Chapter 1: Introduction to Accounting

l DEFINITION OF ACCOUNTING

Accounting is a process of identifying, recording and communicating economic information that is useful
in making economic decisions.

n 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. "Non-accouhtable events" are not recorded in the books of accounts.

"Accountable events" (or 'economic events') are those that affect the assets, liabilities, equity, income
and expenses of a business. Sociological and psychological matters are outside the scope of accounting.

2. Recording - The accountant recognizes (i.e., records) the "accountable events" he has identified. This
process is called "journalizing."

After journalizing, the accountant then classifies the effects of the event on the "accounts." This process
is called "posting."

Account is the basic storage of information in accounting, e.g, "cash," "land," "sales," etc.

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
commmon form of which is the financial statements.

l NATURE OF ACCOUNTING

Accounting is a process with the basic purpose of providing information about economic activities
intended to be useful in making economic decisions.

n Types of information provided by accounting

1. Quantitative information- information expressed in numbers quantities, or units.

2. Qualitative information - information expressed in words or descriptive form. Qualitative information

is found in the notes to financial statements as well as on the face of the other components of financial
statements.

3. Financial information - information expressed in money. Financial information is also quantitative

information because monetary amounts are normally expressed in numbers.

l ACCOUNTING AS SCIENCE AND ART

1. As a Social science, accounting is a body of knowledge which has been systematically gathered,
classified and organized.

2. As a Pratical art, accounting requires the use of creative skills and judgement.

l ACCOUNTING AS AN INFORMATION SYSTEM

A system is one that consists of an input, a pricess and an output.

Accounting system:

Input = Accountable events

Process = Recording, classifying and summarizing

Output = Accounting report

n Bookkeeping and Accounting

Bookkeeping - process of recording the accounts or transactions of an entity. Does not require the
interpretation of the significance of the information processed.

Accounting - covers the whole process of identifying, recording, and communicating information to
interested users.

l FUNCTIONS OF ACCOUNTING IN BUSINESS

Accounting is often referred as "Language of Business".

Two broad functions of accounting in a business.

1. To provide external users with information that is useful in making, among others, investment and
credit decisions.

2. To provide internal users with information that is useful in managing the business.

l USERS OF ACCOUNTING INFORMATION

1. Internal users - directly involved in managing the business.

Examples: a. Business Owners b. Board of Directors c. Managerial Personnel

2. External users - not directly involved in the business.

Examples: a. Existing and potential investors b. Lenders and Creditors c. Government agencies

d. Non-managerial employees e. Customers f. Public

n Types of accounting information classified as to user's needs

1. General purpose accounting information - designed to meet the common needs of most statement
users. Provided by financial accounting and prepared for external users.

2. Special purpose accounting information - designed to meet the specific need of particular statement
users. Provided by management accounting or other branches of accounting and prepared for internal
users.

l BRIEF HISTORY OF ACCOUNTING

Accounting can be traced as far back as the prehistoric times. Since the dawn of civilization when
mankind began to engage in trade, Perhaps more than 10,000 years ago, methods of record keeping and
accounting have been invented.

As early as 8500 B.C., accounting has already existed. Archaeologists have found clay tokens as old as
8500 B.C. in Mesopotamia which were usually cones, disks, spheres and pellets. These tokens
correspond to commodities like sheep, clothing or bread. They were used in the Middle West in keeping
records. After some time, the tokens were replaced by wet clay tablets. During such time, experts
concluded this to be the start of the art of writing.

Other ancient civilizations keeping account records are Babylonia (4500 B.C.), Egypt (2250 B.C.), China
and Greece.

In the middle ages (13th and 15th centuries), trade flourished in places such as Florence, Venice and
Genoa. This has brought advancement in account keeping methods. In 1211 A.D., one of the systems in
accounting was kept by a Florentine banker. However, the system was primitive as the concept of
equality for entries was absent. Double entry records first came out during 1340 A.D. in Genoa.

In 1494, the first systematic record keeping dealing with the "double entry recording system" was
formulated by Fra Luca Pacioli, a Franciscan monk and mathematician. The "double entry recording
system" was included in Pacioli's book titled "Summa di Arithmetica Geometria Proportioni and
Proportionista," published on November 10, 1494 in Venice.

The concept of "double entry recording" is being used to this day. Thus, Fra Luca Pacioli is considered as
the father of modern accounting.

l 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 that cater, to the common needs of a wide range of
external users.

* Financial accounting is governed by the Financial Reporting Standards (PFRSs).

The scope of this book is the fundamentals of financial accounting and reporting.
Financial accounting vs. Financial reporting

The terms "financial accounting" and “financial reporting” are often used interchangeably. Although,
both focus on general purpose financial statements, financial reporting endeavors to promote principles
that are also useful to "other financial reporting."

"Other financial reporting" comprises information provided outside the financial statements that assists
in the interpretation of a complete set of financial statements or improves users' ability to make
efficient economic decisions.

Financial statements vs. Financial report

Ø Financial statements are the structured representation of an entity's financial position and
results of its operations. They are the end product of the accounting process and the means by
which information gathered and processed are periodically communicated to users.

Ø A financial report includes the financial statements plus other information provided outside the
financial statements that assists in the interpretation of a complete set of financial statements
or improves users' ability to make efficient economic decisions.

Financial Statement Financial Report

1 Statement of financial position 1 Stement of financial position

2 Statement of profit or loss and other 2 Statement of profit or loss and other
comprehensive income comprehensive income

3 Statement of changes in equity 3 Statement of changes in equity

4 Statement of cash flows 4 Statement of cash flows

5 Notes 5 Notes

6 Additional stamentnof financial position 6 Additional statement of financial position

7 Other information

Ø Financial reporting - involves the provision of financial information about an entity that is
useful in making economic decisions by external users and assessing management's
stewardship.

Primary objectives of financial reporting

A. To provide information about an entity's economic resources, claims to these resources, and
changes in these resources.
 B. To provide information that is useful in making investment and credit decisions, as well as
assessing the amounts and timing of future cash flows of an entity.

Secondary objective of financial reporting:

C. To provide information useful in assessing management's stewardship or the effectiveness of

the entity's management.

(The term 'entity' refers to the 'reporting entity.' A reporting entity is the one whose financial
statements are being prepared, for example a 'business.' However, not only businesses prepare financial
statements. Other types of organizations, for example, non-profit organizations, the government, or
even a private individual, may also prepare financial statements. Yes, even you can prepare your own
personal financial statements. t,C) As a matter of fact, government employees are required to prepare
and submit their personal financial statement called the `SALN' or Statement of Assets, Liabilities and
Net Worth.)

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.

Financial Accounting Management Accounting

Focuses on the external users Focuses on the internal users

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 entrusted with those funds.

4. Auditing — involves the inspection of an entity's financial statements or business processes to

ascertain their correspondence with an 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 costs 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 range of topics, which may
be related to one or more of the other branches of accounting, the economy as a whole, or the market
environment.

l FORMS OF 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.

n Businesses in the Philippines are organized in following;

1. Sole or single proprietorship - is a business that is owned by one individual. It is the most common and
simplest form of business organization. The business owner is called a "sole proprietor"

A sole proprietorship is registered with the Department of trade and industry (DTI).

2. Partnership — is a business that is owned by two or more individuals who entered into a contract to
carry on the business and divide among thernSelves the earnings therefrom. The business owners are
called partners.

A partnership is registered with the Securities and Exchange Commission (SEC).

3. Corporation — a corporation is also owned by more than one individual. However, unlike a
partnership, a corporation is created by operation of law rather than a contract. Ownership in a
corporation is represented by shares of stocks. The owners are called stockholders or shareholders.

A corporation is an artificial being or a juridical person, meaning in the eyes of the law, a corporation is
like a person, separate from its owners. Therefore, a corporation can transact on its own, have its own
properties, incur its own obligations, and sue or be sued.

For example, when you buy goods from a corporate business, you are actually transacting with the
corporation and not its owners. If you get sick from consuming the goods, you will sue the corporation
and not its owners.

A partnership also has a juridical personality. However, unlike for corporations, the partners are viewed
as agents of the partnership. Meaning, the partners transact on behalf of the partnership.

For example, if you transact with a partner of a business: you are transacting with the partnership
through the partner while if you transact with a stockholder, this does not necessarily mean that you are
transacting with corporation.

The incorporators (i.e., founders) of a Corporation shall not be less than 5 but not more than 15
individuals. However a corporation can have as many stockholders as its authorized capitalization
permits.

A corporation is registered with the Securities and Exchange Commission (SEC).

4. Cooperative — a cooperative is also owned by more than one individual. However, a cooperative is
formed in accordance with the provisions of The Philippine Cooperative Code of 2008. The owners of a
cooperative are called members.

From the root word "cooperate," a cooperative is an association of individuals who joined together to
contribute capital and cooperate in order to achieve certain goals.

For example, a group of farmers may forma cooperative to acquire delivery trucks to be used in
transporting their produce to the market. In here, the farmers voluntarily join together to achieve a
common goal, which is to address their need to get their produce to the market.

Another concept of a cooperative is that members need to patronize the cooperative's goods or
services. In the example above, the member farmers shall hire delivery trucks from the cooperative
rather than from other businesses. If the cooperative earns profit (net surplus), a farmer can recover his
costs through patronage refunds. Patronage refund pertains to the profit that a cooperative returns to
its owners. It should be noted that a member who has not patronized any of the services of the
cooperative for an unreasonable period of may be removed from the cooperative upon the majority
vote vote of the board of directors.

A cooperative also has juridical personality similar to a corporation.

The founding members of a cooperative shall not than 15 individuals. However, a cooperative can have
be less ave as many members as its by-laws permit.

A cooperative is registered with the Coooperative Development Authority (CDA).

n Types of Business According to Activities

The following are the major types of business according to the activities they undertake:

1. Service business 2. Merchandising (Trading) 3. Manufacturing

A. Service business - A service business is one that offers services as its main product rather than
physical goods. A service business may offer professional skills, expertise, advice, lending
service, and similar services.

Examples of service businesses include:

a. Schools b. Professionals (accounting firm, law firm, electrician, etc.) c. Hospitals and clinics

d. Banks and other financial institutions e. Hotels and restaurants

f. Transportation and travel (taxi operator, travel agency, etc)

g. Entertainment and events planners (wedding planners, concert promoters, etc.)

 B. Merchandising business - A merchandising business (or trading business) is one that buys and
sells goods without changing their physical form.

Examples of merchandising businesses include:

a. General merchandise resellers (grocery stores, department stores, hardware stores, pharmacies,
online stores, sari-sari stores, etc.)

b. Distributors and dealers (rice wholesalers, vegetable dealers, 2nd-hand cars dealers, etc.)

C. Manufacturing business - A manufacturing business is one that buys raw materials and
processes them into final products. Unlike a merchandising business, a manufacturing business
changes the physical form of the goods it has purchased in a production process. For example,
a business that buys and sells eggs is a merchandising business. On the other hand, a business
that buys eggs and uses the eggs as ingredient in making cakes for sale is a manufacturing
business.

Examples of manufacturing businesses include:

a. Car manufacturers (Toyota, Ism, Volkswagen, etc)

b. Technology companies (Apple, Samsung, Sony etc)

c. Food processing companies (San Miguel Pure Foods, Silver, etc)

d. Factories (clothing factories, animal feeds factory, plastic wares factories, etc.)

Some businesses, called hybrid businesses, engage in more than one type of activity. For example, a
restaurant uses gredients to cook a meal (manufacturing), sells Coca-Cola drinks (merchandising), and
serves food to customers (service). Nevertheless, a hybrid business is classified into one of the major
types based on the activity that is most in line with the business' purpose. Restaurants are expected to
fill-in customer orders and provide dining services, thus, they are more of a service-type business.

Chapter 2: Accounting Concepts and Principles

l INTRODUCTION

Accounting concepts and principles (assumptions or postulates) 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.

Accounting concepts and principles provide reasonable assurance that information communicated to
users is prepared in a proper way. For example, doctors have a proper way of performing surgery on a
patient; engineers have a proper way of constructing a bridge; accountants too have a proper way of
recording and communicating economic information. This is to maximize the usefulness of accounting
information to the users.
 l BASIC ACCOUNTING CONCEPTS

1. 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. The
personal transactions of the business owner(s) are not recorded.

For example, you started a business. Under the separate entity concept, you will view your business as a
separate person like a friend maybe (your business can also have its own facebook account).

Therefore, the money you invested to the business is now owned by the business. It is not your personal
money anymore. Also, the business owns any money that it earns. If you take money from the business
for your personal use it would be recorded in the book of accounts as a withdrawal of your investment
from the business. Similarly, when you take goods from the business for your personal consumption
which you don't intend to pay, this would also be recorded as a withdrawal of your investment.

Your personal transactions (i.e, those that do not involve the business) must not be recorded in the
books of accounts. For example, if you use your personal money to buy groceries for home
consumption, this will not be recorded in the books of accounts.

The application of the separate entity concept is necessary so that the financial position and
performance of a business can be measured properly. By applying the separate entity concept, you can
objectively know if the business is really earning profits, or if it has the ability to do so.

Many business les have failed because they did not apply the seperate entity concept. Take for example
an owner of a sari-sari store who regards the store's cash register as an extension of his pocket. He takes
money from the business for personal use and consumes the store's goods without recording them. The
business then suffers from lack of working capital. It runs out of goods to sell without any money to
replenish them. Eventually, the business becomes bankrupt. Unknowingly this guy has caused his own
business to fail. If this guy had applied the separate entity concept, he would have had better accounting
information that could have led him to make better business decisions.

2. Historical cost concept (Cast principle) - Under this concept, assets are initially recorded at their
acquisition cost.

3. Going concern assumption - Under this concept, 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 (historical cost concept) is appropriate only when the business is a
going concern.

The opposite of going concern is liquidating concern. This is the case if the business intends to end its
operations or if it has no other choice but to do so, (e.g., the business is bankrupt). The assets of a
liquidating concern are measured at net selling price rather than at historical cost. (Going concerm good,
Liquidating concern - bad).
4. Matching (or Association of cause and effect) - Under this concept, some costs are initially recognized
as assets and charged as expenses only when the related revenue recognized

5. Accrual Basis of accounting - Under the accrual basis of accounting, economic events are recorded in
the period in which they ocour 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.

6. Prudence (or Conservatism) - Under this concept, the accountant 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.

7. Time Period (Periodicity or Accounting period concept) - Under this concept, the life of the business is
divided into series of reporting periods.

Thus, instead of waiting until the life of the business ends before profit is determined, the life of the
business is divided into series of equal short periods called reporting periods (or accounting 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. A calendar year period starts on January 1
and ends on December 31 of the same year. A fiscal year period also covers 12 months but starts on a
date other than January 1, e.g.. July 1, 2017 to June 30, 2018.

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).

8. Stable monetary unit - Under this concept, 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.

9. 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.

For example, material items are communicated to users in a more detailed manner as compared to
immaterial item.

10. Cost-benefit (Cost constraint)-Under this concept, the cost of processing and communicating
information should not exceed the benefits to be derived from it.
Il. Full disclosure principle -This concept is related to both the concepts of materiality and cost-benefit.
Under the full disclosure principle, information communicated to users reflect a series of judgmental
trade-offs. The trade-offs strive for:

a. Sufficient detail to disclose matters that make a difference to users, yet

b. Sufficient condensation to make the information understandable, keeping in mind the costs of
preparing and using it.

