Module 1: Introduction to Accounting

Learning Objectives:

● To learn the importance, purpose, phases, definitions, basic principles and

fundamental concepts of accounting and its branches
● To learn the businesses and organizations
● To learn the concept of basic financial statements and double-entry bookkeeping

Introduction

Do you know the similarity of "selfie" and accounting?

We take "selfie" to capture the memories on our past events and have it posted in our social
media accounts to be able for us to communicate to our friends and families that we have
these moments in our life. This is basically the same reason why companies need
accounting as they need to record the past events on their economic transactions, post the
same in the ledger and communicate the same to the stakeholders through the financial
statements.

Accounting Importance, Purpose and Phases

Accounting has evolved to meet the social and economic needs of society. It provides
information that helps decision-makers make informed choices and allocate resources
efficiently. Accounting measures and communicates business activities and is called the
language of business. It is essential for businesses to know how much they are earning and
spending, and accountants provide this information. Accounting is also important for
personal financial planning, education expenses, loans, taxes, and investments.

The accounting function is an integral part of the broader business system that handles
financial operations and provides information to aid decision-making. It involves recording
historical business transactions, measuring their effects in monetary terms, and classifying
and summarizing the resulting data. The summarized data is presented in financial
statements, which are used to evaluate the liquidity, profitability, and solvency of the
business. Ultimately, accounting provides decision-makers with information to make
informed choices about the allocation of scarce resources.

Definitions of Accounting

Accounting is a service activity. Its function is to provide quantitative information primarily

financial in nature, about economic entities that is intended to be useful in making economic
decisions.1

Accounting is an information system that measures, processes and communicates financial

information about an economic entity.2

Accounting is the process of identifying, measuring and communicating economic

information to permit informed judgments and decisions by users of the information.3

1Statement of Financial Accounting Standards No. 1. "Basic Concepts and Accounting Principles Underlying Financial Statements of Business
Enterprises (Manila: Accounting Standards Council, 1983), par. 1
2Statement of Financial Accounting Concepts No. 1, "Objectives of Financial Reporting by Business Enterprises Norwalk, Conn.. (Financial
Accounting Standards Board, 1978), par. 9

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Accounting is the art of recording, classifying and summarizing in a significant manner and in
terms of money, transactions and events which are, in part at least, of a financial character,
and interpreting the results thereof.4

Fundamental Concepts and Basic Principles of Accounting

Several fundamental concepts underlie the accounting process. In recording business

transactions, accountants should consider the following:

Entity Concept. The entity concept in accounting means that a business or

organization is treated as a separate entity from its owners or other businesses

For example, the personal finances of the business owners or the finances of another
business that the company may own are recorded and evaluated separately

Periodicity Concept. Accounting uses a specific time period, usually one year, to
report an entity's financial information.

Stable Monetary Unit Concept. The Philippine peso is a reasonable unit of

measure and its purchasing power is relatively stable, thus, the effects of inflation in
the accounting records are ignored.

Going Concern. Financial statements are normally prepared on the assumption that
the reporting entity is a going concern and will continue in operation for the
foreseeable future. Hence, it is assumed that the entity has neither the intention nor
the need to enter liquidation or to cease trading.

In order to generate information that is useful to the users of financial statements,

accountants rely upon the following general principles:

Objectivity Principle. Accounting records and statements are based on the most reliable
data available so that they will be as accurate and as useful as possible. Reliable data are
verifiable when they can be confirmed by independent observers Ideally, accounting records
are based on information that flows from activities documented by objective evidence.
Without this principle, accounting records would be based on whims and opinions and is
therefore subject to disputes.

Historical Cost. This principle states that acquired assets should be recorded at their actual
cost and not at what management thinks they are worth as at reporting date.

Revenue Recognition Principle. Revenue is to be recognized in the accounting pened

when goods are delivered or services are rendered or performed.

3American Accounting Association, "A Statement of Basic Accounting Theory" (Evanston, IL: American Accounting Association, 1966, par. 1;
Accounting Principes Board, Statement No. 4, "Basic Concepts and Accounting Principles Underlying Financial Statements of Business
Enterprises (New York: AICPA 1970), par. 40).
4American Institute of Certified Public Accountants, "Review and Resume", Accounting Terminology Bulletin No. 1 (New York: AICPA 1953), par.
9

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Expense Recognition Principle. Expenses should be recognized in the accounting period
in which goods and services are used up to produce revenue and not when the entity pays
for those goods and services.

Adequate Disclosure. Requires that all relevant information that would affect the user's
understanding and assessment of the accounting entity be disclosed in the financial
statements.

Materiality. Financial reporting is only concerned with information that is significant enough
to affect evaluations and decisions. Materiality depends on the size and nature of the item
judged in the particular circumstances of its omission. In deciding whether an item or an
aggregate of items is material, the nature and size of the item are evaluated together.
Depending on the circumstances, either the nature or the size of the item could be the
determining factor.

