Introduction to Accounting - Pt. 1 PDF

Table of Contents Introduction to Accounting 1 Branches of Accounting and Users of Accounting 4 Information Business Organizations 7 Accounting Concepts and Principles 12 Types of Major Accounts 16 T...

Table of Contents Introduction to Accounting 1 Branches of Accounting and Users of Accounting 4 Information Business Organizations 7 Accounting Concepts and Principles 12 Types of Major Accounts 16 The Accounting Equation 19 Books of Accounts and Double-Entry System 21 Business Transactions and their Analysis 26 Accounting Cycle of a Service Business 30 Accounting Cycle of a Merchandising Business 52 Activities 55 INTRODUCTION TO ACCOUNTING DEFINITION OF ACCOUNTING Accounting is a process of identifying, recording, and communicating economic information that is useful in making economic decisions. ESSENTIAL ELEMENTS OF THE DEFINITION OF ACCOUNTING 1. Identifying – The accountant analyzes each business transaction and identifies whether the transaction is an “accountable event” or “non-accountable event.” This is because only accountable events are recorded in the books of accounts. Accountable events are those that affect the assets, liabilities, equity/capital, income, or expenses of a business. Sociological and psychological matters are outside the scope of accounting. 2. Recording – The accountant recognizes (i.e., records) the identified “accountable events.’ This process is called journalizing. After journalizing, the accountant then classifies the effect of the event on the accounts. The process is called posting. Account is the basic storage of information in accounting. Examples are cash, land, sales, and so on. 3. Communicating – At the end of each accounting period, the accountant summarizes the information processed in the accounting system in order to produce meaningful reports. This is important because information processed in the accounting system is useless unless it is communicated to interested users. Accounting information is communicated to interested users through accounting reports, the most common form of which is the financial statements. TYPES OF INFORMATION PROVIDED BY ACCOUNTING 1. Quantitative information – information expressed in numbers, quantities, or units. 1 2. Qualitative information - expressed in words or descriptive form. 3. Financial information – expressed in money. Financial information is also quantitative information because monetary amounts are normally expressed in numbers. BOOKKEEPING AND ACCOUNTING Although bookkeeping function is part of accounting, bookkeeping and accounting are not the same. Bookkeeping refers to the process of recording the accounts or transactions of an entity. Bookkeeping normally ends with the preparation of the trial balance. Unlike accounting, bookkeeping does not require the interpretation of the significance of the information processed. Accounting, on the other hand, covers the whole process of identifying recording and communicating information to interested users. FUNCTIONS OF ACCOUNTING IN BUSINESS Accounting is often referred to as the “language of business” because it is fundamental to the communication of financial information. Accounting has the following two broad functions in a business: 1. To provide non owners of a business (external users) with information that is useful in making among others investment and credit decisions; and 2. To provide business owners and managers (internal users) with information that is useful in managing the business. ACCOUNTING AS A MANAGERIAL TOOL Accounting is an essential managerial tool. This is because accounting provides information that helps a business manager perform his or her management functions. FUNCTIONS OF A MANAGER 2 1. Planning - involves the process of mapping out or arranging in details how a business goal is to be achieved. 2. Organizing - after a plan is formulated, a manager needs to organize his or her personal and other resources according to the plan. Organizing involves assigning responsibilities and granting authority to personnel. 3. Staffing - involves the process of selecting training and developing employees. This function is commonly referred to as human resource management. 4. Directing - after a plan is formulated and resources are organized and made available, a manager needs to lead his personnel to ensure that each is performing his or her responsibilities towards the organization's common goal to the best of his or her ability. Directing involves motivating communicating guiding and encouraging personnel. 5. Controlling - after the other elements are in place, a manager needs to continuously monitor results against goals and take corrective actions necessary to ensure that the plan remains on track. THE DEVELOPMENT OF ACCOUNTING Accounting traces its roots to the Middle East region, whereas early as 8500 BC, merchants used clay objects to represent commodities such as flocks of sheep, jars of spices and oil, bolts of clothing, and other goods. Some archaeologists unearthed clay tablets marred with symbols and other writings and interpreted them to mean records of goods sold and other statistics at those times. The ancient civilization of Babylon, Greece, and Egypt also used clay tablets. These records show wage payments, materials requisitions, and costs of labor, which only shows that accounting has already been in use even during Biblical times. In 1494, Friar Luca Pacioli wrote a book that contains discussions on the double-entry bookkeeping system. The book was untitled "Summa de Arithmetica, Geometria, Proportioni et Proportionalita (Everything about Arithmetic, Geometry, Proportions, and Proportionality). It summarizes the existing mathematical knowledge at that time. Friar Pacioli was considered the father of double-entry bookkeeping and the father of modern accounting. In the mid-18th to the mid-19th centuries, the industrial revolution altered the way goods are produced from the artisan/craftsman method to the assembly-line method. Cost accounting, which deals with the assignment of costs to products, emerged during this period. Also, during this period, the corporate form of business organization was created to accommodate the need for the increasingly large amounts of funds that were required to finance the expansion of businesses. 3 BRANCHES OF ACCOUNTING AND USERS OF ACCOUNTING INFORMATION COMMON BRANCHES OF ACCOUNTING 1. Financial accounting – is the branch of accounting that focuses on general purpose financial statements. General purpose financial statements are those statements that cater to the common needs of external users. Financial accounting is governed by the Philippine Financial Reporting Standards (PFRSs). 2. Management accounting - involves the accumulation and communication of information for use by internal users. An offshoot of management accounting is management advisory services which includes services to clients on matters of accounting, finance, business policies, organization procedures, product costs, distribution, and many other phases of business conduct and operations. 3. Government accounting - refers to the accounting for the government and its instrumentalities, focusing attention on the custody of public funds, the purpose or purposes to which those funds are committed, and the responsibility and accountability of the individuals and trusted with those funds. 4. Auditing - involves the inspection of an entity's financial statements or business processes to ascertain their correspondence with established criteria. 5. Tax accounting - is the preparation of tax returns and rendering of tax advice, such as the determination of tax consequences of certain proposed business endeavors. 6. Cost accounting - is the systematic recording and analysis of the cost of materials, labor, and overhead incident to the production of goods or rendering of services. 7. Accounting education - refers to teaching accounting and accounting related subjects in an organized learning environment. It is a process of facilitating the acquisition of knowledge and skills regarding one or more of the other branches of accounting. 8. Accounting research - pertains to the careful analysis of economic events and other variables to understand their impact on decisions. Accounting research includes a broad 4 range of top which may be related to one or more of the other branches of accounting, the economy as a whole, or the market environment. SPECIALIZED ACCOUNTING FIELDS Accountants are employed in all areas of the economy. The specialized accounting fields wherein an accountant might engaged in are as follows: 1. Public accounting - Accountants and their staff who rendered services for a fee are said to be engaged in public accounting. In this field, an accountant may practice as an individual or as a member of an accounting firm. Certified Public Accountants (CPAs) are public accountants who have met the required education, experience, and have passed the CPA licensure examination. 2. Private accounting - Accountants employed by business firms or by a not-for-profit organization are said to be engaged in private accounting. The scope of activities and duties of private accountants widely varies. These accountants may be hired as an accounting clerk, bookkeeper, management accountant, cost accountant, internal auditor, vice president for finance, or budget director. The chief accountant in a business is called the controller or comptroller. 