12. Consistency concept - Under this concept, a business shall 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.

Accounting policies used this year shall be the same accounting policies used last year. This, however,
does not mean that a business cannot change its accounting policies. Accounting policies can be
changed if it is required by a standard or the change would result in more relevant and more reliable
information. Any change in accounting policy must be disclosed.

l ACCOUNTING STANDARDS

Accounting concepts and principles are either explicit or implicit. Explicit concepts and principles are
those that are specifically mentioned in the Conceptual Framework for Financial Reporting and in the
Philippine Financial Reporting Standards (PFRSs). Implicit concepts and principles are those that are not
specifically mentioned in the foregoing but are customarily used because of their general and longtime
acceptance within the accountancy profession. The terms "concepts," "principles," "standards,"
"assumptions" and "postulates" are used interchangeably in practice. However, the term "standards" is
used to specifically refer to the Philippine Financial Reporting Standards (PFRSs). Traditionally,
accounting standards were referred to as •the generally accepted accounting principles (GAAP).
Philippine Financial Reporting Standards (PFRSs) The Philippine Financial Reporting Standards (PFRSs)
are Standards and Interpretations adopted by the Financial Reporting Standards Council (FRSC). They
consist of the following: a. Philippine Financial Reporting Standards (PFRSs); b. Philippine Accounting
StandardÅ (PASS); and c. Interpretations Just like the basic accounting concepts, the standards serve as
guide when . recording and communicating accounting information. The difference is that the standards
provide a more

rom reportihe th, le "Miscellan ?nts, xpensing outr below. You 'nsistency) 'licit or implicit are specifically'
I Reporting and CRSs). Implicit Ot specifically because of accountancy "standards," hangeably in o
specifically trds (PFRSs). to as •the Standards Standards dards serve ting Accoun re Accounting Concepts
and Principles 61 detailed application of concepts. They also prescribe which principle is most
appropriate for specific economic transactions. They also require certain information that should be
included in financial reports and how this information is presented. you may think of the difference
between basic concepts and standards this way — a basic concept would be like "you need to brush
your teeth three times a day." On the other hand, a standard would prescribe a proper way of brushing
your teeth. It may even suggest a proper time to brush your teeth or even prescribe a certain
toothbrush that is best for you. 00 The PFRSs are issued by the Financial Reporting Standards Council
(FRSC), which is the official accounting standard setting body in the Philippines. The PFRSs are patterned
from the International Financial Reporting Standards (IFRSs) which are issued by the International
Accounting Standards Board (IASB). This means that the accounting standards used here in the
Philippines are similar to those used in other countries. But why do we need to have uniform accounting
standards? Well, this is because, for financial statements to be useful, they must be prepared using
reporting standards that are generally acceptable(a). Otherwise, each business would have to develop
its own standards. If that is the case, every business may just present any asset or income it wants and
omit any liability or expense it does not want to present. Financial statements would not be comparable,
the risk of fraudulent reporting is heightened, and economic decisions based on these financial
statements would be grossly incorrect For this reason, entities should follow a uniform set of reporting
standards when preparing and presenting financial statements. Imaginé a basketball game with no rules
- the players would be like a bunch of monkeys jumping and running around; or a society with no laws
everything would be in chaos. (a)The term "generally acceptable" means that either:

 1. The standard has been established by an authoritative accounting standard setting body; or 2. The
principle has gained general acceptance due to practice over time and has been proven to be most
useful. The process of establishing accounting standards is a democratic process in that a majority of
practicing accountants must agree with a standard before it becomes implemented. Relevant regulatory
bodies Other than the Financial Reporting Standards Council (FRSC), the following also affect the
accounting policies used by businesses and their financial reporting: 1. 2. 3. 4. Securities and Exchange
Commission (SEC) The SEC is tasked with regulating corporations, including partnerships. The SEC
requires corporations and partnerships to file audited financial statements. Bureau• of Internal Revenue
(BIR) — The BIR is tasked in collecting national taxes and administering the provisions the Tax Code.
Although the provisions of the Tax Code do not always reflect the goals of financial reporting, they do at
times influence the choice of accounting methods and procedures tasked ill Bangko Sentral tig Pilipinas
(BSP) The BSP is banking regulating banks and other entities performing . of functions. The BSP
influences the selection and application accounting policies by these businesses. tasked Cooperative
Development Authority (CDA) — the CDA is in regulating cooperatives. The CDA influences the tives. and
application of accounting policies by coopera The COI Just liki Reporting accounta However Conceptua
applicatio Qualitative Among the qualitative c} Qum information information For e. buy a pair. If you
see. You you prefer. acteristics qualities make dwell, then th Sithilarled VVi certain Y With users.
qualitatit foil

The Conceptual
like the standards, the Conceptual Framework for

tual Framework for Financial Reporting

Reporting

accountant in

also prescribes accounting concepts meant

t in preparing and

to guide the

presenting financial statements.

Framework is not a standard. Rather, the

r, the Conceptual

onceptual Framework serves

as a general frame of reference in the

lication or development of the standards.

Qualitative Characteristics of useful financial information

qualitative characteristics of useful financial information

Among the concepts stated in the Conceptual Framework are the

Qualitative characteristics are the traits that make

information useful to users. Without these characteristics,

information may be deemed useless

For example, you need new shoes so you go to a store to

buy a pair. If you get to the store, you don't just buy the first pair

you see. You look around and try some until you find the pair that

you prefer. Your preference is affected by the qualitative

characteristics of the shoes, e.g, how well it fits on your foot, its

design, its durability, its suitableness for running, etc. These

qualities make the shoes useful to you. If the shoes do not fit you

well, then they are useless. If you buy low-quality shoes that get

destroyed within a month of use, then they are again useless.

Similarly with accounting information, the information must have

certain qualitative characteristics so that it can be deemed useful to

users.

The qualitative characteristics are broadly classified into two,

namely:

1. Fundamental qualitative characteristics these refer to the

essential characteristics that information must have before it

can be included in the financial statements. They consist of the

following:

a. Relevance

b. Faithful representation

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

a. Comparability

b. Verifiability

c. Timeliness
d. Understandability

Fundamental qualitative characteristics

Relevance

Information is considered relevant if it has the ability to affect the

decision making of the users. Without this ability, information is

deemed irrelevant and useless.

Elements of relevance:

a. Predictive value - Information has a predictive value if users

can use it as an input in making predictions or forecasts of

outcomes of events.

b. Confirmatory value (or Feedback value) - This concept is related

to the predictive value. Information has a confirmatory value

if users can use it to confirm their past predictions.

Materiality -is an 'entity-specific' aspect of relevance, meaning

it depends on the facts and circumstances surrounding a

specific entity. An item may be considered by one business as

material but considered by another as immaterial. Information

is material

decision making of the users

c.

if omitting it or misstating it could influence the

Faithful representation

Information is faithfully represented if it is factual, meaning it

represents the actual effects of events that have taken place. For

example, if a business makes total sales of PIM, it should report

that amount in its financial statements- no more, no less!

Elements of faithful representation:

a. Completeness - Information must be presented with sufficient

detail necessary for users to understand them. Important

information must not be omitted.

b. Neutrality Information are selected or presented without

bias. Information must not be manipulated to increase the

probability that it will be received favorably or unfavorably by

the users.

c. Free from error - Free from error means information presented

in the financial statements must not be 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 description and in

the process by which the information is selected and applied

Enhancing qualitative characteristics

Comparability

Information has this characteristic if it enables users to make

comparisons to identify and understand the similarities in, and

the differences among, items. Unli

characteristics, comparability does not relate to a single item..A

comparison requires at least two items.

ke the other qualitative

Verifiability

Information is verifiable if it enables different and independent

users

jto reach a general agreement about what the information

intends to depict.

For example, you and your friend are watching live news

on TV. The newscaster tells you, "Zombies are coming, run!" If

you and your friend look out the window and see zombies

coming and you both agree that those are actually zombies, then

the newscaster's information is verifiable. However, if you believe

that those are zombies but your friend tells you, "Nope, those are

not zombies, those are aliens!" then the newscaster's information

is not verifiable.

Timeliness

Information must be provided to users on time to be capable of

influencing their decisions. This is like the Filipino saying

"Aanhin pa ang damo kung patay na ang kabayo."

Understandability

Information must be presented clearly and concisely in order for

users to understand them. On the other hand, users are expected

to have a reasonable knowledge of business and economic

activities and to review and analyze the information diligently,

sufficient for them to understand the information contained in the

financial statements.

67

(a Summary: Qualitative Characteristics

1. Fundamental Qualitative Characteristios

a. Relevance

i. Predictive Value

i. Confirmatory Value

ii. Materiality ('entity-specific aspect of relevance)

b. Faithful Representation

i. Completeness

ii. Neutrality

iii. Free from error

IL. Enhancing Qualitative Characteristics

i. Comparability

ii. Verifiability

ili. Timeliness

iv. Understandability

Chapter 2 Summary:

. Accounting concepts and principles (assumptions or postulates) ane

a set of logical ideas and procedures that guide the accountant

in recording and communicating economic information.

Examples of basic accounting concepts

1. Separate entity concept 7. Time Period

2. Historical cost concept

3. Going concern assumption 9.Materiality concept

4. Matching

5. Accrual Basis of accounting 11. Full disclosure principle

6. Prudence or Conservatism 12 Consistency concept

The accounting standards in the Philippines are represented

by the Philippine Financial Reporting Standards (PFRSs). These

standards are patterned from the International Financial

Reporting Standards (IFRSs).

8. Stable monetary unit

10. Cost-benefit

"

Chapter 3

The Accounting Equation

Learning Objectives

Illustrate the accounting equation.

1.

2 Us

e the accounting equation in solving accounting p

problems.

The Basic Accounting Equation

All the processes in an accounting system must observe the

equality of the accounting equation, which is basically an

ebraic equation. The basic accounting equation is shown below

AssetsLiabilities Equity

ASSETS are the resources you control thaf have resulted from

past events and can provide you with future economic benefits.

Essential elements in the definition of asset

a. Control - You don't necessarily need to own the resource for it

to be considered your asset. What is important is that you

control the economic benefits from the resource. Control

means you have the exclusive right to enjoy those benefits or

you can prevent others from enjoying those benefits

Example 1: Resource owned but not considered an asset

You own a building that you rent to varióus tenants.

However, every time you visit the building, the security guard

shoots at you. So the tenants are actually remitting rentals not

to you but to the guard.

though you "own" the building you do not co

economic benefits (i.e, rentals) from it.®

En

Analysis: In here, the building is not your asset be

Example 2: Resource
You acquired a cellphone from

not owned but considered an asset

a telecommunications

company on a 2-year installment plan. The agreement st

that if you miss an installment payment

telecommunications company can get the cellphone back

the

our

yet until

you

Analysis: Upon taking possession, the cellphone becomes

asset even if you do not actually own the cellphone

you have fully paid the installment price. This is because

control the economic benefits from the cellphone throuh

possession and use

b. Past events the control over a resource have resulted from a

past event or transaction. Therefore, resources for which

control is yet to be obtained in the future do not qualify as

assets in the present.

For example, you have an intention of purchasing a

cellphone next year. Right now, the cellphone is not yet your

asset. It becomes your asset only after you have purchased it

and have taken possession over it.

Physical possession, however, is not always necessary

for control to exist. For example, the money you deposit to a

bank remains your asset even if you have transferred physical

possession. This is because you still control the economic

benefits by withdrawing it or spending it through electronmic

means

c. Future economic benefits "Future" means the resource

expected to provide economic benefits over more than

is

accounting period. If it

accting period, it is not an asset but an expense.

ng

period. If it provides economic benefts only in

"Economic benefits" means the potential of t

no

he resource to

rovide you, directly or indirectly, with cash. For example, the

resource can be:

sSold or exchanged for other assets;

1.

Used singly or in combination with other assets to

produce goods for sale;

ii. Used to settle a liability; or

iv.

Distributed to the owners.

IABILITIES are your present obligations that have resulted

from past events and can require you to give up resources when

settling them.

Essential elements in the definition of liability

a. Present obligation means that right now, you have a

responsibility to pay someone because of an obligating event

that has already transpired.

An obligating event is an event that creates either (a)a

legal obligation or (b) a constructive obligation

A legal obligation arises from:

a. a contract

b., a law; or

c. other operation of law.

practices or published policies that have created a valid

expectation on the part of others that you will pay them.

P A constructive odligation arses from your past busirness

Assets

2,000

Liabilities

1,200

Equity

800

Notes:
Your total assets are now P2

resources that you control (800 from Mr. Piggy plus P1,200

from Mr. Bombay).

Of your total assets of P2,000:

a. P1,200 represents your liability, the amount you ane

obligated to pay Mr. Bombay in the future.

b. P800

represents your equity (i.e., P2,000 assets P1,200

liabilities).

Notice that from Piggy to Bombay, the accounting

equation remains balanced. Please DO NOT forget this concept

my friend! The equality of the accounting equation must be

maintained in all the accounting processes of recording

classifying and summarizing. If the accounting equation doesn't

balance, there is something wrongl®

As mentioned earlier, the accounting equation is basically

an algebraic equation. Therefore we can make variations from it.

Analyze the variations below:

Original form of the equation:

- Liabilities+ Equity

Assets

2,000

1,200

800

Variation #1:
AssetsLiabilities

2,000

Equity

800

1,200

Variation #2:

Equity Liabilities

Assets

2,000

800

1,200

Expanded Accounting Equation

e can expand

the basic accounting equation by including two

elements income and expenses. The expanded accounting

tion shows all the financial statement elements. The expanded

more

accounting equation is as follows:

Assets-Liabilities + Equity + Income - Expenses

Notice that income is added while expenses are deducted

in the equation. These are because income increases equity while

expenses decrease equity.

INCOME - is increases in economic benefits during the period in

form of inflows or enhancements of assets or decreases of

liabilities that result in increases in equity, excluding those

relating to investments by the business owners.

EXPENSES - are decreases in economic benefits during the period

in the form of outflows or depletions of assets or increases of

liabilities that result in decreases in equity, excluding those

relating to distributions to the business owners.

The difference between income and expenses represents profit or

loss.

> If income is greater than expenses, the difference is profit

(profit means 'kita' or 'tubo' in Fillipino).

If income is less than expenses, the difference is loss (loss' means

'lugi' in Filipino).

>

We can make another variation to the equation above as follows

Assets = Liabilities + Equity + Profit /-Loss |

Profit increases equity while loss decreases equity

Ilustration 2: Contimation of lustration I aboo and incurred

During the period, you earned income of P10,000 and incurred

At the end of the period, your total assets increased from

2,000 to Ps,000 and your total liabilities decreased from P1,200 to

P400
Your expanded accounting equation is as follows:

Assets - Liabilities + Equity-+-Income Expenses

This represents you equity from 'Illustration I' above

We can also derive the following variation from the equation

40080010,0006,200

above:

AssetsExpensesLiabilities Equity Income

+ 80010,000

5,0006.200400

Your profit for the period is P3,800 (P10,000 income minus

P6,200 expenses). There is profit because income is greater than

expenses

A variation of the expanded accounting equation is shown below:

AssetsLiabilities Equity Profit

5,000.

400

800+

3,800

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

Add: Income
800

10,000

(6,200)

4,600

dLess:

Expenses

Equity, ending

OR

Equity, beginning

Add: Profit

Equity, ending

800

3,800

4,600

Your basic accounting equation as of the end of the accounting

period is as follows:

Assets

= Liabilities

Equity

4,600

5,000

400

Notice that regardless of its form or variation, the

accounting equation (basic or expanded) remains balaniced.

Applications of the accounting equation

Before we move on, let us master first how the accointing

equation works. I encourage you to diligently study the following

drills:

Case #1: Total assets

If you have total liabilities of P1,200 and equity of P800, how

much is your total assets?

Solution:

+Equity

AssetsLiabilities+

800

1,200

Answer: Total assets = (1,200 + 800) = 2000

Case #2: Total liabilities

If you have total asserts of 2,000 and equity of P800,

your total liabilities?

how much is

Solution

Assets

2,000

Equity

800

Liabilities

Variation $1 of the basic equation

2,000

Equity

800

Liabilities

Assets

Answer: Total liabilities (2,000-800)-1.200

Case #3: Total equity

If you have total assets of P2,000 and total liabilities of 1,200

how much is your total equity?

Solution

LiabitiiesEguity

2,000

-1,200

Variation #2 of the basic equation:

Equit

Assets

2,000

Liabilities

1,200

Answer: Total equity (2,000-1200)-800

Case #41: Profit or loss

If you have total income of P5,000 and total expenses of P2,000

how much is your profit (or loss)?

Solution

Total income

Less: Total expenses

Profit

5,000

2,000

3,000

Case #42: Profit or loss

If you

have total income of P6,000 and total expenses of Pl1,000,

much is your profit (or loss)?