Consistency Principle. The firms should use the same accounting method from period to
period to achieve comparability over time within a single enterprise However, changes are
permitted if justifiable and disclosed in the financial statements.5

Businesses and Organizations

Types of Business
The range of products and services can be summarized in seven broad categories, they are
as follows:

Type Activity Structure Examples

Services Selling Hiring skilled staff and Software development and

people's time selling their time Consultancy Firm
(Microsoft)

Professional Services Firms

(PWC, SGV, Deloitte,
KPMG)

Law Firms (ACCRALaw,

Romulo Mabanta)

Trader Buying and Buying a range of raw Wholesaler (Kimberly Clark)

Selling material and manufactured
products goods and Retailer (7-Eleven)

Type Activity Structure Examples

5Per revised Philippine Accounting Standards (PAS) No. 1, Presentation of Financial Statements and Philippine Accounting Standards (PAS)
No. 8, Accounting Policies, Changes in Accounting Estimates and Errors

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 consolidating them,
making them available for
sale in locations near to
their customers or online
for delivery.

Manufacture Designing Taking raw materials and Vehicle Assembly

products, using equipment and Construction
aggregating staff to convert them into Engineering
components finished goods. Electricity, Water, Food
and and drinks
assembling Chemicals
finished Media
products Pharmaceuticals

Raw Materials Growing or Buying of land and using Farming

extracting raw them to provide raw Mining
materials materials. Oil

Infrastructure Selling the Buying and operating Transport (airport,

utilization of assets (typically large operator, airlines, trains,
infrastructure assets); selling ferries, buses)
occupancy often in Hotels
combination with Telecoms
services. Sports facilities
Property management

Financial Recieving Accepting cash from Bank

deposits, depositors and paying Investment house
lending and them interest; using the
investing money to provide loans
money to borrowers, charging
them fees and a higher
rate of interest than the
depositors receive.

Insurance Pooling Collecting cash from Insurance

premiums of depositors and paying
many to meet them interest; using the
claims of a money to provide loans
few to borrowers, charging
them fees and a higher
rate of interest than the
depositors receive.

Forms of Business Organization

Any of the above types of activities may be performed by a business organization be it a sole
proprietorship, a partnership or a corporation. A business generally assumes one of the
three forms of organization. The accounting procedures depends on which form the
organization takes.

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Sole Proprietorship. This business organization has a single owner called the proprietor
who generally is also the manager. Sole Proprietorships tend to be small service-type (e.g.
physician, lawyers and accountant) business and retail establishments. The owner receives
all profits, absorbs all losses and is solely responsible for all debts of the business. From the
accounting viewpoint, the sole proprietorship is distinct from its proprietor. Thus, the
accounting records of the sole proprietorship do not include the proprietor's personal
financial records.

Partnership. A partnership is a business owned and operated by two or more persons who
bind themselves to contribute money, property, or industry to a common fund, with the
intention of dividing the profits among themselves. Each partner is personally liable for any
debt incurred by the partnership. Accounting considers the partnership as a separate
organization, distinct from the personal affairs of each partner.

Corporation. A corporation is a business owned by its stockholders. It is an artificial being

created by operation of law, having the rights of succession and the powers, attributes and
properties expressly authorized by law or incident to its existence. The stockholders are not
personally

Activities in Business Organizations

Many types of decisions are made in business organizations. Accounting provides activities
as follows, financing, investing, and operating important information to make these
decisions. The three types of organizational activities are as follows: financing, investing,
and operating.

Financing Activities
Organizations require financial resources to obtain other resources used to produce goods
and services. They compete for these resources in financial markets. Financing activities are
the methods an organization uses to obtain financial resources from financial markets and
how it manages these resources. Primary sources of financing for most businesses are
owners and creditors, such as banks and suppliers. Repaying the creditors and paying a
return to the owners are also financing activities.

Investing Activities
Managers use capital from financing activities to acquire other resources used in the
transformation process-that is, to transform resources from one form to a different form,
which is more valuable, to meet the needs of the people. Having the right mix of resources is
essential to efficient and effective operations

An efficient business is one that provides goods and services at low costs relative to their
selling prices. An effective business is one that is successful in providing goods and
services demanded by the customers.

Investing activities involve the selection and management including disposal and
replacement of long-term resources that will be used to develop, produce, and sell goods
and services Investing activities include buying land, equipment, buildings and other
resources that are needed in the operation of the business, and selling these resources
when they are no longer needed.

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Operating Activities
Operating activities involve the use of resources to design, produce, distribute, and market
goods services. Operating activities include research and development, design and
engineering purchasing, human resources, production, distribution, marketing and selling,
and servicing Organizations compete in supplier and labor markets for resources used in
these activities. Also, they compete in product markets to sell the goods and services
created by operating activities.

Double-Entry System

Fra Luca Pacioli's book, Summa, outlines the importance of three essential things for a
successful merchant: sufficient cash or credit, a good bookkeeper, and an accounting
system to view the business affairs at a glance. Pacioli introduces the double-entry
accounting system, in which every debit should have a corresponding credit entry.

Pacioli discusses three books in the Summa: the memorandum, the journal, and the ledger.
The memorandum is a chronological record of all transactions in their original currency. The
journal is a private book where entries are made in one currency in chronological order, and
the ledger is an alphabetical listing of all accounts with their running balance. These
principles established in the 15th century continue to be the foundation for modern
bookkeeping systems.