3. Government accounting - Accountants employed in any governmental units are said to be in the field of government accounting they may be employed as accountant, auditor, budget officer, or consultant in government units like BIR, SEC, NBI, Department of Finance, Bangko Sentral ng Pilipinas, Commission on Audit, and other government agencies. At present, all provinces, cities, and municipalities are already employing CPAs pursuant to the Local Government Code. This widens the job opportunities of accountants. 4. Accounting education - Accountants employed as instructors, professors, reviewers, or researchers are in the field of accounting education. Only CPAs can engage in this field of endeavor. USERS OF ACCOUNTING INFORMATION Users of accounting information are broadly classified into two, namely: 1. Internal users – those who are directly involved in managing the business. Examples of internal users include business owners who are directly involved in managing the business, board of directors, and managerial personnel. 5 2. External users – those who are not directly involved in managing the business. Examples of external users include existing and potential investors, lenders (e.g., banks), creditors (e.g., suppliers), government agencies, non-managerial employees, customers, and public. TYPES OF ACCOUNTING INFORMATION CLASSIFIED AS TO USERS’ NEED 1 General purpose accounting information – is information designed to meet the common needs of most statement users. It is provided by financial accounting and is prepared primarily for external users. 2. Special purpose accounting information – is information designed to meet the specific needs of particular statement users. It is provided by management accounting and is prepared primarily for internal users. 6 BUSINESS ORGANIZATIONS A business is an activity where goods or services are exchanged for money. A person who is engaged in business is called an entrepreneur or businessman. Business come in different forms and types. FORMS OF BUSINESS ORGANIZATIONS Sole Proprietorship A sole proprietorship is a type of business organization in which an individual personally owns the business. The sole proprietorship has no separate legal personality from its owner and the latter is personally liable for all its debts and obligations. Registration of sole proprietorships is with the Department of Trade and Industry (“DTI”). Advantages of a Sole Proprietorship  Easiest and least expensive form of ownership to organize.  Sole proprietors are in complete control, and within the parameters of the law, may make decisions as they see fit.  Profits from the business flow-through directly to the owner’s personal tax return.  The business is easy to dissolve if desired. Disadvantages of a Sole Proprietorship  Sole proprietors have unlimited liability and are legally responsible for all debts against the business. Their business and personal assets are at risks.  May be at a disadvantage in raising funds and are often limited to using funds from personal savings or consumer loans.  May have a hard time attracting high-caliber employees, or those that are motivated by the opportunity to own a part of the business.  Some employee benefits such as owner’s medical insurance premiums are not directly deductible from business income (only partially as an adjustment to income). Partnership A partnership is formed when two or more persons bind themselves to contribute money, property or industry to a common fund with the intention of dividing the profits and ownership among themselves. While the partnership is a separate legal entity from its 7 partners, the latter are personally responsible for the debts and obligations of the partnership. Registration of partnerships is with the Securities and Exchange Commission (“SEC”). Advantages of a Partnership  Partnership are relatively easy to establish; however, time should be invested in developing the partnership agreement.  With more than one owner, the ability to raise funds may be increased.  The profits from the business flow directly through to the partners’ personal tax return.  Prospective employees may be attracted to the business if given the incentive to become a partner.  The business usually will benefit from partners who have complementary skills. Disadvantages of a Partnership  Partners are jointly and individually liable for the actions of the other partners.  Profits must be shared with others.  Since decisions are shared, disagreements can occur.  Some employee benefits are not deductible from business income on tax returns.  The partnership may have a limited life; it may end upon the withdrawal or death of a partner. Corporation A corporation is owned by several people, called shareholders, and has a personality separate and distinct from them. Shareholders are responsible for the debts of the corporation only up to the extent of their capital contribution. Corporations can either be stock or non-stock and are controlled by the Board of Directors or Trustees. Registration of corporations is with the SEC. There are also joint ventures in which two or more entities solidarily bind themselves under a contract to undertake some commercial enterprise. Joint ventures require a community of interest in the performance of the subject, a right to direct and govern the policy connected therewith, and the duty, subject to the agreement of the parties, to share both in profit and losses. The relationship of the joint venture partners is generally governed by the terms of the joint venture contract, supplemented by the law on partnerships. As a rule, corporations cannot enter into partnerships with one another but they are allowed to enter into joint ventures. Advantages of a Corporation  Shareholders have limited liability for the corporation’s debts or judgments against the corporation. 8   Generally, shareholders can only be held accountable for their investment in the stock of the company.  Corporations can raise additional funds through the sale of stock.  A corporation may deduct the cost of benefits it provides to officers and employees. Disadvantages of a Corporation  The process of incorporation requires more time and money than other forms of organizations.  Corporations are monitored by the government and some local agencies, and as a result, may have more paperwork to comply with regulations.  Incorporating may result in higher overall taxes. Dividends paid to shareholders are not deductible from business income; thus, this income can be taxed twice. Cooperative Often referred to as a “co-op”, a cooperative is a limited liability business that can organize for-profit or non-profit. A cooperative differs from a corporation in that it has members, not shareholders, and they share decision-making authority. A cooperative is a business organization owned by a grouped of individuals and is operated for their mutual benefit. The persons making up the group are called members. Cooperatives may be incorporated or unincorporated. Advantages of a Cooperative Organization  Generally inexpensive to register.  A cooperative organization is owned and controlled by members.  Members have an equal vote at general meetings regardless of their level of investment or involvement. One member, one vote.  All members must be active in the co-operative.  This type of organization has a limited liability.  Profit distribution (surplus earnings) to members is carried on in proportion to the use of service; surplus may be allocated in shares or cash. Disadvantages of a Cooperative Organizations  A cooperative organization entails longer decision-making process.  It requires members to participate for success.  It has less incentive, and there’s also a possibility of development of conflict between members.  As co-cooperatives are formed to provide a service to members rather than are turn on investment, it may be difficult to attract potential members seeking a financial return.  There is usually limited distribution of profits to members and some co-cooperatives may prohibit the distribution of any surplus. 9   Members providing greater involvement or investment than others will still only get one vote.  Extension record keeping is necessary in this form of organization. TYPES OF BUSINESS ACCORDING TO ACTIVITIES Service Business A service type of business provides intangible products (products with no physical form). Service type firms offer professional skills, expertise, advice, and other similar products. Examples of service business are schools, repair shops, hair salons, banks, accounting firms, and law firms.  Service business - typically charge for labor or other services provided to government, to consumers, or to other business. Interior decorators, consulting firms and entertainers are service business.  Financial business – include banks and other companies that generate profits through investment and management of capital.  Transportation business – deliver goods and individuals to their destinations for a fee.  Utilities – produce public services such as electricity or sewage treatment, usually under a government. Merchandising Business This type of business buys products at wholesale price and sells the same at retail price. They are known as “buy and sell” business. They make a profit by selling the products at prices higher that their purchase costs. A merchandising business sells a product without changing its form. Examples are grocery stores, convenience stores, distributors, and other resellers.  