Solution:

Total income

Less: Total expenses(11,000)

Loss

6,000

(5,000)

In accounting, amounts in parentheses are negative amounts.

Case #5: Income

If you have total expenses of P2,000 and a profit of P3,000, how

much is your total income?

Solution:

Total income

Less: Total expenses

Profit
? (squeeze)

(2,000)

3,000 (start)

The unknown (?) is simply "squeezed." In accounting, to

squeeze" means to come up with an unknown amount in a given

tormula by performing basic arithmetic functions like adding,

subtracting, multiplying or dividing. When squeezing "upwards"

just like in the illustration above), the arithmetic function is

simply reversed. Thus, the amount P2,000 which is deducted when

solving downwards is added when "squeezing" upwards.

Answer: Total income (3,000+ 2,000)-5,000

When "squeezing" upwards, it is always advisablé to

recheck your answer by squeezing downwards. This is done as

follows:

Rechecking

Total income

Less: Total expenses

5,000 (start)

nses(2.000)v

Profit

3,000 (squeeze)

"Squeezing" simplifies the computation process because it

eliminates the need to make variations of a formula. If we did not

squeeze the amount above, we would have made the following

variation to the formula:

Original formula: Income - Expenses -Profit

Variation: Profit + Expenses Income

>

Case #6: Expenses

If you have total income of P5,000 and a profit of P3,000, how

much is your total expenses for the period?

Solution

Total income

Total expenses

Profit

5,000

(squeeze)

3,000

Answer: Total expenses (5,000 -3,000) 2,000

Rechecking

Total income

Less: Total expenses

Profit

5,000

(2,000)

3,000
Case #7: Income

o have ending" total assets of P4,800, ending total liabilities of

You

1,000 and beginning' equity is P800. If your total expenses for the

pe

/in accounting parlance, the term 'beginning' means'at the start' of an accounting

riod amount

to P2,000, how much is your total income?

while 'ending' means 'at the end' of an accounting period.)

rl

Solution:

Assets

4,800

abilities EquityIncome

1,000

Expenses

2,000

Anstver: Total income (4,800-1,000-800+ 2,000) -5.000

Recheckings (Check out the equality of the accounting equation.)

AssetsLiabilities+ Equity+ Income Expenses

48001,000800 5,000

2,000

Case #8: Expenses for the period

You have ending total assets of P4,800, ending total liabilities of

P1,000 and beginning equity of P800. If your total income for the
period amounts to P5,000, how much is your total expenses?

Solution:

Assets = Liabilities + Equity + Income - Expenses

L 4,800 1,000 + 800 + 5,000

Total expenses-(4,800-1,000-800-5000-2000

Rechecking: (Check out the equality of the accounting equation.)

+ Income Expenses

Assets Liabilities

4,800

ull

1,000 005002,00

our total income

fo

Case #9.1: Ending equity

Your beginning equity is P5,000. If your totali

period is P8,000 while your total expenses are 6,000

is the ending balance of your equity?

Solution:

5,000

8,000

(6,000)

7,000

Equity, beginning
Add: income

Less: Expenses

Equity, ending

OR

Equity, beginning

AddlLess: Profit or Loss (8,000-2,000)

Equity, ending

5,000

2,000

7,000

Case #92: Ending equity

Your begimning equity is P12,000. If your total income for the

period is P5,000 while your total expenses are P8,000, how much

is the ending balance of your equity?

Solution:

uit

12,000

5,000

(8,000)

9,000

Less: Expenses

OR

uity, beginning
s: Profit or Loss (5,000-8,000)(3,000)

12,000

dending

Equity, endir LOS

9,000

tice that profit is an addition to equity while loss is a deductiom.

Case #101: Profit for the period

f vour beginming equity is P5,000 while your ending equity is

000, how much is your profit or loss for the period?

Solution:

Equity, beginning

Add: Profit (or Less: Loss)

Equity, ending

5,000

(squeeze)

7,000

Profit (7,000-5,000)- 2.000

Rechecking:

Equity, beginning

Add: Profit (or Less: Loss)

Equity, ending

5,000

2,000

7,000

Case #102: Loss for the period

If your beginning equity is P6,000 while your ending equity is

P2,000, how much is your profit or loss for the period?

Solution:

Equity, beginning

Add: Profit (or Less: Loss)

Equity, ending

6,000

? (squeeze)

2,000

Loss (2,000-6,000) (4,000)

Rechecking:

Equity, beginning

Add: Profit (or Less: Loss)

Equity, ending

6,000

(4,000)

2,000

You have total assets, liabilities, and equity of P10,000, 7,00

P3,000, respectively, at the beginning of the period. Durin and

period, your total liabilities decreased by P4,000 while yo the

is P5,000. How much is your ending total assets?

Case #11: Ending total assets

Solution:
Assets Liabilities + Fai

10,000# 7,000 + 3

guity

Decrease in liabilities/ Profit

End

4,000) 5,000

23,000 +8,000

Answer Ending total assets (3,000 liabilities, end. +8,000 equity

end.)- 11,000

Rechecking: (Ending balances)

AssetsLiabilities +Equity

11,0003,000 8,000

End.

Case #12: Ending total assets

You have total assets, liabilities, and equity of P10,000, P7,000 an

P300, respectively, at the beginning of the period. During the

period, your total liabilities decreased to P4,000 while your pront

is P5,000. How much is your ending total assets?

Solution:

Assets Liabilities Equity

Irrelevant 3,000

-IFrelevant 5,000

irrelevant (a)
Beg.

Profit

End

4,000 b) 8,000

(irelevant: These amounts are not needed in computing for the requirement

in computing for the requirement in

the problem.)

e) The phrase

"decreased to P4,000" means that P4,000 is the ending

ance of liabilities. Notice the difference between the phrases

"decreased by" (Case #11) and "decreased to" (Case #12).

Answer: Ending total assets (4,000 liabilities, end.+ 8,000 equity

end.) - 12,000

Rechecking: (Ending balances

End.

Assets Liabilities+ Equity

12,000 4,000 + 8,000

Chapter 3 Summary:

Th

e basic accounting equation is Assets - Liabilities + Equity

ssets are resources controlled by an entity resulting from past

events and are expected to provide inflows of future economic

benefits
Liabilities are present obligations of an entity resulting from

past events and are expected to cause outflows of future economic

benefits.

Equity is assets minus liabilities.

The expanded accounting equation is:

Assets Liabilities +Equity + Income - Expenses.

Income is increases in assets or decreases in liabilities resulting

to increases in equity, other than those relating to transactions

with the business owner.

Expenses are decreases in assets or increases in liabilities

resulting to decreases in equity, other than those relating to

transactions with the business owner.

Income less expenses equals profit or loss. If income is greater

than expenses, there is profit. If income is less than expenses,

there is loss.

. Income and profit increases equity while expenses and loss

decreases equity

Chapter 4

Types of Major Accounts

Learning Objectives

. State the five major accounts.

2 Give examples of each type of account.

The 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.

An account may be depicted through a "T-account." A T-

account" is called as such because it resembles the letter "T." A

"T-account" has three parts, namely:

1. Account title - describes the specific item of asset, liability,

2.

3.

equity, income or expense.

Debit side - the left side of the account.

Credit side - the right side of the account.

This is the "account title."

Cash

The term "credit" (Cr)1

simply refers to the right

→ Debit |Credit

Balance 700

The term "debie" (Dr)

1-Jan 500

side of the account. It is

3-Jan 1,000 800 4-Jan. sometimes referred to as

the value parted with."

The difference between the total debits and

credits in the account represents the balance

of the account (500 + 1,000 -800 700).

simply refers to the left

side of the account. It is

sometimes referred to as

If total debits exceed total credits, the account

has a debit balance. If total credits exceed

total debits, the account has a credit balance.

the 'value received."

se terms and their abbreviations come from the Latin

credere (Cr.).

words debere (Dr.) and

The Five Major Accounts

The five major accounts, also called the elements of the

statements, are actually the items in the expanded

countin

equation, discussed in the previous chapter. Let us recall

items

from past events and can provide you with future econ

benefits.

1. ASSETS - are the resources you control that have resul

events and can provide you

2. LIABILITES- are your present obligations that have resultse

from past events and can require you to give up resou

when settling them.

rces

3.

EQUITY -is assets minus liabilities.

4. INCOME are increases in economic benefits during the

period in the form of inflows or enhancements of assets or

decreases of liabilities that result in increases in equity, other

than those relating to investments by the business owners.

Income includes both revenue and gains.

a. Revenue arises in the course of the ordinary activities of a

business, e.g, sales and service fees.

b. Gains represent other items that meet the definition of

income and may or may not arise in the course of the

ordinary activities of an entity.

Example 1:

Your business is selling barbecue. The income you derive from

selling barbecue is called revenue (i.e, sales revenue)

selling barbecue is your main business (ordinary busine

activity).

109

One day, you decided to

you decided to replace your o

umbrella. The umb

yo200. The difference between the sellin

umbrella has a carrying amount of

books ofccounts. You were able to sell the old umbrella

P2,000 in

carrying amount of P2,000, represents gain (P2,200

uainbsiness (not your ordinary business activity)

ng price of P2,200

P200 gain). This is because selling of umbrellas is not

us amount refers to the net amount by which an item is carried

recorded) in the books of accounts.

YPENSES are decreases in economic benefits during the

riod in the form of outflows or depletions of assets or

increases of liabilities that result in decreases in equity, other

period in

than those relating to distributions to the business owners.

Expenses include both expenses and losses.

Expenses arise in the course of the ordinary activities of a

a.

business

b. 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.

Example 2:

In your barbeque business (see Example 1 above), the cost of

the barbecue you have sold is an expense.

If you were able to sell the old umbrella with carrying

amount of P2,000 for only P1,600, the difference now of P400

represents a loss (P1,600 P2,000 P400 loss).

Ii selling price is greater than carrying amount, the difference is a

gain.

l Notes:

If selling price is less than carrying amount, the difference is a loss.

Classification of the Five Major Accounts

The five major accounts are classified according to th

statement where they appear as follows:

fin

BALANCE SHEET

ACCOUNTS

INCOME STATEMENT

ACCOUNTS

1. INCOME

1. ASSETS

2. LIABILITIES

3. EQUITY

2. EXPENSES

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.

component of the statement of comprehensive income, whichis

statements. The income statement shows the profit or loss ofa

The income statement (or the statement of profit or loss) is a sub-

also one of the components of a complete set of financ

business

The financial statements are discussed in detail in Part 2 of

this book.

Chart of Accounts

A chart of accounts is a list of all the accounts used by a business.

The following is an example of a basic chart of accounts:

Chart of Accounts

SHEET A

nt

ACCOUNTS

Account

No ASSETS

No.

INCOME

110 Cash

410 Service fees

Accounts receivable
Allowance for bad debts

420 Sales

430

130 Notes receivable debts

150 Prepaid supplies

160 Prepaid insurance

125

Interest income

440 Gains

Inventory

EXPENSES

155 Prepaid rent

170 Land

180 Building

185 Accumulated

510 Cost of sales

515 Freight-out

520 Salaries expense

525 Rent expense

depreciation - Bldg.

190 Equipment

195 Accumulated

530 Utilities expense

535 Supplies expense

depreciation -
Equipment

Bad debt expense

Depreciation

540

545 expense

550 Advertising expense

555 Insurance expense

560 Taxes and licenses

565 Transportation and

LIABILITIES

210 Accounts payable

220 Notes payable

230 Interest payable

240 Salaries payable

travel expense

570 Interest expense

575 Miscellaneous

250 Utilities payable

260 Unearned income

expense

580 Losses

EQUITY

310 Owner's capital

320 Owner's drawings

112

at

recording, cross-referencing, and retrieval of information

Although there is no standard way of assigning account number

account numbers should be assigned in a manner that the

Account numbers are assigned to the accounts to facilit

accounts are categorized logically.

suits its needs. Large corporations may have thousands

accounts and have more digits in their account numbers. Smal

companies may have fewer accounts and fewer digits in

account numbers. As the number of accounts increases, the digits

in the account numbers also increase to accommodate the

Each business shall formulate a chart of accounts thatb

of

increased number of accounts.

The account titles in the chart of accounts shown above a

re

numbered in the following manner:

1. The first digit in the 3-digit numbering refers to the major

types of accounts:

Major types of accounts

ASSETS

LIABILITIES

EQUITY
INCOME

EXPENSES

Assigned number

Thus, in the chart of accounts, the 3-digit numberings of

all assets start with 1; the 3-digit numberings of all liabilities

start with 2; etc.

110

Cash

The first digit signifies that this

account is an asset account.

113

igit numbering refers to the account

Thus, in the chart of accounts, the second digit in the3-

t numbering of "Cash" is 1 because it is the first asset

accouunt nofehart; the second digit in the 3-digt

second digit in the 3-d

he s and the sequence on how they are listed in the chart of

accounts.

mbring of "Accounts receivable" is 2 because it is the

num

d asset account listed in the chart; etc.

110 Cash

12

Accounts receivable

The second digits refer to specific account titles and the

sequence on how they are listed in the chart of accounts.

The third digit in the 3-digit numbering, if not zero, signifies

that the account is a contra account or an adjunct account to

a related account.

uildin

185A

Accumulated depreciation Bld

The third digit signifies that this account, 'Accumulated

depreciation - Bldg.,' is a contra-account to the 'Building

account.

d Contra and adjunct accounts are discussed in the next chapter.

To promote comparability, a business shall use account

tiles that conform to the PFRSs (Philippine Financial Reporting

Standards) and industry practices. Furthermore, regulated

businesses should have charts of accounts and/or account

humbering system that conform to relevant regulations. For

example:

114
chart

(BSP)

a. The chart of account

chart of accounts of a bank should confor

dorsed by the Bangko Sentral ng Pilipinat of

conform to the

rt of accounts of a cooperative shouldco

ooperative Developr

chart of accounts endorsed by the C

Authority (CDA); and

ment

b. The char

c. The chart of accounts and the account numbering system

national government agency must conform to the Re

of a

Chart of Accounts (RCA) isstued by the Commission on Coiseg

(COA)

The following are the common account titles and

descriptions.

Common Account Titles

their

BALANCE SHEET ACCOUNTS

ASSETS

Cash - includes money or its equivalent that is read

available for unrestricted use, e.g, cash on hand and cash in

Accounts receivable - receivables supported by oral or

Allowance for bad debts - the aggregate of estimated losses

bank.

informal promises to pay.

from uncollectible accounts receivable. Another term is

"allowance for doubtful accounts."

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.

repaid supplies represents the cost of unused office and

Prepaid rent-rent paid in advance.

aid insurance - cost of insurance paid in advance.

d- the lot on which the building of the business

nstructed or a vacant lot which is to be used as future plant

site. Land is not depreciable.

has beer

co

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:

a. Machineries and other factory equipment

b. Transportation equipment, e.g, vehicles, delivery trucks

c. Office equipment, e.g, desks, cabinets, chairs

d. Computer equipment, e.g, server, personal computers

laptops

e. Furniture and fixtures, e.g, desks, cabinets, movable

partitions

(tems 'c' and 'e' are used interchangeably in practice because they may refer

to similar assets. However, the term office equipment' may be used to strictly

refer to those that are being used in the office. For example, a shelf used in

the office may be included in 'office equipment while a shelf used to display

goods for sale may be included in 'furniture and fixture.' Furthermore, items

included in furniture and fixtures' are normally those that are movable.

Immovable items are included in 'building improvement account or leasehold

improvement' account.)

.Accumulated depreciation equipment - the total amou

depreciation expenses recognized, since the equipmto

acquired and made available for use.

Collectively, land, building and equipment are referred

as "Property, plant and equipment" "'Capital assets," or "Fix

to

assets."

LIABILITIES

Accounts payable - obligations supported by oral or informal

promises to pay by the debtor.

Notes payable - obligations supported by written or formal

promises to pay by the debtor in the form of promissory notes.

Accounts payable and accounts receivable are opposites.

Meaning, if I have an account receivable from you, it means

that you have an account payable to me. This is also true for

notes payable and notes receivable.