● The Accounting Equation

The most basic tool of accounting is the accounting equation. This equation presents
the resources controlled by the enterprise, the present obligations of the enterprise
and the residual interest in the assets. It states that assets must always equal
liabilities and owner's equity. The basic accounting model is:

Assets = Liabilities + Owner's Equity

To keep the above equation balanced, we use two types of entries called debits and
credits. We put debits on the left side of the equation and credits on the right side. If
we increase an asset, we use a debit entry. If we increase a liability or owner's
equity, we use a credit entry.

The logic behind debiting and crediting is that every transaction must keep the
accounting equation balanced. This means that every time we make an entry, we
must make sure that the total amount on the left side of the equation is always equal
to the total amount on the right side.

● The Basic Financial Statements and Normal Balance of the Accounts

Type Element Definition or Description

A present economic resource controlled by the entity as a

Asset result of past events. An economic resource is a right that
Balance has the potential to produce economic benefits.
Sheet or
Statement of Liability A present obligation of the entity to transfer an economic
Financial resource as a result of past events.
Position
Equity The residual interest in the assets of the entity after
deducting all its abilities.

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 Increases in assets, or decreases in liabilities, that result in
Income Income increases in equity other than those relating to contributions
Statement or from holders of equity claims.
Statements
of Financial Decreases in assets, or increases in liabilities, that result in
Performance Expenses decreases in equity, other than those relating to
distributions to holders of equity claims.

The normal balance of any account refers to the side of the account debit or credit-where
Increases are recorded. Assel, owner's withdrawal and expense accounts normally have
debit balances, liability, owner's equity and income accounts normally have credit
balances. This result occurs because increases in an account are usually greater than or
equal to decreases.

Increases Recorded by Normal Balance

Account Category Debit Credit Debit Credit

Assets / /

Liabilities / /

Owner's Equity

Owner's Capital / /

Withdrawals / /

Income / /

Expenses / / /

Debits and Credits

Accounting is based on a double-entry system which means that the dual effects of a
business transaction are recorded. A debit side entry must have a corresponding credit side
entry. For every transaction, there must be one or more accounts debited and one or more
accounts credited. Each transaction affects at least two accounts. The total debits for a
transaction must always equal the total credits.

An account is debited when an amount is entered on the left side of the account and
credited when an amount is entered on the right side. The abbreviations for debit and credit
are Dr. (from the Latin debere) and Cr. (from the Latin credere), respectively.

The account type determines how increases or decreases in it are recorded. Increases in
assets are recorded as debits (on the left side of the account) while decreases in assets are
recorded as credits (on the right side). Conversely, increases in liabilities and owner's equity
are recorded by credits and decreases are entered as debits.

The rules of debit and credit for income and expense accounts are based on the relationship
of these accounts to owner's equity. Income increases owner's equity and expense
decreases owner's equity. Hence, increases in income are recorded as credits and
decreases as debits. Increases in expenses are recorded as debits and decreases as
credits. These are the rules of debit and credit. The following summarizes the rules:

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 Balance Sheet Accounts

Assets Liabilities and Owner's Equity

Debit Credit Debit Credit

(+) (-) (-) (+)
Increases^ Decreases_ Decreases_ Increases^

Normal Balance Normal Balance

Income Statement Accounts

Debit for decreases in owner's equity Credit for increases in owner's equity

Expenses Income

Debit Credit Debit Credit

(+) (-) (-) (+)
Increases^ Decreases_ Decreases_ Increases^

Normal Balance Normal Balance

Accounts

Debit Credit

Increases in Increases in
Assets Liabilities
Expenses^ Owner's Capital
Income^

Decreases in Decreases in
Liabilities Assets
Owner's Capital Expenses_
Income_

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Module 2: Introduction to Financial Statements and Reporting

Learning Objectives:

● To learn the elements of financial statements

● To leam the usual accounts being used in recording
● To learn the types and effects of common transactions

Elements of Financial Statements

The elements of financial statements defined in the March 2018 Conceptual Framework for
Financial Reporting (2018 Conceptual Framework) are:

● assets, liabilities and equity-relate to a reporting entity's financial position; and

● income and expenses-relate to a reporting entity's financial performance.

Financial Position

Asset

Per March 2018 Conceptual Framework for Financial Reporting (Conceptual

Framework), asset is a present economic resource controlled by the entity as a result
of past events. An economic resource is a right that has the potential to produce
economic benefits. There are three aspects to these definitions: "right", "potential to
produce economic benefits"; and "control"

Rights that have the potential to produce economic benefits take many forms,
including:

(a) rights that correspond to an obligation of another party, for example:

(i) rights to receive cash

(i) rights to receive goods or services.

(i) rights to exchange economic resources with another party on favorable

terms. Such rights include, for example, a forward contract to buy an
economic resource on terms that are currently favorable or an option to buy
an economic resource.

(iv) rights to benefit from an obligation of another party to transfer an

economic resource if a specified uncertain future event occurs.

(b) rights that do not correspond to an obligation of another party, for example:

(i) rights over physical objects, such as property, plant and equipment or
inventories. Examples of such rights are a right to use a physical object or a
right to benefit from the residual value of a leased object.

(ii) rights to use intellectual property.

An economic resource could produce economic benefits for an entity by entitling

or enabling it to do, for example, one or more of the following:

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(a) receive contractual cash flows or another economic resource

(b) exchange economic resources with another party on favorable terms:

(c.) produce cash inflows or avoid cash outflows by, for example:

(i) using the economic resource either individually or in combination with other
economic resources to produce goods or provide services

(ii) using the economic resource to enhance the value of other economic
resources; or

(iii) leasing the economic resource to another party.