Retailers and distributors – act as middleman and get goods produced by manufacturers to the intended consumers; they make their profits by marking up their prices. Most stores and catalog companies are distributors or retailers. Manufacturing Business Unlike a merchandising business, a manufacturing business buys products with the intention of using them as materials in making a new product. Thus, there is a transformation of the products purchased. A manufacturing business combines raw materials, labor, and factory overhead in its production process. The manufactured goods will then be sold to customers.  Agriculture and mining business – produce raw material, such as plants or minerals. 10  Manufacturers – produce products, either from raw materials or from component parts, then sell their products at a profit, for example cars, clothing or pipes.  Real-estate business – sell, rent and develop properties including land, residential homes and other buildings. 11 ACCOUNTING CONCEPTS AND PRINCIPLES Accounting concepts and principles are a set of logical ideas and procedures that guide the accountant in recording and communicating economic information. They provide a general frame of reference by which accounting practice can be evaluated and they serve as guide in the development of new practices and procedures. BASIC ACCOUNTING CONCEPTS Separate entity concept Under this concept, the business is viewed as a separate person, distinct from its owner/s. Only the transactions of the business are recorded in the books of accounts. Thus, the personal transactions of the business owner/s are not recorded. Historical cost concept (Cost principle) Assets are initially recorded at their acquisition cost. Going concern assumption The business is assumed to continue to exist for an indefinite period of time. This is necessary for accounting measurements to be meaningful. For example, measuring assets at historical cost is appropriate only when the business is a going concern. Matching principle Under this concept, some costs are initially recognized as assets and charged as expenses only when the related revenue is recognized. Accrual Basis of Accounting Under the accrual basis, economic events are recorded in the period which they occur rather than at the point in time when they affect cash. Thus, income is recorded in the period when it is earned rather than when it is collected, while expense is recognized in the period when it is incurred rather than when it is paid. 12 Prudence (Conservatism) Under this concept, the accounting observes some degree of caution when exercising judgments needed in making accounting estimates under conditions of uncertainty. Such that, if the accountant needs to choose between a potentially unfavorable outcome versus a potentially favorable outcome, the accountant chooses the unfavorable one. This is necessary so that assets or income are not overstated and liabilities or expenses are not understated. Time Period (Periodicity, Accounting period, or Reporting period concept) Under this concept, the life of the business is divided into series of reporting periods. A reporting period is usually 12 months, although it can be longer or shorter. A 12-month accounting period is either a calendar year period or a fiscal year period.  Calendar year period – starts on January 1 and ends on December 31 of the same year  Fiscal year period – also covers 12 months but starts on a date other than January 1 (ex. July 1, 2020 to June 30, 2021) An accounting period that is shorter than 12 months is called an “interim period.” An interim period can be a month, a quarter (3 months), or a semiannual period (6 months). Stable monetary unit Assets, liabilities, equity, income, and expenses are stated in terms of a common unit of measure, which is the peso in the Philippines. Moreover, the purchasing power of the peso is regarded as stable. Therefore, changes in the purchasing power of the peso due to inflation are ignored. Materiality concept This concept guides the accountant when applying accounting principles. This is because accounting principles are applicable only to material items. An item is considered material if its omission or misstatement could influence economic decisions. Materiality is a matter of professional judgment and is based on the size and nature of an item being judged. Cost-benefit (Cost constraint) Under this concept, the cost of processing and communicating information should not exceed the benefits to be derived from it. 13 Full disclosure principle This concept is related to both the concepts of materiality and cost-benefit. Under this principle, information communicated to users reflect a series of judgmental trade-offs that strive for:  Sufficient detail to disclose matters that make a difference to users, yet  Sufficient condensation to make the information understandable, keeping in mind the costs of preparing and using it. Consistency concept This concept requires a business to apply accounting policies consistently, and present information consistently, from one period to another. This means that like transactions must be accounted for in like manner. QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL INFORMATION Qualitative characteristics are the traits that determine whether an item of information is useful to users. Without these characteristics, information may be deemed useless. The qualitative characteristics are broadly classified into two, namely: 1. Fundamental qualitative characteristics – these are the characteristics that make information useful to users. They consist of the following:  Relevance  Faithful representation Relevance Information is relevant if it can affect the decisions of users. Without this trait, information is deemed irrelevant. Relevant information has the following aspects:  Predictive value – Information has a predictive value if it can help users to make predictions about future outcomes.  Confirmatory value (Feedback value) – Information has a confirmatory value if it can help users confirm their past predictions.  Materiality – Information is material if omitting it or misstating it could influence the decisions of users. Faithful representation Information is faithfully represented if it is factual, meaning it represents the actual effects of events that have taken place. Faithfully represented information has the following aspects: 14   Completeness – All information necessary for users to have a complete understanding of the financial statements is provided.  Neutrality – Information is selected or presented without bias. Information is not manipulated to increase its favorability or decrease its unfavorability.  Free from error – Free from error means the information is not materially misstated. This does not mean, however, that accounting information must be perfectly accurate in all respects because some accounting information necessarily needs to be estimated. Free from error means there are no errors in the descripted and in the process by which the information is selected and applied. 2. Enhancing qualitative characteristics – these characteristics support the fundamental characteristics. They enhance the usefulness of information. As such, they must be maximized. The enhancing qualitative characteristics consist of the following:  Comparability  Verifiability  Timeliness  Understandability Comparability Information is comparable if it can help users identify similarities and differences between different sets of information. Unlike the other qualitative characteristics, comparability does not relate to only one item because a comparison requires at least two items. Verifiability Information is verifiable if different users could reach a general agreement what the information intends to represent. Timeliness Information is timely if it is available to users in time to be able to influence their decisions. Understandability Information is understandable if it is presented in a clear and concise manner. On the other hand, users are expected to have a reasonable knowledge of business activities and a willingness to analyze the information diligently. 15 TYPES OF MAJOR ACCOUNTS ACCOUNT Account is the basic storage of information in accounting. It is a record of the increases and decreases in a specific item of asset, liability, equity, income, or expense. FIVE MAJOR ACCOUNTS Assets Assets are the economic resources you control that have resulted from past events and can provide you with future economic benefits. Liabilities Liabilities are the present obligations of the company that have resulted from past events and can require to give up resources when settling them. Equity (Capital, Net assets, or Net worth) Equity is the residual amount of assets deducted by liabilities. Income It is the increase in economic benefits during the period in the form of increases in assets, or decreases in liabilities, which result in increases in equity, excluding those relating to investments by the business owner.  Revenue - arises in the course of the ordinary activities of a business  Gains - represent other items that meet the definition of income and may or may not a rise in the course of the ordinary activities of an entity. Expenses These are decreases in economic benefits during the period in the form of decreases in assets, or increases in liabilities, which result in decreases in equity, excluding those relating to distributions to the business owner. 