"Accounts" vs. "Notes": You go to a sari-sari store and

tell the owner, "Aling Nena, pautang nga po ng isang lata ng

sardinas. Pakilista." In here, Aling Nena has an account

receivable from you. On the other hand, you have an account

payable to Aling Nena. It is an "account" rather than a "note"

because your promise to pay is made orally or informally (i.e,

pakilista).

Another example: You go to a bank to obtain a loan. The

bank requires you to fill up a formal and pre-printed form

called promissory note. The promissory note will be notarized by a

lawyer and the corresponding documentary stamp taxes will be

paid. In here, the bank has a note receivable from you.

other hand, you have a note payable to the bank. This time, 1
a "note" rather than an "account' because your promise top

is made formally or in writin

ayable - interest incurred but not yet paid.

Interest

intele arises from interest-bearing liabilities. For

ayal incur interest on your bank loan.

not yet paid. Interest

lities. For example,

payable - salaries al

Salaries payable

not yet paid by the business.

by employees but

rilities payable utilities (e.g,, electricity, water, telephone,

'internet, cable TV, etc.) already used but not yet paid.

be noted that future interest, salaries and utilities are not reco

interest

been

used.)

t sne items must be incurred first before they are.recorded, e.s

shou

, there must be a passage of time; for salaries, ser

rendered by employees; and for utilities, these items must have been

recorded, e.g., for

vices must have

Unearned income - Items related to income that were collected

in advance before they are earned. After the earning process is

completed, these items are transferred to income.

Hints:

The word "receivable" connotes an asset while the word

"payable" connotes a liability.

The word "prepaid" connotes an asset while the word

"unearned" connotes a liability

EQUITY (Capital, Net assets or Net worth)

' Owner's capital (or Owner's equity) - the residual amount

after deducting liabilities from assets.

118

The Owner's Capital account is

DECREASED by:

INCREASED by:

Investments or

contributions by the

Withdrawals or

distributions to the

owners.

owners.

Income or Profit earned> Expenses or Loss incurred

by the business.

by the business.

Owner's drawings - this account is used to record

the

temporary withdrawals of the owner during the period. At the

end of the accounting period, any balance of this account

closed to the 'Owner's capital' account.

INCOME STATEMENT ACCOUNTS

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 not classified as revenue.

EXPENSES

Cost of sales (or Cost of goods sold) - represents the value of

inventories that have been sold during the accounting period

.
t

eier. Other terms for freight-out are "delivery expe

0 Cusnortation-out," and "carriage outwards."

119

represents the sellers' costs of deliveriodbs

to customers

8oods

expense represents the salaries ea

Salaries

employees for

accounting period.

for the

services they have rendered during

salaries earned by

the

ent expense represents the rentals that have been used up

uring the accounting period.

Itilities expense - represents the cost of utilities (egr

'electricity, water, telephone, internet, cable TV, etc.) that have

used during the accounting period.

A business can also have a separate account for ea

of utility, eg, "Electricity expense," "Water expense,"

ch
type

"Technology and Communication expense," and the like.

, Supplies expense - represents the cost of supplies that have

been used during the period.

, Bad debt expense the amount of estimated losses from

uncollectible accounts receivable during the period. Other

term is "doubtful accounts expense."

Depreciation expense - the cost of a depreciable asset (eg,

building or equipment) that has been allocated to the current

accounting period

Advertising expense - represents the cost of promotional or

marketing activities during the period.

surance expense represents the cost of insurance

pertaining to the current accounting period.

120

uired by the government for the conduct of b

-represents the cost of business and

(eg, mayor's permit, other percentage taxes,

taxes

Taxes and licenses

For corporations and partnerships, income taxes are record

in a separate account called "Income tax expense."

Transportation and travel expense

ordinary cost of employees getting from one workpla

another which are reimbursable by the busin

>Transportation expenses represent the necessary

ess

reimbursable taxi fares of employees running

errands and those who are working on late shifts.

some

Travel expenses represent costs incurred when travell

away from home on business trips, e.g, out-of-town travel

costs of employees sent to seminars.

ng

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.

Interest expense and interest income are opposites. For example,

you will incur interest expense on the money you borrowed

from Mr. Bombay. On the other hand, Mr. Bombay will earm

interest income.

Miscellaneous expense represents

expenditures which do not warrant separate presentation.

various small

Losses - expenses which may or may not arise from the

ordinary course of business activities. Losses may an

a. Sale of assets, other than inventory, at a sale price that is

ise from:

less than the carrying amount.

121

es in the value of assets due to

b.

damage, obsolesce

ny market factors, e.g, loss on fire, earthquake, storm,

other calamities, decrease in the value of foreign

currencies held due to changes in exchange rates.

ssets due to destruction,

r changes in values caused

and othe

cal

ess

ity

de Notes:

term "earned" relates to income while the term

"incurred" relates to

expenses.

The "unused" portion

of a cost is an asset while the

rtion is an expense. For example, the cost of

used" po

unused office supplies is an asset (prepaid supplies) while

the cost of office supplies used during the period is

expense (supplies expense).

Drill on Account Titles

ASSET ACCOUNTS

Accounts receivable

A customer bought barbecue worth P500 from your barbecue

business. He told you that he will pay for it next week.

>The P500 collectible from the customer is recorded as an account

receivable.

Allowance for bad debts (Allowance for doubtful accounts)

ф The customer with the P500 account receivable is broke. You

have estimated that you can only collect 420 from him.

expense and accumulated in the allowance for bad debts account.

(See also Bad debt expense'below)

? The P80 (500 420) uncollectible account is recorded as bad debts

Your friend borrowed Pi,000 from your barbecue busin

You required from him a gwritten promissory note to repay

money within 30 days plus 1% monthly interest.

business

Notes receivable
The P1,000 collectible from your friend is recorded as

receivable

Inventory

s You purchased pork worth P1,000 to be marinated and sold

barbecue

>The cost of the pork purchased is recorded as inventory.

Prepaid supplies

You purchased table napkins worth P200 to be used in your

barbecue operations.

> The table napkins, while still unused, are assets recorded as prepaid

supplies. When used, they are recorded as supplies expense. (See

also Supplies expense' below)

Prepaid rent

You are renting a space for your barbecue stand. The lease

contract required you to pay P10,000 rent in advance

The rent paid in advance is an asset recorded as prepaid rent. This

amount will be charged as rent expense when incurred (i.e., 'used

up)

Equipment

You purchased a barbecue grill worth P1 ,000.

. The barbecue grill is an asset recorded as equipment.

123
of equipment or similar item that is expected to be

fhe i over more than one accounting period is initially recor

of this asset is then allocated over the periods in w

the enortion of the cost that is allocated to the current peri

ul

as an osohsset is then allocated over the periods in whi

he

ent is expected to be used.

e periods in which

alled depreciation expense.

ent period is

total

depreciation expenses recognized

the

ipment was acquired

depreciation account.

since the

is piled up in the accumulated

mulated depreciation - Equipment

You expect to use the barbecue grill for 5 years.

The cost of the barbecue grill will be allocated over the 5-year

period that you will be using it. The amount allocated each year is

called the "depreciation expense."

The depreciation expense per year is P200 (P1,000 5 years).

Thus, after a year, the accumulated depreciation of the equipment

will be P200 (P200 x 1 yr); after two years, the accumulated

depreciation will be P400 (P200 x 2 yrs.); after three years, P600

(P200 x 3 yrs.), etc.

In accounting, depreciation means an allocation of cost over

the periods where a depreciable asset is used.

LIABILITY ACCOUNTS

You ran out of inventory of barbecue, so you went to Mr.

Porky's Meat Shop to buy pork. You don't have the available

cash, so you promised orally that you will be paying for the

pork, worth P500, next week.

Accounts payable

124

under accounts payable,

> The P500 payable is a liability reco

Remember your P1,200 loan from Mr. Bombay? (see previous

chapter @) Well, he required you to write a promissory note

Notes payable

to repay the borrowed money at some future

>The Pl,200 payable is a liability recorded under notes payable.

Interest payable

date.

* Your loan from Mr. Bombay requires repayment within 30

days plus 20% monthly interest (five-six). At the end of 30

days, you will be incurring interest expense of P240 (1,200

note payable x 20% interest rate).

Prior to paying the interest, the accrued interest is recorded as

interest payable. (See also 'Interest expense below)

Salaries payable

ф By month-end, total salaries earned by an employee during

the month amounted to P8,000. However, the employee has

not yet claimed the salary

> The unpaid salary already earned by the employee is recorded as

salaries payable.

Utilities payable

Your electricity bill for the month of January amounted to

P2,000. The bill is not yet paid.

rThe unpaid utility already used but not yet paid is recorded us

utilities payable.

125

Unearned income

Unevou received an order of barbecue worth

id the sale price but instructed you to deliver the barbecue

pa

next week.

P800. The customer

Right now, the sale price collected is not yet earned (ie, nearned)
hecause the barbecue is not yet delivered. Thus, the cash collection is

initially recorded as liability (i.e., unearned income) and will be

transferred to incone (i.e., sales) next week when the barbecue is

delivered.

The account titles "Advances from customers" or "Unearned

revenue" may be used in lieu of the "unearned income" account.

EQUITY ACCOUNTS

Owner's capital

You invested P800 to your barbeque business.

Your P800 investment is recorded in the Owner's capital account

>

Owner's drawings

You made temporary withdrawals,of P200 from your

barbeque business

> Your P200 withdrawals are recorded in the Owner's drawings

account.

INCOME ACCOUNTS

Sales

y You sold barbecue worth P500

126

recorded in the Sales account.

For the provision of services, as opposed to sale of goods.

income account used is the Service fees account.

The sale is

After a month, you will have earned the 1% monthly inter°.

on the loan you have extended to your friend. (See

receivable'.)

Interest income

ot

The interest earned is credited to the interest income account.

EXPENSE ACCOUNTS

Cost of sales or Cost of goods sold

The cost of the barbecue that was sold for P500 is P300.

The P300 cost is recognized as expense described as Cost of

sales or Cost of goods sold.

Freight-out

Your business has a hotline. Customers can order barbecue

through phone call, text message, or Facebook message. No

delivery charges. During the period, the cost of gasoline for

your motorcycle, attributable to delivering barbecue to

customers, amounted to P100.

> The delivery costs of P100 are recorded as freight-out.

Salaries expense

You hired a helper in your barbecue business. Your employee

earns compensation of P8,000 per month.

At the end of each month, you will record the P8,000 earned by the
>

employee as salaries expense.

ent expense

renting a space for your barbecue stand. The r

5000 per month

and. The rent is

end of each month, you will record P5,000 as rent expense

At the

Utilities expense

After a month of operations, your business received electricity

1l of P2,000 and water bill of P200.

The electricity and water bills are recorded as utilities expense.

Supplies expense

The cost of table napkins used during the period amounted to

P50. (See also 'Prepaid supplies)

The cost of the supplies used is recorded as supplies expense.

Bad debt expense

ф Of your total accounts receivable of P500, you expect to collect

only about P480.

The P20 uncollectible balance is recorded as bad debt expense. (See

also Allowance for bad debts')

>
Depreciation expense

The P1,000 cost of the barbecue grill will be allocated over the 5

years that you will be using it. The amount allocated each year

is called the "depreciation expense." The depreciation expense

per year is P200 (PI,000 ÷ 5 years). (See also Accumulated

depreciation'.)

At the end of the year, you will record the allocated cost of the

barbecue grill of P200 as depreciation expense.

You paid Justin Bieber P5,000 to endorse your barbecue

business

Advertising expense

>The P5,000 payment is recorded as advertising expense.

Insurance expense

You have obtained a one-year, fire insurance for your

barbecue stand for P12,000.

The used up portion of the insurance is recorded as insurance

expense

>

Taxes and licenses expense

During the period, you paid local taxes amounting to P500

The local taxes paid are recorded as taxes and licenses.

Interest expense

(See 'note payable' and 'interest payable.

. At the end of the month, you will record P240 interest

expense

Loss

Your barbecue grill is stolen! Oh no!

The carrying amount of the stolen barbecue grill is charged as

a loss. The carrying amount is computed as "Acquisition cost

minus Accumulated depreciation." The cost of the barbecue grill

is P1,000. If the accumulated depreciation is P400, the carrying

amount is P600 (1,000-400).

>

hapter 4 Summary:

account is a record of the increases and decreases in a

An

of asset, liability, equity, income or expense.

has three parts, namely: (1) account title, (2) debit side, and (3)

credit side.

pebit is the left side of an account while credit is the right

side.

It

balance of an account is the difference between the total

Th

debits and total credits in that account.

e five major accounts are: Assets, Liabilities, Equity, Income

and Expenses.

The

the income statement accounts are income and expenses.

A chart of accounts is a list of all the accounts used by the

business.

ce sheet accounts are assets, liabilities and equity while

, Account numbers are assigned to each account to facilitate

recording, cross-referencing, and retrieval of information

Chapter 5

Books of Accounts and Double-entry

System

Objectíves

Learning Objectives

Identify the uses of the two beo

Explain the rules of debits and credits.

oks of accounts.

The Books of Accounts

siness maintains two books of accounts, namely:

1. Journal; and

2. 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

Types of Journals

Journals can be classified into the following:

1. Special Journal - is used to record transactions of a similar

nature. Special journals simplify the recording process, thus

providing an efficient way of recording and retrieving of

information.

Common examples of Special journals

a. Sales journal -is used to record sales on account.

b. Purchases journal - is used to record purchases of inventory

on account.

c. Cash receipts journal is used to record all transactions

involving receipts of cash.

d. Cash disbursements journalis 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," etc.

General journal - All other transactions that cannot be recorded

in the special journals are recorded in the general journal.

Examples of such transactions include purchases of inventory

in exchange for notes payable, adjusting entries, correcting

entries, reversing entries, and the like.

2.

If a business does not utilize special journals, all its

transactions are recorded in the general journal.

Examples

a. You sold barbecue to a customer who promised orally to pay

the sale price next week.

This transaction involves sale on account; therefore, it is

recorded in the sales journal.

b. You sold barbecue to a customer who immediately paid the

sale price.

> This transaction involves the receipt of cash: therefore, it is

recorded in the cash receipts journal.

c. You sold barbecue to a customer who promised in writing to

pay the sale price next week

143

s transaction cannot be recorded in the spe

therefore,

it is recorded in the general journal.

he special journals;

Ledger

ledger is a systematic compilation of a group of accounts. It is

ced to classify the effects of business transactions on the accounts.

he ledger is also called the "book of secondary entries" or the

"hook of final entries" because it is used only after business

ctions are first recorded in the journals. The process of

recording in the ledger is called "posting.

nsa

Kinds of ledgers

Ledgers can be classified into the following

a.

General ledger contains all the accounts appearing in the trial

balance.

b. Subsidiary ledger provides a breakdown of the balances of

controlling accounts.

*A controlling account (or control account) is one which consists of a

group of accounts with similar nature. The balance of the

controlling account is shown in the general ledger while the

balances of the accounts that comprise the controlling account are

shown in the subsidiary ledger. Not all accounts in the general

ledger though are controlling accounts. Only those whose

balances necessarily need a breakdown are considered controlling

accounts.

Example

You sell barbecue on credit. The balance of credit sales not yet

collected is P100,000. This information is shown in Accounts

Receivable, which is a controlling account in the General Ledger.

You need a breakdown of this amount. You need information on

which customers owe you money and the amount each customer
However, knowing only the total balance is insufficient.

143

p148

Double-entry system

All transactions are recorded in the accounting records using the

double-entry system. Under this system, each transaction is

recorded in 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.

Recall from our previous discussions that debit (Dr)

simply refers to the left side of an account while credit (Cr.) refers

to the right side of an account.

Concepts of Duality and Equilibrium

"duality" and "equilibrium."

The double-entry system involves the use of the concepts of

The concept of duality views each transaction as having a two-

a.

fold effect on values- a value received and a value parted with,

and each transaction is recorded using at least two accounts.

b. 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 account is recorded. The following are the normal balances

of accounts:

Type of Account

Asset

Liability

Equity

Income

Expense

Normal balance

Debit

Credit

Credit

Credit

Debit

To help us remember the normal balances of accounts, let us rec

the expanded basic accounting equation:

all
Assets

abilities +Equity + Income Expenses

Notes:

r "Assets" which is on the left side of the equation has a normal

debit balance.

