 62,000 D 62,000 E 68,000 158,000 110,000 40,000 70,000 280,000 72,000 217,000 F G 100,000 H (51,000) 440,000 90,000 I 110,000 J K 170,000 90,000 A. _________________ G. _________________ B. _________________ H. _________________ C. _________________ I. _________________ D. _________________ J. _________________ E. _________________ K. __________________ F. _________________ 1-12. Given the following data, solve for the following: Debit Credit Sales P 425,000 Sales returns and allowances P 14,000 Accounts receivable 43,000 Allowance for bad debts 760 1. If the estimate of uncollectibles is made by taking 10% of outstanding accounts receivable, the amount of the adjustment is _______________________. 27  2. The following accounts were abstracted from Lakers Co.’s unadjusted trial balance at December 31, 2020. Debit Credit Accounts receivable P 700,000 Allowance for bad debts 8,000 Net credit sales P 3,000,000 Lakers estimates that 1% of the gross account receivable will become uncollectible. After adjustment at December 31, 2020, the Allowance for Bad Debts should have a credit balance of ___________________. 1-13. The following accounts were found in the ledger of Blondie Company on December 31, 2020: Debit Credit Accounts receivable P 356,800 Allowance for bad debts 8,760 Cash Sales P 913,800 Credit Sales 1,851,000 Instructions: 1.) Prepare the adjusting entry to take up the provision for bad debts account on the books of Blondie Company under each of the following independent assumptions: a) Analysis indicates that 5%of the outstanding accounts receivable will not be collected. b) Accounts receivable of P 40,000 will become uncollectible. c) Accounts receivable of P 10,000 is to be written off, and that the allowance for bad debts is to be adjusted to 10% of the outstanding accounts receivable. 2.) Show how the Accounts Receivable and the Allowance for Bad Debts would appear on the December 31, 2020 Statement of Financial Position. 28