16   Expenses - arise in the course of the ordinary activities of a business.  Losses - represent other items that meet the definition of expenses and may or may not arise in the course of the ordinary activities of the entity. CLASSIFICATION OF THE MAJOR ACCOUNTS BALANCE SHEET ACCOUNTS INCOME STATEMENT ACCOUNTS 1. Assets 1. Income 2. Liabilities 2. Expenses 3. Equity The balance sheet (or the statement of financial position) is one of the components of a complete set of financial statements. The balance sheet shows the financial position of a business. The income statement (or the statement of profit or loss) is a sub component of the statement of comprehensive income, which is also one of the components of a complete set of financial statements. The income statement shows the profit or loss of a business. CHART OF ACCOUNTS A chart of accounts is a list of all the accounts used by a business. COMMON ACCOUNT TITLES The following are the common account titles and their descriptions: Assets  Cash - includes money or its equivalent that is readily available for unrestricted use, e.g., cash on hand and cash in bank  Accounts receivable – receivables supported by oral or informal promises to pay  Allowance for bad debts – the aggregate amount of estimated losses from uncollectible accounts receivable  Notes receivable – receivables supported by written or formal promises to pay in the form of promissory notes  Inventory - represents the goods that are held for sale by a business. For a manufacturing business, inventory also includes goods undergoing the process of production and raw materials that will be consumed in the production process.  Prepaid supplies – represents the cost of unused office and other supplies  Prepaid rent – rent paid in advance  Prepaid insurance – cost of insurance paid in advance 17   Land - The lot on which the building of the business has been constructed or a vacant lot which is to be used as future plant site. Land is not depreciable.  Building - the structure owned by a business for use in its operations  Accumulated depreciation – building - the total amount of depreciation expenses recognized since the building was acquired and made available for use  Equipment - consists of various assets such as: machineries and other factory equipment; transportation equipment; office equipment; computer equipment; furniture and fixtures; and others  Accumulated depreciation – equipment - the total amount of depreciation expenses recognized since the equipment was acquired and made available for use Liabilities  Accounts payable - obligations supported by oral or informal to pay by the debtor  Notes payable - obligations supported by written or formal promises to pay by the debtor in the form of a promissory notes  Interest payable - interest incurred but not yet paid. Interest payable arises from interest-bearing liabilities. For example, you will incur interest on your bank loan.  Salaries payable - salaries already earned by employees but not yet paid by the business  Utilities payable - utilities (electricity, water, telephone, internet, cable TV, etc.) already used but not yet paid Equity  Owner’s equity (Owner’s capital) – the residual amount after deducting liabilities from assets  Owner’s drawings - the account is used to record the temporary withdrawals of the owner during the period Income  Service fees - revenues earned from rendering services (e.g., services of a spa, services of a beauty salon, etc.)  Sales – revenues earned from the sale of goods (e.g., sale of barbecue, sale of souvenir items, etc.)  Interest income – revenues earned from the issuance of interest-bearing receivables  Gains – income earned from the sale of assets (except inventory) or from enhancements of assets or decreases in liabilities that are classified as revenue Expenses  Cost of sales (Cost of goods sold) - represents the value of inventories that have been sold during the accounting period  Freight-out - represents the sellers' costs of delivering goods to customers 18  Salaries expense - represents the salaries earned by employees for the services they have rendered during the accounting period  Rent expense - represents the rentals that have been used up during the accounting period  Utilities expense – represents the cost of utilities that have been used during the accounting period  Supplies expense – represents the cost of supplies that have been used up during the period  Bad debt expense - the amount of estimated losses from uncollectible accounts receivable during the period  Depreciation expense - the portion of the cost of a depreciable asset that has been allocated to the current accounting period  Advertising expense - represents the cost of promotional or marketing activities during the period  Insurance expense - represents the cost of insurance pertaining to the current accounting period  Taxes and licenses - represents the cost of business and local taxes required by the government for the conduct of business  Travel expenses - represent the costs incurred when traveling on business trips  Interest expense - represents the cost of borrowing money. It is the price that a lender charges a borrower for the use of the lender's money. Other terms for interest expense are finance costs and borrowing costs.  Miscellaneous expense - represents various small expenditures which do not warrant separate presentation  Losses - represent other items that meet the definition of expenses and may or may not arise in the course of the ordinary activities of the entity. 19 THE ACCOUNTING EQUATION THE BASIC ACCOUNTING EQUATION All the processes in an accounting system must observe the equality of the accounting equation, which is basically an algebraic equation. The basic accounting equation is shown below: ASSETS = LIABILITIES + EQUITY Illustration A: Mr. T decided to put up a restaurant and have estimated that he will be needing ₱600,000 as start-up capital. He decided to invest all of his idle money worth ₱412,000, and the insufficiencies will be financed by a bank loan. As a result, the accounting equation is as follows: Assets Liabilities + Equity 600,000 188,000 + 412,000 Notes:  The restaurant’s assets are ₱600,000 – the amount of economic resources that he control.  ₱188,000 represents the restaurant’s liability, the amount it is obligated to pay to the bank in the future.  ₱412,000 represents equity (600,000 – 188,000) Liabilities represent the creditors’ claim, while equity represents the owner’s claim, against the total assets of the business. EXPANDED ACCOUNTING EQUATION The expanded accounting equation shows all the financial statement elements. The expanded accounting equation is as follows: ASSETS = LIABILITIES + EQUITY + INCOME – EXPENSES 20 Notice that income is added while expenses are deducted in the equation. These are because income increases equity while expenses decrease equity. Illustration B: (Continuation of Illustration A) During the period, the restaurant earned income of ₱145,000 and incurred expenses of ₱85,000. At the end of the period, the total assets increased from ₱600,000 to ₱630,000 and total liabilities decreased from ₱188,000 to ₱158,000. The expanded accounting equation is as follows: Assets Liabilities + Equity + Income - Expenses 630,000 158,000 + 412,000 + 145,000 - 85,000 Note:  There is a profit of ₱60,000 since income is greater than expenses. Income and expenses (or profit or loss) are closed to equity at the end of each accounting period. Thus, the adjusted ending balance of equity is computed as follows: Equity, beginning 412,000 Add: Income 145,000 Less: Expenses (85,000) Equity, ending 472,000 or Equity, beginning 412,000 Add: Profit 60,000 Equity, ending 472,000 Your basic accounting equation at the end of the accounting period is as follows: Assets Liabilities + Equity 630,000 158,000 + 472,000 21 BOOKS OF ACCOUNTS AND DOUBLE-ENTRY SYSTEM A business maintains two books of accounts: journal and ledger. JOURNAL The journal, also called the “book of original entries,” is the accounting record where business transactions are first recorded. Business transactions are recorded in the journal through journal entries. This recording process is called journalizing. Journals can be classified into the following: 1. Special journal – is used to record transactions of a similar nature. Special journal simplify the recording process, thus providing an efficient way of recording and retrieving of information.  Sales journal – is used to record sales on account.  Purchases journal – is used to record purchases of inventory on account.  Cash receipts journal – is used to record all transactions involving receipts of cash.  Cash disbursements journal - is used to record all transactions involving payments of cash. A business may have other special journals to suit its needs. For example: Purchase returns journal, sales returns journal, and so on. 2. General journal – All other transactions that cannot be recorded in the special journals are recorded in the general journal. Example of such transactions include purchases of inventory in exchange for notes payable, adjusting entries, correcting entries, and the like. If a business does not utilize special journals, all its transactions are recorded in the general journal. LEDGER The ledger is a systematic compilation of a group of accounts. It is used to classify the effects of business transactions on the accounts. 