"Liabilities," "Equity," and "Income" which are additions on the

right side of the equation have normal credit balances.

"Expenses" which is a deduction on the right side of the

equation has a normal debit balance.

Income increases equity, thus, it has a normal credit balance

(same with equity). Expense decreases equity, thus, it has a

normal debit balance (opposite of that of equity)

Another way to depict the normal balances of the accounts is

as follows:

DEBITS

CREDITS

Assets + Expenses|= | Liabilities + Equity + Income

Friendly advice: I encourage you to memorize the normal

balances of the accounts as this will make your study of

accounting much easier.

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.

increase that account. To debit it means to decrease it. Analyze the

table below.
To credit an account with a normal credit balance means to

Debit

Credit

Credit

Credit

Debit

Increase

Decrease

Decrease

Decrease

Increase

Credit

Decrease

Increase

Increase

Increase

Decrease

Type of account Normal balanceDebit

Asset

Liability

Equity

Income

Expense
t Recall the following concepts:

An account takes the form of a "T-account" which re

The left side of all accounts is the debit side while

side of all accounts is the credit side.

the alphabetical letter "T."

The normal balance of an account is the side

account is increased.

The previous concepts are integrated in the following illustration:

Balance Sheet Accounts:

LIABILITY ACCOUNTS

Debit for

ASSET ACCOUNTS

Credit for

Credit for

Debit for

increases (+) decreases ()

decreases (increases(+)

EQUITY ACCOUNTS

Credit for

Debit for

decreases () increases (+)

Income Statement Accounts:

EXPENSE ACCOUNTS

INCOME ACCOUNTS

Debit for
decreases (-) increa

or Credit for

Credit for

increases(+decreases () decreaseincrease

decreases (

151

ding balance of an account

t (or equal to) the credits to that acc

an (

En

ts to a specific asset or expense account should be greater

dits to a liability, equity or income account should be greater

The difference between the monetary totals of debits and

hat account. On the other hand

or equal to) the debits to that account.

ts to an account represents the ending balance of that

cre

t. The minimum ending balance of an account is zero. This

rs when the total debits equal total credits to an account.

If an asset or expense account results to an ending balar

that is a credit, meaning the total amount of debits is less than the

total amount of credits, then the account is said to have an

abnormal balance. This means a recording error has been

mmitted. A 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. Analyze the T-accounts

below:

ASSET ACCOUNT

Debit

1.

Credit

20

100

Ending Balance

(100 Dr. -20 Cr) NORMAL*

80

The ending balance of P80 is a "normal balance" because the total

debits is greater than the total credits (i.e., 100 > 20).

ASSET ACCOUNT

Credit

2.

Debit

100100

Ending Balance

(100 Dr. 100 Cr.) NORMAL*

153
hen

Solution:

Cash

Dr.

2,000

10,000

Cr.

Beginning balance

Cash collections

Ending balance

10000 8000

4,000 0 Cash payments

Notes:

r The beginning balance is placed on the debit side because

"Cash" is an asset account and assets have a normal debit

balance.

y Cash collections increase the balance of cash; thus, they are

placed on the debit side.

r Cash payments decrease the balance of cash; thus, they are

placed on the credit side.

The ending balance is the difference between the debits and

credits in the account. It is computed as follows: 2,000 Dr. +

10,000 Dr.-8,000 Cr. -4,000 ending balance.

The 2,000 and 10,000 amounts are added because they are both

debits. The 8,000 amount is deducted because it is a credit.

Remember the following:

"Debit and debit" results to addition. Same is true for "credit

and credit."

"Debit" and "credit," or vice-versa, results to deduction.

Case #2: Liability account

At the beginning of the period, you have a note payable of P1,200.

During the period, you obtained an additional loan amounting to

P800 and made total payments of P500.

Requirement: Using a T-account, compute for the ending balance of

notes payable

Chapter 5

Solution:

Notes payable

Cr.

1,200 Beginning balance

r.

Payments on the

loan

800 Additional loan

1,500 Ending balance

500

Notes:

The beginning balance is placed on the credit side because

Notes payable" is a liability account and liabilities have a

normal credit balance.

Additional loan increases the balance of notes payable; thus,it

is placed on the credit side.

Payment of loan decreases the balance of notes payable; thus,

it is placed on the debit side.

"The ending balance is the difference between the total credits

and total debits in the account. The ending balance is

computed as follows: 1,200 Cr. +800 Cr. - 500 Dr. 1,500.

The 1,200 and 800 amounts are added because they are both

credits. The 500 amount is deducted because it is a debit.

Contra and Adjunct accounts

Some accounts have related accounts to them. An account related

to another account is referred to as either a contra account or an

adjunct account.

> 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.

155

Thus:

If an account has a normal debit

has a normal credit balance (the

debit balance means to deduct.

If an account has a normal debit balance, its adjunct account

has a normal debit balance (the same). To debit a normal debit

balance means to add.

balance, its contra account

opposite). To credit a normal

On the other hand:

If an account has a normal credit balance, its contra account

has a normal debit balance (the opposite). To debit a normal

credit balance means to deduct.

If an account has a normal credit balance, its adjunct account

has a normal credit balance (the same). To credit a normal

credit balance means to add.

>

t A contra asset account has a normal credit balance while an

adjunct asset account has a normal debit balance.

Examples of accounts with contra accounts:

. Accounts receivable

RELATED ACCOUNT

Allowance for bad debts

Type of account: CONTRA

ACCOUNT

ACCOUNT

> Accumulated depreciation-

e Building
Building

> Type of account: CONTRA

ACCOUNT

Accumulated depreciation -

Equipment

Equipment

> Type of account: CONTRA

ACCOUNT

contra or adjunct account is called the net carrying amount (or

simply the 'carrying amount) of that account.

The sum of the balances of an account and its related

Example 1:

Your accounts receivable has a balance of P100,0

allowance for bad debts account has a balance of

is the carrying amount of your accounts recevable?

while the related

P20,000. How much

balance

Solution:

Accounts receivable

Allowance for bad debts

Accounts receivable -net

P100,000
(20,000)

P80,000

otice that the "Allowance for bad debts" is deducted because it is

a contra account to "Accounts receivable."

Example 2:

You have a building with a historical cost of P1,000,000 and an

accumulated depreciation of P300,000. How much is the carrying

amount of your building?

Solution:

P1,000,000

Building

Accumulated depreciation -Building(300,000)

Building-net

P700,000

Chapter

Summary

The two books of accounts are the Journal and the Ledger

Business transactions are first recorded in the journal ("book of

original entries"). Subsequently, the effects of the transactions

on the accounts are posted to the ledger (book of secondary

entries')

Special journals are used to record transactions of a similar

.

ture. Transactions that cannot be recorded in the special

journals are recorded in the General journal.

The General ledger contains all the accounts appearing in the

trial balance. The Subsidiary ledger provides a breakdown of

the controlling accounts in the general ledger.

Under the "double-entry system," each transaction is

in two parts- debit and credit.

Assets and Expenses have normal debit balances while

Liabilities, Equity, and Income have normal credit balances.

For an asset or expense account: debit means increase while

credit means decrease.

For a liability, equity or income account: debit means decrease

while credit means increase.

recorded

. Income increases equity; while expense decreases equity

. Debit and debit (or credit and credit) results to addition.

. Debit and credit, or vice versa, results to deduction.

. A contra account is deducted from its related account whern

computing for the carrying amount of the related account. On

the other hand, an adjunct account is added to its related

account.
Decrease

Type of Account

ASSET

LIABILITY

EQUITY

INCOME

EXPENSE

Increase

(NORMAL BALANCE)

Debit

Credit

Credit

Credit

Debit

Credit

Debit

Debit

Debit

Credit

Chapter 6

Business Transactions and their

Analysis

Learning Objectives

1.
Describe the nature, and give examples, of business

transactions.

2. Identify the different types of business documents.

3. Identify the accounts affected by common business

transactions

The Accounting Cycle

The accounting cycle represents the steps or procedures used to

record transactions and prepare financial statements. The

accounting cycle implements the accounting processes of

identifying, recording, and communicating economic information

Steps in the Accounting cycle

The following are the 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.

Posting - information from the journal are transferred to the

ledger.

3.

Preparing the unadjusted ftrial balance- the balances of the

general ledger accounts are proved as to the equality of debits

and credits. The unadjusted trial balance serves as basis for

adjusting entries.

4.

aring 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 (or worksheet

preparation) - the equality of debits and credits are rechecked

after adjustments are made. The adjusted trial balance serves

as 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.

debits and credits are again rechecked after the closing

process.

9. Preparing the post-closing trial balance the equality of

10. Recording of reversing entries - reversing entries are usually

e beginning of the next accounting period and are

the recording of certain transactions in the

made at th

made to simplify

next accounting period.

172

Summary of the steps in the accounting cycle:

1. Identifying and analyzing

2. Journalizing

3. Posting

4. Unadjusted trial balance

5. Adjusting entries

6. Adjusted trial balance (andlor Worksheet)

7. Financial statements

8. Closing entries

9. Post-closing trial balance

10. Reversing entries

The preparation of trial balances and reversin

10) are optional, meaning they

ts

ould

represented in steps (4) (6), (9), and (

are not required in the preparation of financial statemen

However, for best internal control purposes, trial balances sh

be prepared.

are discussed in the succeeding chapters

Identifying and analyzing transactions and events

Steps 1 and 2 are discussed in this chapter. The other steps

This is the first step in the accounting cycle. It involves identifying

a business transaction and analyzing whether or not that

transaction affects the assets, liability, equity, income or expenses

of the business.

A transaction that has an effect on the accounts is an

"accountable event," which needs to be recorded in the books of

accounts. On the other hand, a transaction that has no effect on the

accounts is a "non-accountable event," which is not recorded in the

books of accounts.

Transactions are normally identified from "soura

documents. Source documents are written evidences containing

information about transactions. Source documents

various forms which include, but not limited to, the followin

come in

Sales invoices,

173

a.

Official receipts,

b.

Purchase orders

d. Delivery receipts,

e. Bank deposit slips,

f. Bank statements
g. Checks

C.

Statements of account, and the like

ustration: Source Documents

Sales invoice vs. Official receipt

sales invoices (SI) are used for the sale of goods while Offcial receipts

are used for the sale of services. For example, if you buy

store will issue you a sale invoice; if you pay

(OR)

groceries, the grocery

your tuition fee in school, the school will issue you an official

receipt.

Purchase order

A purchase order is a document issued by a buyer to a sellen

indicating the types, quantities and agreed prices for products on

services that the buyer intends to purchase. Purchase orders are

prepared as internal control over purchases.

For example, to prevent unnecessary purchases, y

should require your personnel to prepare purchase orders for

the purchases of your business.

Delivery receipt
delivery receipt is a document signed by the receiver of a

shipment acknowledging the receipt of the goods.

Bank deposit slip

posit slip evidences a deposit to a bank account. It shows

of deposit, the bank account name and number, an

de

the

amount deposited

Bank statement

A bank statement is a report issued by

a bank (on a monthly basis)

ch shows the deposits and withdrawals during the period and

the cumulative balance of a depositor's bank account

Check

A check is an instrument that orders a bank (drawee) to pay the

person named on the check or the bearer thereof (payee) a definite

amount of money from the drawer's bank account.

of account

tatetement of account is a report a business sends to its customer

the transactions with the customer during a period, the

isuments made by the customer and any remaining balance due

the customer. A statement of account also serves as a notice

of billing.

For example, a school periodically issues statements of

counts to its students reminding them to settle any unpaid

tuition fee.

Types of events

1. External events are transactions that invar sale, purchase,

and another external party. Exampties, an

ransactions that involve the business

money, payment of liabilities, and the like.

ents are events that do not involve an extern

amples include production (cooking of barbecue) and

osses (eg, destruction of properties due to storm

al

ses (e

earthquake, and the like)

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:

PXx

Dale Account title to be debited

Account title to be credited

Pxx

short description of the transaction

The following are the parts of a journal entry:

1. Date journal entries are recorded in the journal

chronologically, i.e, arranged according to the dates they are

recorded.

2. Account titles and Amounts to be debited and credited

under the double-entry system, each transaction is recorded in

the journal in two parts -debit and credit.

3. Short description of the transaction - a short description of

the transaction is provided for future reference.

181

e and Compound journal entries

simpl

A journal entry

may have one of the following formats:

single credit element. The illustrated journal entry above is an

ample of a simple journal entry.

have

ntry - one which contains a single debit and a

hCompound journal entry - one which contains two or more

debits or credits.

Ilustration 1: Journal entries- Start-up

this illustration, we will discuss how to set up the accounting

In

records of a start-up business.

following were the business transactions on this date:

Transaction #1: Initial investment

You opened a barbecue stand on January 1, 20x1. The

You provided P800 cash as initial investment to your business.

Step #1: Transaction analysis

"Cash" (asset) and "Owner's capital"

(equity)

Cash is increased, Owner's capital is

increased.

> Accounts

affected:

> Effect on

accounts:

> Debit/Credit: Asset is increased through debit. Equity is

increased through credit.

Step #2: Journal entry

Your initial investment is recorded in the journal as follows:

Debit Credit

DJOURNAL

Account titles

Date

Jan. 1,20x1 Cash

800

800

Owner's capital

to record the owner's initial

investment to the business

Note the following parts of a journal entry: (1) Eate, (

Accounts and amounts debited and credited, and 3) Shor

description of the transaction.

The effects of the entry above on the basic accounting ecpuation

are analyzed below:

ASSETS

LIABILITIES

EQUrTY

1) Cash

800

+ Owner's capital 00
Transaction #2: Loan

The business obtained a loan of P1,200.

Step #1: Transaction analysis

Accounts "Cash" (asset) and "Notes payable"

affected

Effect on

accounts

(liability)

Cash is increased; Notes payable is

increased

> Debit/Credit: Asset is increased through debit. Liability

is increased through credit.

Step #2: Journal entry

The business loan is recorded as follows:

JOURNAL

Date

Jan. 1, 20x1

Account titles

Debit Credit

1,200

Cash

Notes payable

1,200

to record the loan obtained

Both the journal entries above are examples of "simple

jounal entries" because they have single debits and credits.

The effects of the entries above on the basic accounting

equation are analyzed below:

183

ASSETS

LIABILITIES

800

n Cash

1.200 =| Note payable-200 +

EQUITY

Owner's capital 800

Cash

Totals 2,000

1,200

800

Observe that the equality of the basic accounting equation

maintained as each transaction is recorded. This is in accordance

with the concepts of duality and equilibrim

Transaction #3: Capital expenditures

The business acquired the following for cash:

Item description

Barbecue grill
Cooking accessories

Beach umbrella

Cost

P1,000

120

400

The items acquired are considered "capital expenditures"

(or "capital assets") because they will be used for a period longer

than one year (i.e, they provide future economic benefits). Thus,

the items acquired will be recorded as assets.

Step #1: Transaction analysis

>Accounts

"Equipment" (asset) and "Cash" (asset)

affected:

> Effect on

Equipment is increased, Cash is decreased.

accounts:

P Debit/ Credit: Asset is increased through debit and

decreased through credit

Step #2: Journal entry

The

acquisition of equipment is recorded as follows:

JOURNAL
Date

Account titles

1,000

120

400

Jaw 1, 20x1 Equipment -Barbecue grill

Equipment-Cooking accessories

Equipment - Beach umbrella

1,520

Cash 1,000+ 120+ 400)

to record the acquisition of

equipment

Additional analyses:

Equipment (i.e, barbecue grill, cooking accessories and beach

umbrella) is debited because these are the assets that the business

has obtained, ie, "value received."

.Cash is credited because this is the asset given up in order to

obtain the equipment, i.e, "value parted with."

The journal entry above is an example of a "compound

journal entry" because it has more than one debit.