(d) receive cash or other economic resources by selling the economic resource, or

(e) extinguish liabilities by transferring the economic resource.

An entity controls an economic resource if it has the present ability to direct the use
of the economic resource and obtain the economic benefits that may flow from it.
Control includes the present ability to prevent other parties from directing the use of
the economic resource and from obtaining the economic benefits that may flow from
it. It follows that, if one party controls an economic resource, no other party controls
that resource.

Liability

A liability is a present obligation of the entity to transfer an economic resource as a

result of past events. For a liability to exist, three criteria must all be satisfied:

(a) the entity has an obligation

(b) the obligation is to transfer an economic resource, and

(c) the obligation is present obligation that exists as a result of past events

An obligation is a duty or responsibility that an entity has no practical ability to avoid.

An obligation is always owed to another party (or parties) The other party (or parties)
could be a person or another entity, a group of people or other entities, or society at
large. It is not necessary to know the identity of the party (or parties) to whom the
obligation is owed. If one party has an obligation to transfer an economic resource, it
follows that another party (or parties) has a right to receive that economic resource.

Obligations to transfer an economic resource include, for example:

(a) obligations to pay cash

(b) obligations to deliver goods or provide services

(c) obligations to exchange economic resources with another party on unfavorable

terms. Such obligations include, for example, a forward contract to sell an economic
resource

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Typical Account Titles Used

● Statement of Financial Position

• Assets
Assets should be classified only into two current assets and noncurrent
assets. Per revised Philippine Accounting Standards (PAS) No. 1. an entity
shall classify assets as current when:

a. it expects to realize the asset, or intends to sell or consume it, in its

normal operating cycle
b. it holds the asset primarily for the purpose of trading
c. it expects to realize the asset within twelve months after the reporting
period; or
d. the asset is cash or a cash equivalent (as defined in PAS No. 7)
unless the asset is restricted from being exchanged or used to settle a
liability for at least twelve months after the reporting period.

All other assets should be classified as non-current assets. Operating

cycle is the time between the acquisition of assets for processing and their
realization in cash or cash equivalents. When the entity's normal operating
cycle is not clearly identifiable, it is assumed to be twelve months.

• Current Assets

Cash. Cash is any medium of exchange that a bank will accept for deposit at face
value, it includes coins, currency, checks, money orders, bank deposits and drafts.

Cash Equivalents. Per PAS No. 7, these are short-term, highly liquid investments
that are readily convertible to known amounts of cash and which are subject to an
insignificant risk of changes in value.

Notes Receivable. A note receivable is a written pledge that the customer will pay
the business a fixed amount of money on a certain date.

Accounts Receivable. These are claims against customers arising from sale of
services or goods on credit. This type of receivable offers less security than a
promissory note.

Inventories. Per PAS No. 2, these are assets which are (a) held for sale in the
ordinary course of business; (b) in the process of production for such sale, or (c) in
the form of materials or supplies to be consumed in the production process or in the
rendering of services.

Prepaid Expenses. These are expenses paid for by the business in advance. It is an
asset because the business avoids having to pay cash in the future for a specific
expense. These include insurance and rent. These prepaid items represent future
economic benefits-assets-until the time these start to contribute to the earning
process; these, then, become expenses.

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• Non-current Assets

Property, Plant and Equipment. Per PAS No. 16, these are tangible assets that are
held by an enterprise for use in the production or supply of goods or services, or for
rental to others, or for administrative purposes and which are expected to be used
during more than one period Included are such items as land building, machinery and
equipment. furniture and fixtures, motor vehicles and equipment.

Accumulated Depreciation. It is a contra account that contains the sum of the

periodic depreciation charges. The balance in this account is deducted from the cost
of the related asset-equipment or buildings-to obtain book value.

Intangible Assets. Per PAS No. 38, these are identifiable, nonmonetary assets
without physical substance held for use in the production or supply of goods or
services, for rental to others, or for administrative purposes. These include goodwill.
patents, copyrights, licenses, franchises, trademarks, brand names, secret
processes, subscription lists and non-competition agreements

• Liabilities

Per revised Philippine Accounting Standards (PAS) No. 1, an entity shall classify a
liability as current when

a. it expects to settle the liability in its normal operating cycle

b. it holds the liability primarily for the purpose of trading
c. the liability is due to be settled within twelve months after the reporting period; or
d. the entity does not have an unconditional right to defer settlement of the liability for
at least twelve months after the reporting period.

All other liabilities should be classified as non-current liabilities.

• Current Liabilities

Accounts Payable. This account represents the reverse relationship of the accounts
receivable. By accepting the goods or services, the buyer agrees to pay for them in
the near future.

Notes Payable. A note payable is like a note receivable but in a reverse sense. In
the case of a note payable, the business entity is the maker of the note; that is, the
business entity is the party who promises to pay the other party a specified amount of
money on a specified future date.

Accrued Liabilities. Amounts owed to others for unpaid expenses. This includes
salaries payable, utilities payable, interest payable and taxes payable account

Unearned Revenues. When the business entity receives payment before providing
its customers with goods or services, the amounts received are recorded in the

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 unearned revenue account (liability method). When the goods or services are
provided to the customer, the unearned revenue is reduced and income is
recognized.