22 The ledger is also called the "book of secondary entries” or the "book of final entries" because it is used only after business transactions are first recorded in the journals. The process of recording in the ledger is called “posting.” Ledgers can be classified into the following: 1. General ledger – contains all the accounts appearing in the trial balance 2. Subsidiary ledger – provides a breakdown of the balances of controlling accounts. Pictures DOUBLE-ENTRY SYSTEM All transactions are recorded in the accounting records using the “double-entry system.” Under this system, each transaction is recorded into two parts - debit and credit. No transaction is recorded by a debit alone or a credit alone. For each amount that is debited, there must be a corresponding amount that is credited, and vice versa. This is in order for the accounting equation to be balanced at all times. If at any time the accounting equation does not balance, there is an error. DUALITY AND EQUILIBRIUM The concept of duality views each transaction as having a two-fold effect on values - a value received and a value parted with, and each transaction is recorded using at least two accounts. The concept of equilibrium requires that each transaction is recorded in terms of equal debits and credits. For every peso debited, there is a corresponding peso credited, and vice versa. NORMAL BALANCES OF ACCOUNTS The normal balance of an account is on the side where an increase in that amount account is recorded. The following are the normal balances of accounts: Type of Account Normal balance Asset Debit Liability Credit Equity Credit Income Credit Expense Debit 23 RULES OF DEBITS AND CREDITS To debit an account with a normal debit balance means to increase that account. To credit it means to decrease it. To credit on account with a normal credit balance means to increase that account. To debit means to decrease it. Analyze the table below. Type of account Normal balance Debit Credit Asset Debit Increase Decrease Liability Credit Decrease Increase Equity Credit Decrease Increase Income Credit Decrease Increase Expense Debit Increase Decrease ENDING BALANCE OF AN ACCOUNT Debits to a specific asset or expense account should be greater than (or equal to) the credit to that account. On the other hand, credits to a liability, equity, or income account should be greater than (or equal to) to that account. The difference between the monetary totals of debits and credits to an account represents the ending balance of that account. The minimum ending balance of an account is zero. This occurs when the total debits equal total credits to an account. If an asset or expense account results to an ending balance that is a credit, meaning the total amount of debits is less than the total amount of credits, the account is said to have an abnormal balance. This means a recording error has been committed. Correction is needed to eliminate the abnormal balance. This is also true when a liability, equity, or income account results to an ending balance that is a debit. Example: At the beginning of the period, Company A has a cash balance of ₱50,000. During the period, the company had cash collections of ₱12,000 and made total cash payments of ₱14,000. Compute for the ending balance of Company A’s cash. Cash Debit (Dr.) Credit (Cr.) Beginning balance 50,000 Cash collections 12,000 14,000 Cash payments Ending Balance 48,000 24 CONTRA AND ADJUNCT ACCOUNTS Contra accounts are presented in the financial statements as deduction to their related accounts. Adjunct accounts are presented in the financial statements as addition to their related accounts. Examples of accounts with contra accounts: Account Related account Accounts receivable Allowance for bad debts Building Accumulated depreciation – Building Equipment Accumulated depreciation – Equipment Example: Chalk Company’s accounts receivable has a balance of ₱90,000, while the related allowance for bad debts account has a balance of ₱25,400. Compute the carrying amount of Chalk’s accounts receivable. Accounts receivable ₱90,000 Allowance for bad debts (25,400) Accounts receivable – net ₱64,600 25 BUSINESS TRANSACTIONS AND THEIR ANALYSIS THE ACCOUNTING CYCLE The accounting cycle represents the steps or procedures used to record transactions and preparing financial statements. The accounting cycle implements the accounting processes of identifying, recording, and communicating economic information. STEPS IN THE ACCOUNTING CYCLE 1. Identifying and analyzing business documents or transactions The accountant gathers information from source documents and determines the effect of the transactions on the accounts. 2. Journalizing - the identified accountable events are recorded in the journals. 3. Posting - information from the journal are transferred to the ledger 4. Preparing the unadjusted trial balance - the balances of the general ledger accounts are proved as to the equality of debits and credits. The unadjusted trial balance serves as the basis for adjusting entries. 5. Preparing the adjusting entries - the accounts are updated as of the reporting date on an accrual basis by recording accruals, expiration of deferrals, estimations, and other events often not signaled by new source documents. 6. Preparing the adjusted trial balance - the equality of debits and credits are rechecked after adjustments are made. The adjusted trial balance serves as the basis for the preparation of the financial statements. 7. Preparing the financial statements - these are the means by which the information processed is communicated to users 8. Closing the books - this involves journalizing and posting closing entries and ruling the ledger. Temporary accounts, or nominal accounts, are closed and the resulting profit or loss is transferred to an equity account. 26 9. Preparing the post-closing trial balance - the equality of debits and credits are again rechecked after the closing process. 10. Recording of reversing entries - reversing entries are usually made at the beginning of the next accounting period to simplify the recording of certain transactions in that period. JOURNALIZING After an accountable event is identified and analyzed, the second step is to record it in the journal by means of a journal entry. This recording process is called “journalizing.” JOURNAL ENTRY A journal entry has the following format: Date Account titles Debit Credit Account title to be debited xx Account title to be credited xx short description of the transaction SIMPLE AND COMPOUND JOURNAL ENTRIES Simple journal entry contains a single debit and a single credit element, while compound journal entry is the one that contains two or more debits or credits. ILLUSTRATIONS OF JOURNAL ENTRIES Mr. Pam opened a barbecue stand on January 2, 2021. The following were the business truncations on this date: Transaction 1: Mr. Pam provided ₱2,000 cash as initial investment to his business. January 2 Cash 2,000 Mr. Pam, Capital 2,000 To record owner’s initial investment Transaction 2: The business borrowed ₱2,000 through a note from a bank. January 2 Cash 2,000 Notes payable 2,000 To record the borrowed money from a bank Transaction 3: The business acquired the following for cash: Barbecue grill ₱1,000 Cooking accessories 600 27  Beach umbrella 600 January 2 Equipment – Barbecue grill 1,000 Equipment – Cooking accessories 600 Equipment – Beach umbrella 600 Cash 2,200 To record the acquisition of equipment Transaction 4: The business purchased inventory for ₱500 cash. January 2 Inventory 500 Cash 500 To record the acquisition of inventory The effects of the entries above on the basic accounting equation are analyzed as follows: ASSETS LIABILITIES + EQUITY 1 2,000 0 2,000 2 2,000 2,000 0 3 1,000 600 600 (2,200) 4 500 (500) Totals 4,000 2,000 + 2,000 Mr. Pam’s barbecue operations started on January 3, 2021. The following were the business transactions on this date: Transaction 5: Total cash sales of barbecue amounted to ₱700. The total cost of the barbecues sold is ₱300. January 3 Cash 700 Sales 700 To record the sales of barbecue January 3 Cost of goods sold 300 Inventory 300 To record the cost of the barbecues sold as expense Transaction 6: The business paid ₱50 for miscellaneous expenses. January 3 Miscellaneous expense 50 Cash 50 To record paid miscellaneous expenses 28 The effects of the entries above on the basic accounting equation are analyzed as follows: ASSETS LIABILITIES + EQUITY 1 2,000 0 2,000 2 2,000 2,000 0 3 1,000 600 600 (2,200) 4 500 (500) 5 700 700 (300) (300) 6 (50) (50) Totals 4,350 2,000 + 2,350 29 ACCOUNTING CYCLE OF A SERVICE BUSINESS This Chapter will discuss the accounting cycle as applied by a service business. Again, a service business is one that offers services as its main product rather than physical goods. POSTING Posting is the process of transferring the entries from the journal to the accounts in the ledger. If an account is debited in the journal, it will also be posted on the debit side of the account in the ledger. A credit entry in the journal is also posted in the credit side of the account in the ledger. The steps in posting are as follows: 1. Locate in the ledger the debit and credit accounts in the journal entry. 2. Enter the date of the transaction, and in the posting reference column of the ledger, the page of the journal from which entry originates. 