The effects of the entries above on the basic accountin

equation are analyzed below:

1) Cash

2) Cash

ASSETS
LIABILITIES+

EQUITY

800

Owner's

capital800

payable 1,200+

3)Equipment:

BBQ grill 1,000

- Cooking

accessories

-Beach

umbrella

Cash

Totals

120

400

(1,520)

2,000 I

1,200+

800

Notice that the acquisition of equipment through payment

of cash did not affect the total assets. This is because the

is recorded as an increase in
equpment)

decrease in cash).

one asset (i.e., increase in

t) and simultaneously a decrease in another asset, (ie

action #4: Acquisition of

siness purchased inventory for P480 cash.

The business purchased inventorentory

Step # 1: Transaction analysis

> Accounts

"Inventory" (asset) and "Cash" (asset)

affected:

> Effect on

accounts:

Inventory is increased; Cash is decreased.

Debit / Credit:Asset is increased through debit and

decreased through credit.

Step #2: Journal entry

The purchase of inventory is recorded as follows:

JOURNA

Account titles

Date

Debit Credit

Jam. 1, 20x1 Inventory

480

Cash
480

to record the acquisition of inventory

Additional analyses:

Inventory is debited because this is the asset obtained while cash is

credited because this is the asset given up in order to obtain the

inventory.

You may also want to think of it this way

en you purchased inventory, your inventory increased

Inventory is an asset account and recall that an asset is increased

by debiting it. Therefore, to record an increase in inventory, you

need to debit the inventory áccount.

When you paid for the inventory purchased, your cash decreased.Your

Cash is an asset account and recall again that an asset is

decreased by crediting it. Therefore, to record a decrease in cash,

you need to credit the cash account

follow

Trans

Total

the b

The effects of the entries above on the basic accounting

equation are analyzed as follows:

ASSETS

=| LIABILITIES
EQUITY

St

1) Cash

Owner's

capital

800

800

Note

2) Cash

payable 1,200+

Equipment:

3)

BBQ grill

- Cooking

accessories

- Beach

umbrella

Cash

1,000

120

400

(1,520)

4) Inventory 480

(480)

2,000
Cash

Totals

1,200+

800

*Remember the following:

The initial investment by an owner to the business is recorded

as debit to the asset contributed (e.g., "Cash") and credit to an

equity account called "Owner's capital."

Receipts of cash are debited to the "Cash" account while

payments of cash are credited to the "Cash" account.

187

lustration 2: Journal entries-Operations

our barbecue operations started on January 2, 20xl. The

lowing were the business transactions on this date:

Transaction #5: Sale

otal cash sales of barbecue amounted to P700. The total cost of

the barbecues sold is P280.

Step #1: Transaction analysis

Accounts

affected:

> "Cash" (asset) and "Sales" (income);

"Cost of sales" (expense) and

"Inventory" (asset)
Cash is increased; Sales is increased.

Cost of sales is increased; Inventory is

decreased

Effect on

accounts:

> Debit/ Credit: Asset is increased through debit and

decreased through credit.

Income is increased through credit.

Expense is increased through debit.

Step #2: Journal entry

The sales are recorded as follows:

JOURNAL

Date

Account titles

Debit Credit

Jan. 2, 20x1 Cash

700

Sales

700

to record total sales of barbecue

The cost of sales is recorded as follows:

JOURNAL

Debit Credit

DateAcc
Jan. 2, 20xl Cost of goods sold

Account titles

280

280

Inventory

to record the cost of the barbecues sold as expense

Additional analyses:

ted to record the cash you received from the

is credited to record the income you earned from the

ost of goods sold" is debited to record the cost of the

"Cash" is debi

customers.

sale of inventory

barbecues sold as expense.

to sale.

Inventory" is credited to record the decrease in inventory due

The entry above to record the cost of goods sold is an

application of the "matching concept" discussed in Chapter2

Recall that under this concept, costs that are directly associated

with the earning of revenue are recognized as expenses in the

same period where the related revenue is recognized.

Thus, in the transactions above, the cost of the inventory

purchased is initially recorded as asset (i.e, inventory) and

recognized as expense (iey cost of goods sold) when the inventory

is sold. This way, expense is "matched" or recognized in the same

period where sales revenue is recognized.

The effects of the entries above on the basic accounting

equation are analyzed as follows:

p189

Chapter 6

Transaction #6: Expense

The business paid P20 for supplies expense.

Step #1: Transaction analysis

Accounts

affected:

Effect on

accounts:

Debit/Credit:

"Supplies expense" (expense) and "Cash

(asset) is

Cash is decreased; Supplies expense is

increased

Expense is increased through debit. Asset

is decreased through credit.

Step #2: Journal entry

The supplies expense is recorded as follows:

Debit Credit

Date

Account titles

20

Jan. 2, 20x1 Supplies expense

Cash

20

to record supplies expense

Additional analyses:

"Supplies expense" is debited to record the cost of the supplies

used as expense

"Cash" is credited to record the cash paid for the purchase of

supplies.

The effects of the entries above on the basic accounting

equation are analyzed as follows:

p191

Chapter 6

Illustration 3: Non-accountable events

A. You are planning purchase

o purchase new equipment in the future

because voudr yet placed an order for the new equipment

don't have the money yet.

Step # 1: Transaction analysis

Accounts

affected:

Effect on

accounts

Debit/Credit: None

None. A mere plan to purchase does not

affect the accounts of the business

None

No journal entry shall be made because the transaction is non-

accountable.

Step #2: Journal entry

E. Your dog, "Buloy," died because he ate a barbecue stick.

Step #1: Transaction analysis

Accounts

affected:

None. The event does not affect any of the

accounts of the business.

None

> Effect on

accounts:

Debit/Credit: None
Step #2: Journal entry

No journal entry shall be made because the transaction is non-

accountable.

cording drills:

pe

have the following recording drills:

1.1: Initial investment in cash

nuary 1, 20x1, the owner invests P100,000 cash to the

businesS.

al entry to record the transaction is as folloWs:

The journal

Jan. Cash

Owner's capital

100,000

1,

20x1

to record the owner's initial investment

100,000

to the business

to save space, we will use the above fo

save space, we will use the above format for journal entries in this illustration and

the succeeding illustrations

in
The effect of the transaction on the basic accounting equation

is analyzed as follows:

. ASSET = LIABILITIES +

EQUITY

Owners

capital 100,000

Cash 100,000

Case #12: Initial investment in non-cash assets

On January 20, 20x1, the owner provides a building valued at

P1,000,000 and an automobile valued at P500,000 to the business.

Step #1: Transaction analysis

Building" (asset), "Transportation

Accounts

affected

equipment" (asset), and "Owner's capital

(equity)

Building and Transportation equipment

are increased, Owner's capital is

increased.

. Effect on

accounts:

> Debit/Credit: Asset is increased through debit. Equity is

increased through credit.

Chapter 6

Step #2: Journal entry

The compound joumal entry to record the transaction

Jan. Building

20, Transportation equipment

1,000,000

500,000

20x1

Owner's capital.

1,500,000

to record the owners non-cas!h

investments to the business

Alternatively, the transaction above can be recorded

through simple journal entries as follows:

1,000,000

Jan. Building

20,

20x1

1,000,000

Owner's capital

to record the owner's non-cash investment

to the business

500,000

a. Transportation equipment
20,

500,000

0 Owner's capital

20x1

to record the owner's non-cash

investment to the business

Both entries above - compound and simple, are acceptable.

The effect of the current* transaction on the basic accounting

equation is analyzed as follows:

ASSET

= LIABILITIES

EQUITY

Building

Transportation

equipment OO000

1,000,000

Owner's

capital

1,500,000

Total

1,500,000 =

+ Total

1,500,000

* To save space again, we will present only the effect of the current transaction on the

accounting equation. We will not re-illustrate the analyses of the effects of the previous
transáctions

1: Acquisition of asset Equipment

Case nuary 25, 20x1, the business acquires a machine for

e for P20,000

mal entry to record the transaction is as follows:

The journal

Jan. Machinery a)

25,

Cash

20,000

to record the acquisition of machine

20,000

20x7

uipment" account may be used in lieu of the "Machinery" account.

The effect of the current transaction on the basic accounting

equation is analyzed as follows:

ASSET

Machinery 20,000

Cash(20,000)0

Totals

LIABILITIES EQUITY

0
0

? Notice again that the accounting equation remains balanced

each time a transaction is recorded.

Case #22: Acquisition of asset-Inventory (Cash basis)

On January 26, 20x1, the business acquires inventories for P50,000

cash.

The journal entry to record the transaction is as follows:

Jan. Inventory

26, Cash

50,000

50,000

20

to record the acquisition of inventory on

cash basis

The effect of the current transaction on the basic accou

equation is analyzed as follows:

ntin

ASSET

EQUITY

= LIABILITIES

Inventory

Cash

Totals
50,000

(50,000)

Case #2.3A: Acquisition of asset-inventory (On account/ Credit)

worth

n January 27, 20x1, the business purchases inventories wo

P70,000 on account (on credit,).

Step # 1: Transaction analysis

Accounts affected: "Inventory" (asset) and "Accounts

payable" (liability)

>Effect on accounts: Inventory is increased. Accounts payable

is increased.

Debit/Credit:Asset is increased through debit.

Liability is increased through credit

Step #2: Journal entry

The journal entry to record the transaction is as follows:

70,000

Jan. Inventory

27,

Accounts payable

70,000
20x1

to record the acquisition of inventory on

credit

The effect of the current transaction on the basic accountin

equation is analyzed as follows:

ASSETS

LIABILITIES

Accounts

payable 70,000

+EQUITY

Inventory 70,000

Totals

70,000

70,000 +

Case #23B Payment of accounts payable

On January 31, 20x1, the business settles the P70,000 account

payable from the January 27 purchase.

# 1: Transaction analysis

Accounts

affected:

y Effect on

"Accounts payable" (liability) an

Accounts payable is decreased. Cash is

decreased

accounts:

Debit/Credit: Liability is decreased through debit. Asset

is decreased through credit

Step #2: Journal entry

e journal entry to record the transaction is as follows:

Jan. Accounts payable

31, Cash

20x1

70,000

to record the settlement of accounts

70,000

payable

The effect of the current transaction on the basic accounting

equation is analyzed as follows:

ASSETS

LIABILITIES

+ EQUITY

Cash(70,000)Accounts

Totals

payable (70,000)+

(70,000) +

(70,000)

Case #31: Liability

On February 1, 20x1, the business obtains a bank loan of P800,000.

The journal entry to record the transaction is as follows:

Feb. Cash

1 Notes payable

800,000

800,000

20x1

to record the loan taken from a bank

※ The effect of the current transaction on the accounting

equation is shown below:

LIABILITIES

+EQUITY

ASSETS

Cash 800,000 Notes payable 800,000+

Case #32: Payment of a liability

On March 1, 20x1, the business makes a partial p

P400,000 on the bank loan.

Step #1: Transaction analysis

sAccounts

"Notes payable" (liability) and "Cash"

asset)

Notes payable is decreased. Cash is

affected:
Effect on

accounts:

decreased

Debit/Credit: Liability is decreased through debit. Asset

is decreased through credit.

Step #2: Journal entry

The journal entry to record the transaction is as follows:

Mar. Notes payable

400,000

400,000

20x1 Cash

to record the partial payment of note

payable

÷ The effect of the current transaction on the accounting

equation is shown below

ASSETS

LIABILITIES

+EQUITY

Cash

(400,000)

Notes payable (400,000) 0

Case #41: Income-Cash sale

On March 2, 20x1, the business makes a cash sale of P100,000. The

cost of the inventories sold is P30,000.

The journal entries to record the transaction are as follows:

Mar Cash

MSale

199

to record the cash sale

20x1

lar

er. Cost of sale

100,000

Inventory

100,000

to charge the cost of imentories sold as

30,000

20x7

expense

30,000

effect of the current transaction on the basic ac

The

uation is analyzed as follows:

ASSETS = LIABILITIES+ EQUITY

Cash

100,000-

+ Sales 100,000

(30,000)0Cost of sales (30,000)

Totals

70,000

70,000

Recall that income (eg., sales) increases equity while

expenses (e.g, cost of sales) decrease equity.

&

The effect of the transaction on the expanded accounting equation

is analyzed as follows:

ASSETS L EINCOME EXPENSES

100,000 =

+ 100,000

(30,000)

70,000

- 30,000

+ 100,00030,000

Case #4.2A: Income-Credit sale (Sale on account)

On March 4, 20xl, the business makes a sale on account of

P80,000. The sale price is collectible on March 8, 20x1. The cost of

the inventories sold is P20,000.

Step # 1: Transaction analysis

> Accounts

Accounts receivable" (asset) and

"Sales" (income)

affected:
"Cost of sales" (expense)

Inventory" (asset)

> Accounts receivable is increased

is increased.

Cost of sales is increased; Invento

decreased

Effect on

accounts:

es

> Debit/Credit:Asset is increased through debit and

decreased through credit.

Income is increased through credit.

Expense is increased through debit

Step #2: Journal entry

The journal entries to record the transaction are as follows:

Mar. Accounts receivable

80,000

4,

20x1

Sale

80,000

to record credit sale

Mar. Cost of sale

4,

20,000

Inventory

20,000

20x1

to charge the cost of inventories sold as

expense

The effect of the current transaction on the basic accounting

equation is analyzed as follows:

ASSETS

LIABILITIES +

EQUITY

Accounts

80,000

80,000

(20,000)

60,000

+ Sales

receivable

Inventory(20,000)

Totals

t Cost of

sales

60,000

Case #4.2B: Collection of accounts receivable

On March 8, 20xl, the business collects P80,000 accounts

receivable.

201

#1:Transaction analysis

Accounts

affected:

"Cash" (asset) and "Accounts receivable

(asset

decreased.

2 Effect on

accounts

1decreasencreased. Accounts receivable is

Credit:

Asset is increased through debit and

decreased through credit.

Step #2: Journal entry

The journal entry r

Mar. Cash

to record the transaction is as follows:

80,000

Accounts receivable

to record collection of accounts receivable

80,000
20x1

Notice that income (i.e, sale) is recognized on March 4,

20x1 (i.e., date of sale) rather than on March 8, 20xl (i.e, date of

cash collection). This is in accordance with the accrual basis of

accounting.

The effect of the transaction on the basic accounting equation

is analyzed as follows:

LIABILITIES EQUITY

ASSETS

80,000

Cash

Accounts receivable (80,000)

Totals

p202

#1 :Transaction analysis

Accounts

affected:

Owner's drawings" (contra equity") and

"Cash" (asset)

Owner's drawings is increased. Cash is

decreased
Effect on

accounts:

ahiCredit: Contra equity is increased through

/tonpuiy is

debit.** Asset is decreased through credit.

"Owner's drawings" account is closed to the “Owner's

al" account, as a direct deduction, at the end of the

g period. Thus, the "Owner's drawings" account is a

otra account to an equity account (ie, contra equity). (See

cotn

discussion of "contra accounts" in Chapter 5.)

Ii equity is increased through credit, then contra equity is

increased through debit (i.e, the opposite).

Step #2: Journal entry

The journal entry to record the transaction is as follows:

Apr. Owner's drawings

, Cash

20x1

10,000

10,000

to record the ooner's drawings

The effect of the current transaction on the basic accounting

equation is analyzed as follows:

EQUITY

IABILITIES+
Owner's

t drawings (10,000

ASSETS

Cash -(10,000)-=

Chapter 6 Summary:

The accounting cycle represents the steps or a

procedures used to record transactions and pre

statements.

Steps in the accounting cycle:

1. Identifying and analyzing

2. Journalizing

3. Posting

4. Unadjusted trial balance

5. Adjusting entries

6. Adjusted trial balance (and/or worksheet)

7. Financial statements

8. Closing entries

9. Post-closing trial balance

10. Reversing entries

Only "accountable events" are recorded in the accounting

records. "Accountable events" are those that affect the accounts.

Types of events: (a) External events - involve the business and

another external party; (b) Internal events - involve the business

only.

Journalizing is the process of recording transactions in

journal by means of journal entries.

A journal entry has the following parts: (a) Date, (b) Accounts

and Amounts debited and credited, and (c) Short description f tht

transaction.