Current Portion of Long-Term Debt. These are portions of mortgage notes, bonds
and other long-term indebtedness which are to be paid within one year from the
balance sheet date.

• Non-current Liabilities

Mortgage Payable. This account records long-term debt of the business entity for
which the business entity has pledged certain assets as security to the creditor. In
the event that the debt payments are not made, the creditor can foreclose or cause
the mortgaged asset to be sold to enable the entity to settle the claim.

Bonds Payable. Business organizations often obtain substantial sums of money

from lenders to finance the acquisition of equipment and other needed assets. They
obtain these funds by issuing bonds. The bond is a contract between the issuer and
the lender specifying the terms of repayment and the interest to be charged.

• Owner's Equity

Capital (from the Latin capitalis, meaning "property"). This account is used to record
the original and additional investments of the owner of the business entity. It is
increased by the amount of profit earned during the year or is decreased by a loss.
Cash or other assets that the owner may withdraw from the business ultimately
reduce it. This account title bears the name of the owner.

Withdrawals. When the owner of a business entity withdraws cash or other assets,
such are recorded in the drawing or withdrawal account rather than directly reducing
the owner's equity account.

Income Summary. It is a temporary account used at the end of the accounting

period to close income and expenses. This account shows the profit or loss for the
period before closing to the capital account.

● Income Statement/Statement of Financial Performance Accounts

• Income

Service Income. Revenues earned by performing services for a customer or client,

for example, accounting services by a CPA firm, laundry services by a laundry shop.

Sales. Revenues earned as a result of sale of merchandise; for example, sale of

building materials by a construction supplies firm.

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 • Expenses

Cost of Sales. The cost incurred to purchase or to produce the products sold to
customers during the period, also called cost of goods sold.

Salaries or Wages Expense. Includes all payments as a result of an employer-

employee relationship such as salaries or wages, 13th month pay, cost of living
allowances and other related benefits.

Telecommunications, Electricity, Fuel and Water Expenses. Expenses related to

use of telecommunications facilities, consumption of electricity, fuel and water

Rent Expense. Expense for space, equipment or other asset rentals.

Supplies Expense. Expense of using supplies (eg. office supplies) in the conduct of
daily business

Insurance Expense. Portion of premiums paid on insurance coverage (e.g on motor

vehicle, health, life, fire, typhoon or flood) which has expired.

Depreciation Expense. The portion of the cost of a tangible asset (eg. buildings and
equipment) allocated or charged as expense during an accounting period,

Uncollectible Accounts Expense. The amount of receivables estimated to be

doubtful of collection and charged as expense during an accounting period. Interest
Expense. An expense related to use of borrowed funds.

Types and Effects of Transactions

It will be beneficial in the long-term to be able to understand a classification approach

that emphasizes the effects of accounting events rather than the recording
procedures involved. This approach is quite pioneering Although business entities
engage in numerous transactions, all transactions can be classified into one of four
types, namely:

1. Source of Assets (SA). An asset account increases and a corresponding

claims (abilities or owner's equity) account increases. Examples: (1)
Purchase of supplies on account; (2) Sold goods on cash on delivery basis.
2. Exchange of Assets (EA). One asset account increases and another asset
account decreases. Example: Acquired equipment for cash.
3. Use of Assets (UA). An asset account decreases and a corresponding
claims (liabilities or equity) account decreases. Example (1) Settled accounts
payable: (2) Paid salaries of employees.
4. Exchange of Claims (EC). One claims (liabilities or owner's equity) account
increases and another claims (liabilities or owner's equity) account
decreases. Example: Received utilities bill but did not pay.

Every accountable event has a dual but self-balancing effect on the accounting
equation. Recognizing these events will not in any manner affect the equality of the
basic:

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 accounting model. The four types of transactions above may be further expanded
into nine types of effects as follows:

1. Increase in Assets = Increase in Liabilities (SA)

2. Increase in Assets Increase in Owner's Equity (SA)
3. Increase in one Asset Decrease in another Asset (EA)
4. Decrease in Assets Decrease in Liabilities (UA)
5. Decrease in Assets Decrease in Owner's Equity (UA)
6. Increase in Liabilities Decrease in Owner's Equity (EC)
7. Increase in Owner's Equity Decrease in Liabilities (EC)
8. Increase in one Liability Decrease in another Liability (EC)
9. Increase in one Owner's Equity = Decrease in another Owner's Equity (EC)

Accounting for Business Transactions

Accountants observe many events that they identify and measure in financial terms. A
business transaction is the occurrence of an event or a condition that affects financial
position and can be reliably recorded.

Financial Transaction Worksheet

Every financial transaction can be analyzed or expressed in terms of its effects on the
accounting equation. The financial transactions will be analyzed by means of a financial
transaction worksheet which is a form used to analyze increases and decreases in the
assets, liabilities or owner's equity of a business entity.

Distinction between Revenues and Receipts

At this point, it will be useful to learn the distinction between revenues and receipts as
illustrated in the following table. The table shows various types of sales transactions and
classifies the effect of each on cash receipts and sales revenues for "this year":

This Year

Transaction Amount Cash Receipts Sales Revenue

1. Cash sales made this year. P200,000 P200,000 P200,000

2. Credit sales made last 300,000 300,000 0

year; cash received this
year

3. Credit sales made this 400,000 400,000 400,000

year; cash received this
year.