3. Record the debit and credit amounts in their respective accounts as they appear in the journal. 4. Enter in the posting reference column of the journal the account number to which the amount was posted. Illustration: CASH Account Number: 101 Date Items P/R Debit Date Items P/R Credit TRIAL BALANCE A trial balance is a summary listing of the account titles and the balance of each account. It is prepared to test the equality of the debit and credit balances of the accounts in the ledger. However, even if the trial balance is equal, it does not provide a complete proof of the accuracy of the accounting records because there are errors which do not affect the equality of the trial balance. But then, if the trial balance does not balance, it is an indication that error has been committed. Steps in preparing a trial balance: 1. Write the heading of the trial balance as follows: 30  Name of the business or proprietor Trial Balance Date 2. List the accounts with corresponding balances. Accounts should be arranged according to financial statement appearance. 3. Write down the account balance on either the debit or credit column of the trial balance. If the account balance is debit, it is written on the debit column. If the account balance is credit, it is placed on the credit column of the trial balance. 4. Add the debit and credit columns of the trial balance. Normally, the debit and credit totals are equal. 5. Double rule or draw a double line under the totals of both columns. Illustration: Mr. Vic Castro opened VC Portrait, a portrait studio, on December 1, 2021. Following were the company’s transactions during the month: December Transactions 1 Began business by depositing ₱300,000 in the business checking account. 1 Paid two months' rent in advance for the studio, ₱40,000. 2 Bought photography equipment on account, ₱100,000. 5 Purchased office equipment for cash, ₱50,000. 8 Purchased photography supplies for cash ₱30,000. 15 Received cash for portraits, ₱70,000. 16 Billed customers for portraits, ₱25,000. 21 Paid for one-half of the photography equipment purchased on December 2. 22 Paid utility bill for the month of December, ₱15,000. 28 Received payment from customers biiled on December 16, ₱12,000. 29 Mr. Castro withdrew cash for personal use, ₱20,000. 30 Received cash from customers for portraits, ₱22,000. 30 Paid wages of employees, ₱23,000. The payroll voucher showed the following information: Gross Pay ₱ 25,000 Less: Deductions Withholding tax ₱ 1,200 SSS Contributions 600 PhilHealth Contributions 200 2,000 Net Pay ₱ 23,000 Following is the chart of accounts of BS Images: 31  VC PORTRAIT Chart of Accounts Acct. Acct. No. No. ASSETS REVENUE Cash 101 Portrait Revenue 401 Accounts Receivable 102 Interest Income 402 Photography Supplies 103 Prepaid Rent 104 EXPENSES Photography Equipment 105 Wages Expense 501 Accumulated Depreciation - 106 Utilities Expense 502 Photography Equipment Office Equipment 107 Supplies Expense 503 Accumulated Depreciation - Office 108 Depreciation Expense-Photography 504 Equipment Equipment LIABILITIES Depreciation Expense-Office 505 Equipment Accounts Payable 201 Rent Expense 506 Wages Payable 202 SSS Contributions Expense 507 Utilities Payable 203 PhilHealth Contributions Expense 508 Withholding Taxes Payable 204 Miscellaneous Expense 509 SSS Contributions Payable 205 PhilHealth Contributions Payable 206 CAPITAL Vic Castro, Capital 301 Vic Castro, Drawing 302 The journal entries to record the business transactions, posting of the entries, and unadjusted trial balance of VC Portrait can be seen on the next pages. 32 33 34 35 36 37 The trial balance of VC Portrait at December 31, 2021 is shown below: VC PORTRAIT TRIAL BALANCE DECEMBER 31, 2021 38 ADJUSTING ENTRIES Adjusting entries are entries made prior to the preparation of financial statements to update certain accounts so that they reflect correct balances as of the designated time. PURPOSE OF ADJUSTING ENTRIES 1. To take up unrecorded income and expense of the period. 2. To split mixed accounts into their real and nominal elements. Adjusting entries are subdivided into the following: 1. Accrued Expenses/Revenues 2. Prepaid/Deferred Expenses 3. Unearned/Deferred Revenues 4. Depreciation of Property, Plant, and Equipment 5. Uncollectible accounts or bad debts 6. Merchandise Inventory ACCRUED EXPENSES Accrued expenses (a liability account) are expenses already incurred but not yet paid. These are also called accrued liabilities or accrued payable. Examples of accrued expenses are as follows: Taxes Payable, Interest Payable, Utilities Payable, Salaries/Wages Payable, Rent Payable, Advertising Payable, and so on. Illustration: Assume that on September 30, 2021, the company has unpaid taxes amounting to ₱20,000. The tax pertains to the month of September but it will be paid in October. Under the accrual basis of accounting, the tax expense must be recorded in September. Because it remains unpaid as of September 30, the company must record the liability for the unpaid tax. September 30 Taxes Expense 20,000 Taxes Payable 20,000 To record accrued taxes as at Sept. 30 Illustration: On December 1, 2021, the company issued a 60-day, 10% notes payable for ₱75,000. Assume the company’s accounting period ends on December 31. The accrued interest on notes payable as of December 31, 2021 is computed as follows: ₱75,000 x 10% x (30 days/360 days) = ₱625 39 Though the term of the note is sixty days, the accrued interest as of December 31, 2021 is thirty days only (Dec. 1-31). The adjusting entry to be prepared on December 31, 2021 to record the accrued interest on the above notes payable is December 31 Interest Expense 625 Interest Payable 625 To record accrued interest at Dec. 31, 2021 ACCRUED REVENUES Accrued revenue (an asset account) is revenue already earned by the business but not yet collected or received at the end of the accounting period. Normally, accrued revenue is not recorded yet since it has not been received. Illustration: On October 1, 2021, Pepla Company received a 6-month, 10% promissory note from a customer in the amount of ₱100,000. From the above data, an adjusting entry for accrued interest on notes receivable should be prepared by Pepla at December 31, 2021, the end of the company’s calendar year. The adjusting entry is December 31 Interest Receivable 2,500 Interest Revenue 2,500 To record accrued interest revenue at Dec. 31, 2021 Computation: ₱100,000 x 10% x (3 months/12 months) = ₱2,500 PREPAID OR DEFERRED EXPENSES Prepaid expenses are expenses paid in advance. Since the benefits will be received in the future, prepaid expenses are treated as asset. They are expected to become expenses through the passage of time or through the use and consumption. Examples include Supplies, Prepaid Rent, Prepaid Insurance, and Prepaid Interest. The adjusting entries for prepaid expenses depend upon the method used to record the prepayment. The two methods of recording prepaid expenses are the Asset Method and the Expense Method. 1. Asset Method – Under this method, the account debited upon payment is an asset account. Upon adjustment, an expense account is debited with a corresponding credit to an asset account. 40 2. Expense Method – the account debited upon payment is an expense account. Upon adjustment, an asset account is debited and an expense account is credited. A company may use either of the two methods, since they are both acceptable. However, there must be consistency in using the method chosen. Illustration: Assume that El Fili Pawnshop is using a monthly accounting period. On January 2, 2021, the company paid ₱30,000 representing 3-month insurance beginning January 2, 2021. The company adjusts and closes its books every month. The following entries upon payment and adjustments are made under both methods as follows: Upon payment Asset Method: January 2 Prepaid Insurance 30,000 Cash 30,000 To record three month insurance paid in advance. Expense Method: January 2 Insurance Expense 30,000 Cash 30,000 To record three month insurance paid in advance. Adjusting entries Asset Method: January 31 Insurance Expense 10,000 Prepaid Insurance 10,000 To take up the expired portion of prepaid insurance. Expense Method: January 31 Prepaid Insurance 20,000 Insurance Expense 20,000 To take up the prepaid portion of insurance expense. Postings to the T-accounts of Prepaid Insurance and Insurance Expense under both methods are shown below: 41  Asset Method Expense Method Prepaid Insurance Insurance Expense Jan. 2 30,000 Jan 31 10,000 Jan. 2 30,000 Jan 31 20,000 Adj. bal. 20,000 Adj. bal. 10,000 Insurance Expense Prepaid Insurance Jan. 31 10,000 Jan. 31 20,000 Under both methods, the amount of Prepaid Insurance that will be reported at January 31 is ₱20,000 (the asset portion) whereas the amount of Insurance Expense for the month of January will be ₱10,000 (the used or expired portion). UNEARNED OR DEFERRED REVENUES Unearned or Deferred Revenues (a liability account) are revenues collected or received in advance by the business. These revenues are not yet earned but already collected or received by the business. The adjusting entries for Unearned Revenues depend upon the method used in recording the advance collection. The methods of recording unearned revenue are as follows: 1. Liability Method – Under this method, the account credited upon receipt of cash is a liability account. Upon adjustment, such liability account will be debited and a revenue account is credited. 