A simple journal entry is one which contains a single debit

a single credit element. A compound journal entry is one

contains two or more debits or credits.

which

p205 206

Chapter7

Posting to the Ledger

Learning Objectives

1. Post transactions in the ledger.

2. Prepare the unadjusted trial balance.

Introduction

We have already discussed the first two steps in the accou

cycle in the previous chapter. In this chapter, we

discussing steps (3) an (4)

Steps in the accounting cycle:

1. Identifying and analycing

2. Journalizing

3. Posting

4. Unadjusted trial balance

5. Adjusting entries

6. Adjusted trial balance (and/or worksheet)

7. Financial statements

8. Closing entries

9. Post-closing trial balance

10. Reversing entries

Finished

Now

Later

Posting

Posting, the third step in the accoumting cycle, is the process

transferring data from the journal to the appropriate accounts it

the ledger. More specifically, posting is done by transferring the

amounts of debits and credits in a recorded journal entry to

ledger accounts.

of

The purpose of posting is to classify the effecs c

of

transactions on specific asset, liability, equity, income an

accounts in order to provide more meaningful information.

p217

Although the transactions have already been recorded

does not provide readily available information

the following:

> How much is the total service fees earned

>

rma

on, for ex

during the we

ed durino We

How much are the total expenses incurred duri

How much is the total cash collections during th

How much is the total cash disbursements durin

ing the weel

>If the cash balance at the beginning of the week wa

ek?

sP

how much is the cash balance at the end of the we

How much accounts receivable is outstanding at the

the week?

These and other information may be needed by

manager in performing his or her managerial functions

answer these questions, we need to classfy the effectsdf

transactions on specific asset, liability, equity, income and expe

accounts. This procedure is called posting.

p218

p219-221

p222-223

Steps in the accounting cycle

I. Identifying and analyzing

2 Journalizing

3. Posting

4. Unadjusted trial balance

5. to 10.

Now showing

Coming soon @s

Preparing the Unadjusted Trial Balance

A trial balance is a list of general ledger accounts and their

It is prepared to check the equality of total debits and to

credits in the ledger. The preparation of the trial balance

starting point for the preparation of the financial statements

Types of Trial balance

a Unadjusted trial balance - this is prepared before adjusting

entries are made. Adjusting entries, and consequent

financial statements, cannot be prepared unless the total debts

and credits in the unadjusted trial balance are equal.

b. Adjusted trial balance -this is prepared after adjusting entries

but before the financial statements are prepared.

c. Post-closing trial balance - this is prepared afterthe closing

process.

Although optional, a trial balance shall nevertheless be

prepared because it helps in revealing some errors.

Errors revealed by a trial balance

The trial balance can reveal errors that caused the total debits

total credits to be unequal. Examples:

and

nalizing

or posting one-half of an

225

hout a credit, or vice versa

wit

entry, ie, a debit

one part of an entry for a different amount than the

other part.

rs of Transplacement (Slide error) on one side of an entry

f Transposition on one side of an entry

4. Error

splacement error is committed when the number of digits

n amount is incorrectly increased or decreased, for

ample, a P1,000 amount is recorded as P100 or P10,000.

ition error is committed when digits in an amount are

interchanged, for example, a P15,652 amount is recorded as

P15,625 or P15,265.

Errors not revealed by a trial balance

The trial balance cannot reveal errors that do not cause the total

debits and total credits to be unequal. Examples:

1. Omitting entirely the entry for a transaction

2. Journalizing or posting an entry twice

3. Using wrong account with the same normal balance as the

correct account

Wrong computation with the same erroneous amounts posted

to debit and credit sides

4.

t The purpose of preparing a trial balance is to determine whether

the total debits and total credits in the ledger are equal.

If total debits and credits are not equal, an error surely exists in

the accounts.

However, if total debits equal total credits, it does not mean that

there are no errors in the accounts

Notes:

r The unadjusted trial balance is simply a list of the ending

balances of accounts in the general ledger.

The heading of the trial balance consists, of the following

1. Name of the business (i.e., 'Tiga Laba Laundry Shop)

answers the question "Who?"

2. Title of the report (i.e., 'Unadjusted Trial Balance)-

answers the question "What?"

3. Date of the report (i.e., January 7, 20x1) - answers the

question "When?"

Account titles are listed in the unadjusted trial balance in the

following order:

1. Assets;

2. Liabilities;

3. Equity;

4. Income; and

5. Expenses

Recall again the normal balances of accounts:

Assets and Expenses

Liabilities, Equity, and Income .. CREDIT

DEBIT

hapter 7 Summary:
The steps in the accounting cycle a

re:

Identifying and analyzing

2. Journalizing

3. Posting;

4. Unadjusted trial balance;

5. Adjusting entries;

6. Adjusted trial balance (Worksheet),

7. Financial statements;

8. Closing entries

9. Post-closing trial balance; and

10. Reversing entries

.Posting is the process of transferring the amounts of debits and

credits in a recorded journal entry to the ledger accounts.

The ending balance of an account is the difference between the

total debits and total credits in that account.

A trial balance is a list of general ledger accounts and their

balances. It is prepared to check the equality of total debits and total

credits in the ledger. The 3 types of trial balances are: ()

nadjusted trial balance, (2) Adjusted trial balance, and (3) Post-

closing trial balance

Chapter 8

Adjusting Entries
Learning Objectives

1. Enumerate the common end-of-period adjust

2. Prepare adjusting entries.

en

Introduction

Let us have a recount of what we have learned so far:

Steps in the accounting cycle:

1. ldentifying and analyzing

2. Journalizing

3. Posting

4. Unadjusted trial balance

5. Adjusting entries

6. to 10.

Now!

Later 3

Adjusting entries

Adjusting entries are entries made prior to the preparation d

financial statements to update certain accounts so that they refled

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 o into their real and nominal elements

(a) Mixed, real and nominal accounts will be discussed momentarily.

Our subsequent discussions on adjusting entries a

subdivided into the following

1. Accruals of income and expenses

2. Recognition of depreciation expense and bad debts expense

3. Deferrals of income and expenses (splitting of

yed

accounts').

e and Expenses

of Incom

Is

nting, the term acl" (or to

nize an

ome that is already ea

accrue) means to

already earned but not yet collected; or

nthat is already incurred but not

that is already incurred but not yet

paid.

Accruals give rise to both income and receivable (or both

ense and payable)

the application of the following concepts in the

ding illustrations:

All adju

sting entries involve at least one balance sheet account

ne income statement account (or statement of comprehensive

come

dustingentries affect the profit or loss for the period (or

income account).

comprehensive income for the period).

ustration: Adjusting entries- Accruals of income & expense

ABC Co. is preparing its financial statements for the period ended

December 31, 20xi. Adjustments are needed for the following

Case #1: Accrual of income-interest income

ABC Co. received a 12%, P100,000, one-year, note receivable on

April 1, 20x1. ABC uses a calendar year period. The principal and

interest on the note are due on April 1, 20x2.

Concepts, given information, analyses and conclusion:

Concepts:

a. Notes receivable give rise to interest income.

b.

Interest income is earned due to passage of time.

Given information:

a. ABC uses a calendar year period. Therefore, the current

terest on the note is collectible on April 1, 20x2 (ie, in

the next accounting period).

accounting period ends on December 31, 20x1.

Analysis

As of December 31, 20xl (end of accounti

income should have been earned because th

passage of time (from April 1 to December 31, 20x ae

interest will only be collected in the next accounting

i.e, April 1, 20x2).

ng period

Pe is already

there is alread

> Conclusion:

Interest income shall be accrued for the 9 months

April 1 to December 31, 20x1.

The interest income is accrued as follows:

Formula:

Where:

i interest

P principal

r rate

t = time

(i-Prt: Interest equals principal times rate times time)

.Principal (P) is the P100,000 face amount of the note.

. Rate (r) is the 12% interest rate.

is the expired time of 9 months (i.e., April 1 to

December 31, 20x1) over the total of 12 months in a year.

Interests (100,000 x 12% x 9/12)-2000

Step #1: Transaction analysis

> Accounts

"Interest receivable" (asset) and "Interes

income" (income)

affected:

241

Interest receivable is increased. Interest

income is increased.

Asset is increased through debit. Income

is increased through credit.

Effect on

accounts

Debit/Credit:

Adjusting journal entry (AJE)

diusting entry for the accrued interest income is as follows:

Dec Interest receivable

31,

20x7

Interest income

9,000

to accrue interest income earned but

9,000

not yet collected

Notes:

The adjusting entry is dated as at the end of the reporting

period (i.e, December 31, 20x1).

r "Interest receivable" is debited because the interest is yet to be

collected in the future (i.e, on April 1, 20x2).

r In 20x1, interest income is recognized only for the expired

period (time passed) of April 1 to December 31, 20x1. Interest

covering the remaining 3 months of January 1 to March 31,

20x2 will be recognized in the next accounting period. This is

an application of the time period concept.

In the next accounting period, the collection of the interest

is recorded as follows:

12,000

April Cash a

Interest receivable b

Interest income c

9,000

3,000

to record the collection of interest

e cash collection pertains to the 1-year total interest covering

months of April 1, 20x1 to March 31, 20x2. This is computed as

ows: i prt (100,000 x 1290 x 1202) 12,000.

the

follo
241

Interest receivable is increased. Interest

income is increased

Asset is increased through debit. Income

is increased through credit

Effect on

accounts

Debit/Credit:

Debit /Credit icot

42: Adjusting journal entry (AJE)

Sieh iusting entry for the accrued interest income is as follows:

The

Interest receivable

Interest income

9,000

31,

20x1

to accrue interest income earned but

9,000

not yet collected

Notes:

The adjusting entry is dated as at the end of the reporting

period (i.e, December 31, 20x1).

"Interest receivable" is debited because the interest is yet to be

collected in the future (i.e, on April 1, 20x2)

In 20x1, interest income is recognized only for the expired

period (time passed) of April 1 to December 31, 20x1. Interest

covering the remaining 3 months of January 1 to March 31,

20x2 will be recognized in the next accounting period. This is

an application of the time period concept.

In the next accounting period, the collection of the interest

is recorded as follows:

12,000

April Cash a

Interest receivable b

Interest incomec

9,000

3,000

to record the collection of interest

e cash collection pertains to the 1-year total interest covering

e months of April 1, 20x1 to March 31, 20x2. This is compute as

ows: i-prt (100,000 x 12% x 12/12) = 12,000.

the

The credit to interest receivable pertains to the

on December 31, 20x1 (see AJE above).

h interest

e earned in the months of Jan. 1 to Mar. 31, 20 ine

computed as follows: i>M (100,000 x 12% x 3/12)-3.000, This is

The credit to interest income pertains to the 3-mon

9-mo. interest:

Apr. 1 to Dec. 31, 20x1

(100,000 x 12% x 9/12)-9,000

recognized in 20a

1-yr. interest:

Apr. 1, 20x1 to Mar. 31, 20x2:

(100,000 x 12% x 12/12,-

12,000

3-mo. Interest:

Jan. 1 to Mar. 31, 20x2:

(100,000 x 12% x 3/12-

3,000 recognized in 20x2

The preparation of adjusting entries is an application of

the concepts of time period and accrual basis of accounting (ee Chaper

The application of the accrual basis causes timing

differences between the date income is recognized and the dateit

is collected. Adjusting entries are needed to ensure that income is

recognized in the proper period when it was earned (time period.

Case #2: Accrual of income-Rent income

ABC Co. rents out its building to a tenant for a monthly rent of

P50,000 As of December 31, 20x1, the tenant has not yet paid the

rent for the month of December.

Concept, given information, and conclusion:

Concept:

Income is recognized when earned rather than when

- accrual basis of accounting.

Given information:

The

not yet paid the rent.

tena

nt has already used the

>Conclusion:

7 nincoe for the month of December shall be accrued on

t inco

December 31, 20x1.

Step #1: Transaction analysis

y Accounts

affected:

Effect on

accounts:

Debit / Credit: Asset is increased through debit. Income

"Rent receivable" (asset) and "Rent

income" (income)

Rent receivable is increased. Rent income

is increased.

is increased through credit

Step #2: Adjusting journal entry (AIE)

The adjusting entry is as follows:

Dec. Rent receivable

31, Rent income

50,000

50,000

20x1

to accrue rent income

When the rent is collected in the next accounting period, it

will be recorded as follows:

50,000

Jan. Cash

20x2

2Rent receivable

50,000

to record the collection of the Dec.

20x1 rent

Observe that rent income is recognized in 20x1 when it

earned rather than in 20x2 when it was collected.

ABC Co. issued a 12%, P100.000, one-year, no

20x2.

Concepts, given information, analyses and conclusion:

Case #3: Accrual of expense-Interest expense

payable on

on October,

October 1, 20x1. The principal and interest are due on ableon

a. Notes payable give rise to interest expense.

b. Interest expense is incurred due to passage of time.

> Concepts:

Given information:

a. Interest on the note is payable on October 1, 2022 (ie, in

.e., in

the next accounting period)

The current accounting period ends on December3

b.

> Analysis:

As of December 31, 20x1 (end of accounting period), interest

expense is incurred because there is already a passage of

(October 1 to December 31, 20x1), although interest will only

be paid in the next accounting period (i.e, October 1, 20x2)

time

Conclusion:

Interest expense shall be accrued for the 3 months covering

October 1 to December 31, 20x1.

The interest expense is accrued as follows:

Formula:

Principal (P) P100,000 face amount.

. Rate (r)-12%
. Time () expired time of 3 months (i.e, October 1to

December 31, 20x1) over 12 months in a year.

, Interest (100,000 x 12% x 3/12)-3,000

t: Transaction analysis

Interest expense" (expense) and "Interest

> Accounts

payable" (liability)

affected

Effect on

accounts

Debit

Interest expense is increased. Interest

lpayable is increased

Credit:Expense is increased through debit.

Liability is increased through credit.

#2: Adjusting journal entry (AJE)

Gtep

the adjusting entry for the accrued interest expense is as follows:

Dec. Interest expense

3,000

1. Interest payable

20xl
to accrue interest expense incurred but

3,000

not yet paid

Notes:

r Interest payable" is credited because the interest is yet to be

paid in the future (i.e., Oct. 1, 20x2).

r In 20x1, interest expense is recognized only for the expired

period (time passed) - from October 1 to December 31, 20x1.

Interest covering the remaining 9 months of January 1 to

October 31, 20x2 will be recognized in the next accounting

period.

In the next accounting period, the payment of the interest

is recorded as follows:

Interest payable (al

2n2 Interest expense tb

3,000

9,000

12,000

Cash (c)

to record the payment of interest

Decen debit to interest payable pertains to the accrued interest on

er 31, 20x1 (see adjusting entry above).

a The debit to interest expense pertains to the 9 mon

expense incurred in the months of Jan. 1 to Oct. 1,

computed as follows: i-H (100,000 x 12% x 912)-9.00

x2,

e The cash payment pertains to the total 1-year interest

the months of Oct. 1, 20xl to Sept. 30, 20x2. This is comoty

follows: i-Prt (100,000 x 12% x i2/12)-12,000.

mputed

3-mo. interest:

Oct. 1 to Dec. 31, 20x1

(100,000 x 12% x 3/12)-P3.00.

recognized in 20x

1-yr. interest

Oct. 1, 20x1 to Sept. 30, 20x2:

(100,000 x 12% x 12012)-

P12,000

9-mo. Interest:

Jan. 1 to Sept. 30, 20 2:

(100,000 x 12% x 9/12-

P9,000 recognized in 2022

Case #4: Accrual of expense-Utilities expense

The cost of electricity used for the month of December 20x1 is

P4,000. The electricity bill was received and paid in January 20x

Concept, given information, and conclusion:

> Concep

Expense is recognized when incurred ('used') rather than

when paid - accrual basis of accounting.

Given information:

The electricity bill,although paid in January 20x2, pertains

the cost of electricity used in December 20x1.

Conclusion:

Utilities expense shall be accrued in December 20x1.

ansaction analysis

"Utilities expense" (expense) and

attected

Effect on

acounts:

Debit/Credit:

Utilities payable" (liability)

Utilities expense is increased. Utilities

,Accounts

payable is increased

it: Expense is increased through debit.

Liability is increased through credit.