4. Credit sales made this 100,000 0 100,000

year, cash to be received
next year

Total P900,000 P700,000

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Illustration. Galicano Del Mundo decided to establish a sole proprietorship business and
named it Del Mundo Graphics Design. Del Mundo is a graphic designer who has extensive
experience in drawing layout, typography, lettering, diagramming and photography. He
possesses the talent to visually communicate to a target audience with the right combination
of words, images and ideas.

Del Mundo Graphics Design can do the layout and production design of newspapers,
magazines, corporate reports, journals and other publications. The entity can create
promotional displays; marketing brochures for services and products; packaging design for
products; and distinctive logos for businesses. He also enters into agreements with clients
for the progressive development and maintenance of their web sites. His initial revenue
stream comes from web designing

The owner, Galicano Del Mundo, makes the business decisions. The assets of the company
belong to Del Mundo and all obligations of the business are his responsibility. Any income
that the entity earns belongs solely to Del Mundo

When a specific asset, liability or owner's equity item is created by a financial transaction, it
is listed in the financial transaction worksheet using the appropriate accounts. The
worksheet that follows shows the first transaction of the Del Mundo Graphics Design. The
dates are enclosed in parentheses

During March 2018, the first month of operations, various financial transactions took place.
These transactions are described and analyzed as follows:

Mar. 1 Del Mundo started his new business by depositing P350,000 in a bank account in the
name of Del Mundo Graphics Design at BPI Poblacion Branch

Del Mundo Graphics Design

Financial Transaction Worksheet
Month of March 2018

Assets = Liabilities + Owner's Equi

Cash = Del Mundo, Capital

(1) P350.000 = P350.000

The financial transaction is analyzed as follows:

● An entity separate and distinct from Del Mundo's personal financial affairs is created.
● An economic resource-cash of P350,000 is invested in the business entity. The
source of this asset is the contribution made by the owner, which represents owner's
equity. The owner's equity account is Del Mundo, Capital.
● The dual nature of the transaction is that cash is invested and owner's equity
created. The effects on the accounting equation are as follows: increase in asset-
cash from zero to P350,000 and increase in owner's equity from zero to P350,000.
● At this point, the entity has no liabilities, and assets equal owner's equity.

Mar. 5 Computer equipment costing P145,000 is acquired on a cash basis. The effect of the
transaction on the basic equation is:

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 Assets = Liabilities + Owner's Equity

Cash + Computer = Del Mundo, Capital

Equipment
Bal. P350,000 = P350,000
Mar. (5) (145,000) 145,000 =
Bal. P205,000 + P145,000 = P350,000
P350,000 = P350,000
This transaction did not change the total assets but it did change the composition of the
assets-it decreased one asset-cash and increased another asset-computer equipment by
P145,000. Note that the sums of the balances on both sides of the equation are equal. This
equality must always exist

Mar. 9 Computer supplies in the amount of P25,000 are purchased on account

Assets = Liabilities + Owner's Equity

Cash + Computer + Computer = Accounts + Del Mundo, Capital

Supplies Equipment Payable
Bal. P205,000 145,000 = P350,000
(9) P25,000 = P25,000 _________
Bal. P205,000 P25,000 P145,000 = P25,000 P350,000
P375,000 = P375,000

Assets don't have to be purchased in cash. It can also be purchased on credit. Acquiring the
computer supplies with a promise to pay the amount due later is called buying on account
This transaction increases both the assets and the liabilities of the business. The asset
affected is computer supplies and the liability created is an accounts payable.

Mar. 11 Del Mundo Graphics Design collected P88,000 in cash for designing interactive
websites for two exporters based inside the Ortigas Ecozone.

Assets = Liabilities + Owner's Equity

Cash + Computer + Computer = Accounts + Del Mundo, Capital

Supplies Equipment Payable
Bal. P205,000 P25,000 145,000 = P25,000 P350,000
(11) 88,000 88,000
Bal. P293,000 P25,000 P145,000 = P25,000 P438,000
P463,000 = P463,000

The entity earned service income by designing web sites for clients. Del Mundo rendered his
professional services and collected revenues in cash. The effect on the accounting equation
is an increase in the asset-cash and an increase in owner's equity. Income increases
owner's equity. This transaction caused the business to grow, as shown by the increase in
total assets from P375,000 to P463.000

Mar. 16 Del Mundo paid P18,000 to Ceradoy Bills Express, a one-stop bills payment service
company, for the semi-monthly utilities.

Assets = Liabilities + Owner's Equity

Cash + Computer + Computer = Accounts + Del Mundo, Capital

Supplies Equipment Payable
Bal. P293,000 P25,000 145,000 = P25,000 P438,000

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(16) 18,000 (18,000)
Bal. P275,000 P25,000 P145,000 = P25,000 P420,000
P445,000 = P445,000
Expenses are recorded when they are incurred. Expenses can be paid in cash when they
occur. or they can be paid later. The payment for utilities is an expense for the month of
March. It represented an outflow of resources and a reduction of owner's equity. Expenses
have the opposite effect of income; they cause the business to shrink as shown by the
smaller amount of total assets of P445,000.