2. Revenue Method/Income Method – The account credited at the date of collection is a revenue or income account. Upon adjustment, a revenue account is debited and a liability account is credited. A company may use either of the two methods, since they are both acceptable. However, there must be consistency in using the method chosen. Illustration: 42 On October 1, 2021, Sikreto Apartelle received ₱120,000 from Cha Company, a tenant occupying an office space in the building. The amount is for one year rental beginning month of October paid in advance by Cha. The entries to record the cash collection and the adjustment of Sikreto Apartelle on December 31, 2021 under both methods are: Upon payment by tenant Liability Method October 1 Cash 120,000 Unearned Rent Revenue 120,000 To record receipt of advance payment Revenue Method October 1 Cash 120,000 Rent Revenue 120,000 To record receipt of advance payment Adjusting entries Liability Method December 31 Unearned Rent Revenue 30,000 Rent Revenue 30,000 To take up the income portion of the unearned rent Revenue Method December 31 Rent Revenue 90,000 Unearned Rent Revenue 90,000 To take up the unearned portion of the rent revenue DEPRECIATION OF PROPERTY, PLANT, AND EQUIPMENT Physical resources that are owned and used by a business which are relatively fixed or permanent in nature that have a long useful life are called “Property, Plant, and Equipment.” They are sometimes called fixed assets or plant assets. Examples include land, building, equipment, furniture and fixtures, and transportation vehicles. These assets help generate income for the business. Therefore, it is important and proper that a portion of the asset cost be recorded as expense in each accounting period. 43 Since fixed assets are expected to be useful for a longer time, it is not recorded as expense in the year it is acquired but rather it is recorded as an asset. The matching principle requires that a portion of the cost of plant assets be recorded as expense in each period of usefulness. The process of allocating the depreciable cost of a fixed asset over its estimated useful life is called “Depreciation Accounting.” The accumulated amount of depreciation expense from the year of recognition to the latest balance sheet date is referred to as “accumulated depreciation.” The pro-forma adjusting entry to take up depreciation expense of fixed asset follows: Depreciation Expense (name of asset) xx Accumulated Depreciation (name of asset) xx Factors to be considered in computing depreciation (using the straight line method):  Asset cost – includes its purchase price plus other direct costs incurred in acquiring and brining the asset to its intended use. Examples of these other costs are freight cost and installation cost.  Estimated Residual Value – estimated amount the fixed asset can be sold at the end of its useful life. Other terms used are salvage value, scrap value, or trade in value.  Estimated useful life – this may be expressed in years or number of units, or hours that the asset can be used. Illustration: On January 2, 2021, ML Company bought equipment for a total cost of ₱500,000. Its estimated useful life is 10 years and the estimated residual value is ₱50,000. The company uses the straight-line method of computing depreciation. To record the purchase of equipment on January 2, the entry is: January 2 Equipment 500,000 Cash 500,000 To take up the depreciation of equipment on December 31, 2021, the adjusting entry is: December 31 Depreciation Expense-Equipment 45,000 Accumulated Depreciation-Equipment 45,000 Using the straight-line method, the depreciation expense is computed as follows: Cost of fixed asset (Equipment) 500,000 Less: Estimated residual value 50,000 Depreciable cost 450,000 Divide by the estimated useful life 10 years Annual depreciation 45,000 44 The book value of equipment at December 31, 2021: Cost of fixed asset (Equipment) 500,000 Less: Accumulated Depreciation-Equipment 45,000 Book value, December 31, 2021 455,000 PROVISION FOR UNCOLLECTIBLE ACCOUNTS Uncollectible accounts or bad debts relates to the company’s receivables which might not be collected. Extending credit or rendering services on account is normal in business operations. There are times when receivables from clients can no longer be collected. To comply with the matching principle, companies prepare adjusting entry to recognize the anticipated loss that the business might incur arising from these uncollectible accounts. The pro-forma adjusting entry to take up provision for uncollectible accounts is: Uncollectible Accounts Expense/Bad Debts Expense xx Allowance for Uncollectible Accounts/Allowance for Bad Debts xx Illustration: Assume that on December 31, 2022, the end of the company’s annual accounting period, the company has outstanding Accounts Receivable of ₱400,000. The company estimates that 4% of these receivables might not be collected. The Allowance for Uncollectible Accounts has no balance. The adjusting entry that will be prepared by the company on December 31, 2022 is: December 31 Uncollectible Accounts Expense 16,000 Allowance for Uncollectible Accounts 16,000 (400,000 x 4%) For the year 2022, the company will report uncollectible account expense of ₱16,000 on its Income Statement. Whereas, on its December 31, 2022 Statement of Financial Position (balance sheet) Accounts Receivable will be presented as follows: Accounts Receivable 400,000 Less: Allowance for uncollectible accounts 16,000 Expected or Net Realizable Value 384,000 WORK SHEET The work sheet is a columnar sheet of paper used to summarize information needed to make the adjusting and closing entries and to prepare the financial statements. A work sheet is only a tool by accountants and is not part of the formal accounting record. A work sheet is 45 used each time financial statements are prepared, either monthly, quarterly, semi-annually, or annually. Steps in preparation of the work sheet are as follows: 1 Enter the titles and balances of ledger accounts in the Trial Balance columns. 2. Enter the adjustments in the Adjustments columns. Identify each adjustment with letters. 3. Enter adjusted account balances in the Adjusted Trial Balance columns. 4. Extended adjusted balances of revenue and expense accounts from the adjusted trial balance columns to the income statement column. 5. Extend adjusted balances of assets, liabilities, and owner’s equity accounts from the Adjusted Trial Balance columns to the balance sheet column. 6. Determine the total of the income statement and the balance sheet columns. Enter the net income/loss as a balancing figure in both pair of columns, and again compute column totals. Illustration: Here is the trial balance of Cruz Service Center on December 31, 2021: Debits Credits Cash 90,000 Accounts Receivable 73,000 Supplies 62,000 Equipment 120,000 Accounts Payable 88,850 Cruz, Capital 200,150 Service Revenue 100,000 Rent Expense 12,000 Salaries Expense 24,000 Miscellaneous Expense 8,000 Total 389,000 389,000 The adjustments for Cruz Service Center are as follows: (a) Supplies on hand as of December 31, ₱15,000. (b) Depreciation of equipment for the month, ₱10,000. (c) Unearned service revenue, ₱60,000. (d) Unbilled service revenue performed in December, ₱15,000. (e) Accrued utilities at the end of the month, ₱5,000. The following are the adjusting entries for each adjustments: (a) December 31 Supplies expense 47,000 Supplies 47,000 46 (b) December 31 Depreciation expense-Equipment 10,000 Accumulated Depreciation-Equipment 10,000 (c) December 31 Service Revenue 60,000 Unearned Service Revenue 60,000 (d) December 31 Accounts Receivable 15,000 Service Revenue 15,000 (e) December 31 Utilities expense 5,000 Utilities payable 5,000 The work sheet can be seen on the following page. 47  CRUZ SERVICE CENTER Work Sheet For the Year Ended December 31, 2021 Trial Balance Adjustments Adjusted Trial Balance Income Statement Balance Sheet Account Title debit credit debit credit debit credit debit credit debit credit Cash 90,000 90,000 90,000 Accounts Receivable 73,000 (d) 15,000 88,000 88,000 Supplies 62,000 (a) 47,000 15,000 15,000 Equipment 120,000 120,000 120,000 Accounts Payable 88,850 88,850 88,850 Cruz, Capital 200,150 200,150 200,150 Service Revenue 100,000 (c) 60,000 (d) 15,000 55,000 55,000 Rent Expense 12,000 12,000 12,000 Salaries Expense 24,000 24,000 24,000 Miscellaneous Expense 8,000 8,000 8,000 389,000 389,000 Supplies Expense (a) 47,000 47,000 47,000 Depreciation Expense-Equipment (b) 10,000 10,000 10,000 Accumulated Depreciation-Equipment (b) 10,000 10,000 10,000 Unearned Service Revenue (c) 60,000 60,000 60,000 Utilities Expense (e) 5,000 5,000 5,000 Utilities Payable (e) 5,000 5,000 5,000 137,000 137,000 419,000 419,000 106,000 55,000 313,000 364,000 Net Loss 51,000 51,000 106,000 106,000 364,000 364,000 48 INCOME STATEMENT The information needed to prepare the income statement can be taken from the income statement columns in the work sheet. The income statement of Cruz Service Center follows: CRUZ SERVICE CENTER Income Statement For the Year Ended December 31, 2021 Service Revenue ₱55,000 Less: Operating Expenses Rent Expense ₱12,000 Salaries Expense 24,000 Miscellaneous Expense 8,000 Supplies Expense 47,000 Depreciation Expense 10,000 Utilities Expense 5,000 Total Operating Expenses 106,000 Net Loss ₱51,000 CLOSING ENTRIES Closing entries are entries prepared at the end of the accounting period to bring the balances of the temporary or nominal accounts to zero, so that they will be ready to receive data for the next accounting period. These temporary accounts are the revenues, expenses, and drawing accounts. These accounts are closed at the end of each period so that we may identify their balances by the year of occurrence. Hence, we say the sales of 20x2 must not include the sales of 20x1. Closing entries are prepared as follows:  All income accounts are debited and all expense accounts are credited. The resulting balance is recorded in a clearing account called the “Income Summary.”  