Adjusting joumal entry (AJE)

adjusting entry is as follows:

Utilities expense

4,000
Ulities payable

4,000

to accrue unpaid utilities

In the next accounting period, the payment of the

jetricity bill is recorded as follows:

4,000 4000

m.Utilities payable

2 Cash

to record the payment of the Dec. 20x1

electricity bill

Case #5: Accrual of expense-Salaries expense

mployees earned total salaries of P100,000 in December 20x1.

owever, the salaries were paid only in January 20x2.

1: Transaction analysis

Accounts

affected:

Effect on

accounts

Debit/ Credit:

Salaries expense" (expense) and "Salaries

payable" (liability)

Salaries expense is increased. Salaries

payable is increased

Expense is increased through debit.

Liability is increased through credit.

Stp 12: Adjusting journal entry

The adjusting entry to record the accrued salaries is

100,000

Dc Salaries expense

31 Salaries payable

20x1

100

to accrue

salaries expense

Recognition of Depreciation expense

The Concept of Systematic and rational allocation

Under the concept of systematic and rational allocatio

that provide economic benefits over several accounting

but canmot be directly associated with the earning of revenuen.

recognized as expenses over the periods where thee

benefits are consumed.

ues are

econom

One application of this concept is the recognition

depreciation expense. The expenditure to acquire equipment

initially recorded as asset. However, since this expenditure

be directly associated with sales (as opposed to the cost d

inventories sold), the expenditure is recognized as expense

the periods the equipment is used.

Illustration: Adjusting entries - Depreciation

Case #1: Deprèciation expense

The business expects to use the equipment over the next 4 years

On January 1, 20x1, a business acquired equipment for P20.00

The entry on January 1, 20x1 to record the acquisition li

Jan. Equipment

follows:

20,000

1,Cash

20x1

20,

to record the acquisition of equipment

efits, i.e, th

er e, the equipment will be used over the next 4 years.

initi

n expense) because it provides future economic

f the

equipment

is initially recorded as an as

set

rather than

t equipment is used, a portion of the cost is

as expense on a piecemeal basis (or 'little by little). This

eounreaP

st of a ass

gn

is called depreciation

rionaccounting, depreciation means the allocation of the

ciable asset over the periods the asset is used.

05

December 31, 20x1, the equipment has already been used for 1

On

out of its total useful life of 4 years. Thus, one-fourth of the

gost should be recognized as expense.

The annual depreciation expense is computed as follows:

Cost

Divide by: Useful life

Anmual depreciation expense

P20,000

P5,000

A P5,000 depreciation expense shall be recorded at the end

of each of the next four years (i.e., every December 31) as adjusting

entries.

Depreciation = Allocation
the useful life of a depreciable asse

set

Year 1 depreciation

expense P5,000

Year 2 depreciation

Cost of equipment

with 4-year useful

life is initially

recognized as

asset: P20,000.

7expense: P5,000.

Year 3 depreciation

expense: P5,000.

Year 4 depreciation

expense: P5,000.

Step #1: Transaction analysis

"Depreciation expense" (expense) and

"Accumulated depreciation" (contra

asset)

Depreciation expense is increased.

Accumulated depreciation is increased.

s Accounts

affected:

> Effect on

accounts
> Debit/Credit:

Expense is increased through debit.

Contra-asset is increased through credit

Step #2: Adjusting journal entry (AE)

The adjusting entry is as follows:

Dec. Depreciation expense

31,

20x1

Accumulated depreciation

5,000

to record the depreciation expense for

the period

e carrying amount of the equipment as of December 31,

t is determined as follows

Equipment

251

ccumulated depreciation

Equipment -net

P20,000

5,000

P15,000

nition of Bad debts expense

tration: Adjusting entries- Bad debts expense

business has total accounts receivable of P2,000 on December

0x1 before any adjustments. Of the total amount, it was

31,

ted that P500 is doubtful of collection (doubtful of collection' in

Filipino means alanganin na makolekta)

Step #1: Transaction analysis

> Accounts

"Bad debts expense" (expense) and

"Allowance for bad debts" (contra-asset)

Bad debts expense is increased. Allowance

for bad debts is increased.

affected:

> Effect on

accounts:

Debit/Credit: Expense is increased through debit.

Contra-asset is increased through credit.

Step #2: Adjusting journal entry

The adjusting entry is as follows:

Dec. Bad debts expense

81, Allowance for bad debts

500

500

20x1

to record the bad debts expense for the

period
After recording the adjusting entry, the carrying amount

of

anmufe receivable is brought equal to the estimated collectible

amount of P1,500.

P2,000

Accounts receivable

Allowance for bad debts

Accounts receivable net

(500)

P1,500

Under the concept of immediate recognition, a cost that

no future economic benefits or an asset that cea

The Concept of Immediate recognition

ses to

future economic benefits is recognized immediately as an rovi

ecognition of bad

receivable is

One application of this concept is the recognih

debts expense. In the case above, the P500 account reeia

immediately charged as bad debt expense because it ceased

provide future economic benefits, i.e, it became uncollectible.

As of this point, we have already completed discussino

three expense recognition principles. A summary is shown belovw

Description

Costs that are directly

associated with the earning

of revenue are recognized as

expenses in the same period

where the related revenue is

recognized (See also Chapter

Expense recognition principles

1. Matching

- Application: The cost of

inventory is initially

recognized as asset and

charged as expense (i.e., Cost

of goods sold) when the

inventory is sold.

2. Systematic& rational-Costs that are not directly

allocation

associated with the eaming

of revenue are recognized as

expenses over the periods the

economic benefits a

consumed.

Application: The cost of

equipmentis initially

recognized as a

charged as

Deciationexpense (ie,

periods the

used.

sset and

pense i.e.

over the

equipment is

mmediate recognition

- Costs that do not provide

future economic benefits or

assets that cease to provide

future economic benefits are

recognized immediately as

expenses

- Application: An account

receivable that becomes

doubtful of collection is

immediately recognized as

expense (i.e., Bad debts

expense)

Now, let's move on to the third type adjusting entries which is the

splitting of the components of a "mixed account."

Real, Nominal and Mixed Accounts

counts are also classified into one of the following

Real Accounts (Permanent accounts) -are accounts which are not

cosed at the end of the accounting period. These accounts

include all balance sheet accounts, except the "Owner's

drawings" account.

are closed at the end of the accounting period. Thounts

include all income statement accounts, drawin

clearing accounts and suspense accounts.

accounts

These accour

2. Nominal Accounts (Temporary accounts) - are a

A clearing account is an account used temporarily

amounts that will eventually be transferred ty to w

account. An example is the "Income summary" accoun o

stores amounts of income and expenses during the er

balance of the "Income summary" account represents tho. h

or loss during the period. The "Income summary" is lPi

the "Owner's capital" account before the financial state

are prepared.

period. The

th

closed t
en

temporarily tb

A suspense account is an account used tenm

store discrepancies in the accounts pending their analysis as

permanent classification. An example is the "Cash shortage a

overage" account which is temporarily used to record cad

shortages or overages pending their investigation. Depending

on the result of the investigation, the "Cash shortage or overage'

account is closed to a receivable or loss account (for shortages

or a payable or gain account (for overages).

and

3. Mixed accounts - accounts that have both real and nominal

account components. These accounts are subject to

adjustment.

Mixed accounts include unadjusted prepayments

both expired and unexpired components

(prepaid assets') and deferrals ('unearned income) that have

> The expired portion is the nominal account component w

the unexpired portion is the real account component.

> At the end of the period, adjusting entries are

separate these components because the nominal acou

component is presented in the income statement while

real account component is presented in the balance shet.

ore adjustments:

Re

After adjustments:

Real account

(presented in the

Balance sheet)

Mixed account

Real &Nominal

Account

Adjusting entry

(to separate the

two components)

Components)

Nominal account

(presented in the

Income statement)

Wethods of Inital Recording of income and expenses

understand how adjusting entries for "mixed accounts" are

made, let us first take up the methods of initial recording of

income and expenses

ncome

Advanced collections of income may initially be recorded using

either the (1) liability method or (2) income method.

1. Liability method

under this method, cash receipts from

items of income are initially credited to a liability account. At

the end of the period, the earned portion is recognized as

income while the unearned portion remains as liability.

Income method - under this method cash receipts from items

of income are initially credited to an income account. At the

end of the period, the unearned portion is recognized as

liability while

the earned portion remains as income.

Illustration: Liability method vs. Income method

A business rents out its building to various tena

20xl, the business receives one-year rent in advance o

from one of its tenants. Rent per month is P10,000.

The receipt of the advance rent is recorded as follows:

Income method

Liability method

Cash

120,000

120,000

120,000

Rent income 12000

120,000

to record the receipt of -

Unearned rent
200sh

to recond the recipt of'- year rent

in advance

rent in advance

Observe that under the liability method, the rent r

eceived in

advance is credited to a liability account; while under the incom

method, the rent received in advance is credited to an income account

Before any necessary year-end adjustments on December

31, 20x1, both the "unearned rent" (liability method) and the ret

income" (income method) accounts are considered "mized

accounts." This is because both accounts contain earned and

unearned portions. The "earned" portion relates to the income

statement (nominal account) while the "unearned" portion relates to

the balance sheet (real account). These portions are analyzed as

follows:

a. Earned portion ('used up') - pertains to the first 9 months df

the 1-year rent in advance covering the months of April 1 a

December 31, 20x1. This portion is computed as follows.

(10,000 rent per month x 9 months)- 90,000; or

(120,000 x 9 mos./12 mos.) 90.000.

The earned

period (i.e, 20x1).

portion is recognized as income

for the
nearned

scs covering January 1 to March 31, 202. This portion is

ed

portion

(unused') - pertains to the remaining 3

mputed as follows:

20 rent per month x 3 months)-30,000: or

10,

120,000 x 3 mos./12 mos.) -

December

next accounting period (i.e, 20x2).

e unearned portion is recognized as liability on

31, 20x1. It will only be recognized as income in the

Adjusting entry is needed to

separate the following:

Before adjustments

(Earned portion - Income)

P90,000 (120,000 x9/12)

April 1 to Dec. 31, 20x1

Mixed account

P120,000

One year rent in advance

(Unearned portion - Liability)

P30,000 (120,000 x 3/12)

Jan. 1 to Mar. 31, 20x2

Adjusting entries are needed to separate the real account and

nominal account components of a mixed account.

The adjusting entries (AJE) on December 31, 20x1 are as

follows:

Income method

Liability method

Dec. 31. 20x1

Dec. 31, 20x1

Unearned rent

Rent income 30,000

90,000

Unearned rent 30,000

Rent income

90,000

to recygrize the unearned

to recognize the earned portion of

-year rent in advance

portion of the 1-year rent in advance

the

Under the liability method, adjusting

recognize the earned portion (income) of a mixeda heeded

Under the income method, adjusting entry count

recognize the unearned portion (iability) of a miet

Notes

entry is

is needed

ас

acce

Both the liability and income methods area

Regardless of the method used, the adjusted am

income and unearned rent to be presented in

statements are the same. These are analyzed in

below:

sted amounts of rea

ted in the financia

the Tac

LIABILITY METHOD

Rent income

unearned rent

120,000 4/1/x1

90,000 AJE

90,000 End bal.

AJE 90,000

30,000 End bal.

INCOME METHOD

Unearned rent
Rent income

120,000 4/1/x1

30,000 AJE 30,000

30,000 End bal.

90,000 End bal.

Expenses

(1) asset method or (2) expense method.

1. Asset method - under this method, cash disbursements

Prepayments of expenses may initially be recorded using either ba

items of expenses are initially debited to an asset accoun

'expired) is recognized as expense while the unused poi

t.

the end of the period, the incurred portion (u

used up or

portion

remains as asset.

259

d- under this method, cash disbursements for

are initially debited to an expense ac

end of the period, the unused

the

nired') is recognized as asset while the incurred

count
portion ('not yet incurred

on remains as expense

ioni Asset method vs. Expense method

trness prepays one-year insurance for P120,000 on October 1,

d busi

ayment of insurance is recorded as follows:

Asset method

Expense method

repaid insurance 120,000

Insurance expense 120,000

Cash

120000 Cash

120,000

to record the prepayment of

to record the prepayment of

l-year imsurance

1-year insurance

Observe that under the asset method, the prepayment of

insurance is debited to an asset account; while under the expense

method, the prepayment is debited to an expense account.

Before any necessary year-end adjustments on December

31, 20x1, both the "prepaid insurance" (asset method) and the

nsurance expense" (expense method) accounts are considered

mixed accounts." This is because both accounts contain incurred

and not yet incurred portions. The "ncurred" portion relates to the
income statement

(nominal account) while the "not yet incurred"

portion relates to the balance sheet (real account). These portions are

nalyzed as follows:

expired) - pertains to the first 3

ncured portion ('used up' or

tonths of the 1-year prepaid insurance covering the months

oi Oct. 1 to December 31, 20x1. This portion is computed as

ncurred

follows:

(120,000 x 3 mos./12 mos.)-30.000

The incurred portion is recognized as expense

period (i.e., 20x1).

- pertai

the remaining 9 months of January 1 to Sept30

portion is computed as follows:

b. Not yet incurred portion (unused" or 'unexpired

(120,000 x 9 mos/12 mos.)-90,000

The not yet incurred portion is recognized as asse

December 31, 20x1. It will only be recognized as expense in

mert accounting period (ie, 20x2).

Adjusting entry is needed to

separate the following

Before adjustments

(Incurred portion- Expense

P30,000 (120,000 x 3/12)

Oct. 1 to Dec. 31, 20xl

Mixed account

P120,000

One year prepaid

Not yet incurred portion-

Asset)

P90,000 (120,000 x9 /12)

Jan. 1 to Sept. 30, 20x2

insurance

Adjusting entries are needed to separate the real account

and nominal account components of a mixed account.

The adjusting entries on December 31, 20x1 are as follows:

Expense method

Asset method

Dec. 31. 20x1

Dec. 31, 20x1

Insurance expense 30,000

Prepaid insurance 90,000

Insurance expense

Prepaid insurance 30,000

to recognize the expired portion

of the 1-year insurance

o recognize the unexpire

Lportion of the 1-year insurance

oer the asset method, adjusting entry is needed to

Undenize the expired portion (expense) of a mixed account.

r Under

er the expense method, adjusting entry is needed to

Under

gnize the unexpired portion (asset) of a mixed account.

th the asset and expense methods are acceptable.

of the method used, the adjusted amounts of insurance

Bo

Rega and prepaid insurance to be presented in the financial

ements are the same. This is analyzed in the T-accounts below

ASSET METHOD

expense

Prepaid insurance

Insurance expense

101x 120,000

30,000 AJE 30,000

End bal. 30,000

End bal. 90,000

EXPENSE METHOD
Prepaid insuranc

Insurance expense

10/1/x1 120,000

90,000 AJE

AJE 90,000

End bal. 90,000

End bal. 30,000

The recording of items of income that were collected irn

advance and items of expense that were paid in advance is

referred to as deferrals. To defer means to postpone the

recognition. Thus:

The unearned portion of an item of income that was

collected in advanced is recognized as liability. This will

be recognized as income only when earned.

The unexpired portion of an item of expense that was paid

in advanced is recognized as asset. This will be recognized

as expense only when incurred.

Accruals and deferrals are opposites.

Deferral

Accrual

To recognize income that isTo postpone the io

Dance

collection. The advance

collection is treated as

liability until earned.

already earned but not yetrecognition of a e

collected

To recognize expense that isTo postpone the expense

already incurred but not yet recognition of a

paid

prepayment. The

prepayment is treated as

asset until incurred.

Chapter 8 Summary:

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. Adjusting

entries normally involve the following: (1) Accruals of income

and expenses; (2) Recognition of depreciation expense and bad debts

expense; and (3) Deferrals of income and expenses (splitting of

mixed accounts').

. The three expense recognition principles are (1) Matching 2)

Systematic & rational allocation; and (3) Immediate recognition.

Accounts are also classified into the following: (1) Rel

accounts; (2) Nominal accounts; and (3) Mixed accounts.

Advance collections of income may be recorded using e

the (1) Liability method or (2) Income method.

either
. Prepayments of expenses may be recorded using either the t

Asset method or (2) Expense method