Mar. 17 The entity has service agreements with several Netpreneurs to maintain and update
their web sites weekly, Del Mundo billed these clients P35,000 for services already rendered
during the month.

A = L + OE

Cash + Accounts + Computer + Computer = Accounts + Del Mundo,

Receivable Supplies Equipment Payable Capital
Bal. P275,000 P25,000 145,000 = P25,000 P438,000
(17) P35,000 P35,000
Bal. P275,000 P35,000 P25,000 P145,000 = P25,000 P455,000
P480,000 = P480,000

The entity has performed services to clients so income should already be recognized. Del
Mundo is entitled to receive payment for these but the clients did not pay immediately.
Performing the services creates an economic resource, the clients promise to pay the
amount which is called accounts receivable. This transaction resulted to an increase in an
asset-accounts receivable and an increase in owner's equity of P35.000.

Mar. 19 Del Mundo made a partial payment of P17,000 for the Mar. 9 purchase on account.

A = L + OE

Cash + Accounts + Computer + Computer = Accounts + Del Mundo,

Receivable Supplies Equipment Payable Capital
Bal. P275,000 P25,000 145,000 = P25,000 P455,000
(19) (17,000) (17,000) .
Bal. P258,000 P35,000 P25,000 P145,000 = 8,000 P455,000
P463,000 = P463,000

This transaction is a payment on account. The effect on the accounting equation is a

decrease in the asset-cash and a decrease in the liability-accounts payable. The payment of
cash on account has no effect on the asset-computer supplies because the payment does
not increase or decrease the supplies available to the business.

Mar. 20 Checks totaling P25,000 were received from clients for billings dated Mar. 17.

A = L + OE

Cash + Accounts + Computer + Computer = Accounts + Del Mundo,

Receivable Supplies Equipment Payable Capital
Bal. P258,000 P35,000 P25,000 145,000 = 8,000 P455,000
(20) (25,000) (25,000) .
Bal. P283,000 P10,000 P25,000 P145,000 = 8,000 P455,000

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 P463,000 = P463,000

Last Mar 17, Del Mundo billed clients for services already rendered. On Mar 20, the entity
was able to collect P25,000 from them. The asset-cash is increased by P25,000. The
business should not record service income on Mar 20 since it has already recorded the
income last Mar. 17. Total assets are unchanged. The business merely reduced one asset-
accounts receivable and increased another-cash.

Mar. 21 Del Mundo withdrew P20,000 from the business for his personal use.

A = L + OE

Cash + Accounts + Computer + Computer = Accounts + Del Mundo,

Receivable Supplies Equipment Payable Capital
Bal. P283,000 P10,000 P25,000 145,000 = 8,000 P455,000
(21) (20,000) (20,000)
Bal. P263,000 P10,000 P25,000 P145,000 = 8,000 P435,000
P443,000 = P443,000

Withdrawal of cash or other assets for personal use is the way by which the owner of the
entity receives advance distribution of the profits. On Mar 1, Del Mundo invested P350,000,
both cash and owner's equity increased. The transaction was an investment by the owner
and not an income-generating activity. Del Mundo simply transferred funds from his personal
account to the business. A cash withdrawal is exactly the opposite. The P20,000 cash
withdrawal transaction resulted to a reduction in both cash and owner's equity.

Mar. 27 Warlito Blanche Publishing submitted a bill to Del Mundo for P8,000 worth of
newspaper advertisements for this month. Del Mundo will pay this bill next month.

A = L + OE

Cash + Accounts + Computer + Computer = Accounts + Del Mundo,

Receivable Supplies Equipment Payable Capital
Bal. P263,000 P10,000 P25,000 145,000 = 8,000 P435,000
(27) 8,000 (8,000)
Bal. P263,000 P10,000 P25,000 P145,000 = 16,000 P427,000
P443,000 = P443,000

Warlito Blanche rendered services on account. Del Mundo Graphics Design has incurred an
expense in the amount of P8,000 by availing of Warlito Blanche's services. There was no
payment during the month. This advertising expense resulted to a decrease in owner's
equity and an increase in the liability-accounts payable.

Mar. 31 Del Mundo paid his assistant designer salaries of P15,000 for the month.

A = L + OE

Cash + Accounts + Computer + Computer = Accounts + Del Mundo,

Receivable Supplies Equipment Payable Capital
Bal. P263,000 P10,000 P25,000 145,000 = 16,000 P427,000
(31) (15,000) (15,000)
Bal. P248,000 P10,000 P25,000 P145,000 = 16,000 P412,000
P428,000 = P428,000

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This transaction resulted to a reduction in owner's equity as well as a reduction in cash. By
providing his services to Del Mundo for the month, the assistant designer has created for the
business an expense-salaries expense.

Use of T-Accounts

Analyzing and recording transactions using the accounting equation is useful in conveying a
basic understanding of how transactions affect the business. However, it is not an efficient
approach once the number of accounts involved increases Double-entry system provides a
formal system of classification and recording business transactions.

Illustration. The rules of debit and credit will be applied to the Del Mundo Graphics Design
illustration for comparison. Three transactions will be added to the example. Before being
recorded, a transaction must be analyzed to determine which accounts must be increased or
decreased. After this has been determined, the rules of debit and credit are applied to effect
the appropriate increases and decreases to the accounts.