The balance of “Income Summary” is closed to the “Owner’s capital” account.  Any balance in the “Owner’s drawings” account is closed to the “Owner’s capital” account. Illustration: Here below are the closing entries for Cruz Service Center on December 31, 2021: 49 Closing entry - Income Summary December 31 Service Revenue 55,000 Income Summary 51,000 Rent Expense 12,000 Salaries Expense 24,000 Miscellaneous Expense 8,000 Supplies Expense 47,000 Depreciation Expense-Equipment 10,000 Utilities Expense 5,000 Closing entry – Income Summary closed to Equity December 31 Cruz, Capital 51,000 Income Summary 51,000 Closing entry – Drawings account closed to Equity There is no closing entry for drawings account to be closed in Equity since no drawings was made on the accounting period. POST-CLOSING TRIAL BALANCE A post-closing trial balance is the trial balance prepared after the adjusting and closing procedures. Sometimes it is called a statement of financial position (balance sheet) in a trial balance form, because the items appearing in the post-closing trial balance consists of assets, liabilities, and owner’s equity/capital. The temporary accounts had been closed, so they are no longer included in the post-closing trial balance. Illustration: The post-closing trial balance of Cruz Service Center as of December 31, 2021 is shown as follows: CRUZ SERVICE CENTER Post-Closing Trial Balance December 31, 2021 Debits Credits Cash 90,000 Accounts Receivable 88,000 Supplies 15,000 Equipment 120,000 Accumulated Depreciation-Equipment 10,000 Accounts Payable 88,850 50  Utilities Payable 5,000 Unearned Service Revenue 60,000 Cruz, Capital 149,150 Total 313,000 313,000 REVERSING ENTRIES These are entries usually made on the first day of the next accounting period to reverse certain adjusting entries immediately preceding period. Reversing entries are optional, meaning they are not required in the preparation of the financial statements. However, business often use reversing entries to simplify the recording process in the next accounting period. Not all adjusting entries may be reversed. Only the adjusting entries made for the following may be reversed:  Accruals for income or expense  Prepayments initially recorded using the expense method  Advanced collections initially recorded using the revenue/income method Illustration: Cruz Service Center paid its utilities payable on January 6. Entries – no reversing entry Entries – with reversing entry Dec. 31 Utilities Expense 5,000 Utilities Expense 5,000 Utilities Payable 5,000 Utilities Payable 5,000 Jan. 1 No entry Utilities Payable 5,000 Utilities Expense 5,000 Jan. 6 Utilities Payable 5,000 Utilities Expense 5,000 Cash 5,000 Cash 5,000 51 ACCOUNTING CYCLE OF A MERCHANDISING BUSINESS This chapter will tackle the accounting cycle of a merchandising business. A merchandising business is one that buys and sells goods without changing their physical form. Accounting for a merchandising business is more complex than a service business. For example, the accounting system for a merchandiser must be designed to record the receipt of goods for resale, keep tract of the goods available for sale, and record the sale and cost of the merchandise sold. INVENTORY The main difference between a merchandising business and a service business is that a merchandising business necessarily holds inventory of physical goods for sale. Inventories are accounted for using either of the following inventory systems: perpetual inventory system or periodic inventory system. The perpetual inventory system provides detailed records of the quantity and cost of each item of inventory and continuously shows the cost of goods on hand. This inventory system has traditionally been used by companies that sell high-unit value items since this system also provides an effective means of control over inventory. Under the perpetual inventory method, the cost of each item is debited to the Merchandise Inventory account as it is purchased. As items are sold, the Merchandise Inventory account is credited and the Cost of Goods Sold is debited for the cost of the items sold. At the end of the accounting period, a physical inventory is taken by actually counting the numbers of units on hand which is then compared with the records showing the number of units remaining. On the other hand, under the periodic inventory system, the count of the physical inventory takes place periodically, usually at the end of the accounting period, and no detailed records of the physical inventory on hand are maintained during the period. The Purchases account is used to record the cost of merchandise bought by the business. When merchandise is sold, revenue is recorded but not the cost of merchandise sold. When financial statements are prepared, the company takes a physical count of the ending merchandise inventory which is then used in computing the cost of goods sold. 52 Illustration: Perpetual and Periodic Journal Entries Perpetual System Periodic System 1. The company purchased goods worth ₱10,000 on account. Inventory 10,000 Purchases 10,000 Accounts Payable 10,000 Accounts Payable 10,000 2. The company paid shipping costs of ₱1,000 on the purchase above. Inventory 1,000 Freight-in 1,000 Cash 1,000 Cash 1,000 3. The company returned damaged goods worth ₱2,000 to the supplier. Accounts Payable 2,000 Accounts Payable 2,000 Inventory 2,000 Purchase returns 2,000 4. The company sold goods costing ₱5,000 for ₱20,000 on account. Accounts Receivable 20,000 Accounts Receivable 20,000 Sales 20,000 Sales 20,000 Cost of goods sold 5,000 Inventory 5,000 5. A customer returned goods with sale price of ₱800 and cost of ₱200. Sales returns 800 Sales returns 800 Accounts Receivable 800 Accounts Receivable 800 Inventory 200 Cost of goods sold 200 Under the perpetual inventory system, the balances of inventory on hand and cost of goods sold are readily determinable from the ledger. Inventory beg. Bal - (1) Purchases 10,000 2,000 (3) Purchase return (2) Freight-in 1,000 5,000 (4) cost of goods sold (5) Sales return 200 4,200 end. Bal. Cost of goods sold - (4) cost of goods sold 5,000 200 (5) Sales return 4,800 end. Bal. Under the periodic inventory system, the balances of inventory on hand and cost of goods sold are not readily determinable without performing first a physical count of the quantity of goods on hand. 53 Assume that a physical count revealed inventory on hand of 105 units costing ₱40/unit. The inventory on hand and cost of goods sold under the periodic inventory system are determined as follows: Beginning inventory ₱ - Purchases (1) ₱10,000 Freight-in (2) 1,000 Purchase returns (3) (2,000) Purchase discounts - Net purchases 9,000 Total goods available for sale 9,000 Ending inventory (105 units x ₱40) (4,200) Cost of goods sold ₱4,800 GROSS PROFIT Gross profit (gross income, gross margin, or sales profit) is simply “Net sales minus Cost of Goods Sold.” Net sales* ₱xx Cost of Goods Sold (xx) Gross profit xx Rent expense (xx) Depreciation expense (xx) Salaries expense, etc. (xx) Profit/(Loss) xx (xx) *Net Sales = Gross sales – Sales Returns and Allowances – Sales Discounts 54  ACTIVITIES FUNDAMENTALS OF ACCOUNTING, BUSINESS, AND MANAGEMENT 1 _____________________________ NAME _______________________________________ GRADE LEVEL/SECTION _______________________________________ SCHOOL 55  ACTIVITY A Identification. 1. It is a process of identifying, recording, and communicating economic information that is useful in making economic decisions. 2. It is a facet of business that is responsible for building good rapport with customers. 3. An explanatory note explaining why certain expenses have increased during the period is considered as ________ information. 4. In this phase, accounting information is disseminated to interested parties. 5. Human resource management refers to what management function? 6. He is considered the father of modern accounting. 7. The management function of continuously monitoring results against goals and taking corrective actions necessary to ensure that the business plan remains on track. 8. Leadership refers to the management function of what? 9. This refers to the accounting process of ascertaining whether a business transaction is to be recorded or not. 10. Its function is to provide quantitative information, primarily financial in nature, about economic entities, that is intended to be useful in making economic decisions. 11. Only ____ events are recorded in the books of accounts. 12. Information expressed in words or descriptive form. 13. Accounting, as a ______, is a body of knowledge which has been systematically gathered, classified, and organized. 14. Bookkeeping normally ends with the preparation of the ______. 15. It is the most common form used to communicate accounting information to the interested users. 56 ACTIVITY B True or False. 1. Accounting