Mar. 1 Del Mundo started his new business by depositing P350,000 in a bank account in the
name of Del Mundo Graphics Design at BPI Poblacion Branch.

Assets (Increase) = Owner's Equity (Increase)

Cash Del Mundo, Capital

Debit Credit Debit Credit

(+) (-) (-) (+)

3-1 350,000 3-1 350,000

This transaction increased both the asset-cash and owner's equity. According to the rules of
debit and credit, an increase in asset is recorded as debit while an increase in owner's equity
is recorded as credit, thus, the entry is to debit cash and to credit Del Mundo, Capital. The
transaction dates are placed on the left side of the amounts for reference.

Mar. 2 Computer equipment is acquired by issuing a P50,000 note payable to Maribeth

Buenviaje Office Systems. The note is due in six months.

Assets (Increase) = Liabilities (Increase)

Computer Equipment Notes Payable

Debit Credit Debit Credit

(+) (-) (-) (+)

3-2 50,000 3-2 50,000

The transaction increased by P50,000 the asset-computer equipment and the liability-notes
payable. Computer equipment must be debited and notes payable must be credited.

Mar. 3 Del Mundo paid P15,000 to RF Refozar Suites for rent on the office studio for the
months of March, April and May.

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 Assets (Decrease) = Assets (Increase)
Cash Prepaid Rent

Debit Credit Debit Credit

(+) (-) (+) (-)

3-1 350,000 3-3 15,000 3-3 15,000

The entity paid advance rent for three months. A resource having future economic benefit-
prepaid rent, is acquired for a cash payment of P15,000. Increases in assets are recorded by
debits and decreases in assets are recorded by credits. The transaction resulted to a debit to
prepaid rent and a credit to cash for P15,000. The prepaid rent is consumed based on the
passage of time so that after one month, P5,000 of the prepaid rent will be transferred to the
rent expense account.

Mar. 4 Received advance payment of P18,000 from Marco Polo Ortigas Hotel for web site
updating for the next three months.

Assets (Increase) = Liabilities (Increase)

Cash Unearned Revenues

Debit Credit Debit Credit

(+) (-) (-) (+)

3-1 350,000 3-3 15,000 3-4 18,000

3-4 18,000

The entity has an obligation to Marco Polo Ortigas Hotel for the next three months. This
liability is called unearned revenues. The asset-cash is increased by a debit of P18,000 and
the liability- unearned revenues is increased by a credit of P18,000. As it renders service,
the entity discharges its obligation at a rate of P6,000 per month for the next three months.

Mar. 5 Computer equipment costing P145,000 is acquired on cash basis.

Assets (Decrease) = Assets (Increase)

Cash Computer Equipment

Debit Credit Debit Credit

(+) (-) (+) (-)

3-1 350,000 3-3 15,000 3-2 50,000

3-4 18,000 3-5 145,000 3-5 145,000

This transaction increased the asset-computer equipment and decreased the asset-cash.
Assets are increased by debits and decreased by credits; thus, computer equipment is
debited and cash is credited for P145,000.

Mar. 9 Computer supplies in the amount of P25,000 are purchased on account.

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 Assets (Increase) = Liabilities (Increase)
Computer Supplies Accounts Payable

Debit Credit Debit Credit

(+) (-) (-) (+)

3-9 25,000 3-9 25,000

The asset-computer supplies is increased by a debit of P25,000 while the liability account-
accounts payable is increased by a credit for the same amount.

Mar. 11 Del Mundo Graphics Design collected P88,000 in cash for designing web sites.
Assets (Increase) = Owner's Equity (Increase)
Cash Design Revenues

Debit Credit Debit Credit

(+) (-) (-) (+)

3-1 350,000 3-3 15,000 3-11 88,000

3-4 18,000 3-5 145,000
3-11 88,000

The transaction increased the asset-cash and increased the income account-design
revenues. Assets are increased by debits, income are increased by credits; hence, a debit of
P88,000 to cash and a credit of P88,000 to design revenues is made. Increases in income
increase owner's equity.

Mar. 16 Del Mundo paid P18,000 to Ceradoy Bills Express for the semi-monthly utilities.
Assets (Increase) = Owner's Equity (Decrease)
Cash Utilities Expense

Debit Credit Debit Credit

(+) (-) (+) (-)

3-1 350,000 3-3 15,000 3-16 18,000

3-4 18,000 3-5 145,000
3-11 88,000 3-16 18,000

Expenses are increased by debits and assets are decreased by credits; therefore, utilities
expense is debited and cash credited for P18.000. Increases in expenses decrease owner's
equity.

Mar. 17 Del Mundo billed clients P35,000 for services already rendered during the month.
Assets (Increase) = Owner's Equity (Increase)
Accounts Receivable Design Revenues

Debit Credit Debit Credit

(+) (-) (-) (+)

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 3-17 35,000 3-11 88,000
3-17 35,000

Assets are increased by debits, income are increased by credits. Increases in income
increase owner's equity. A debit of P35,000 to accounts receivable and a credit of P35,000
to the income account-design revenues is needed.

Mar. 19 Del Mundo partially paid P17,000 for the Mar. 9 purchase of computer supplies.

Assets (Decrease) = Liabilities (Decrease)

Cash Accounts Payable

Debit Credit Debit Credit

(+) (-) (-) (+)

3-1 350,000 3-3 15,000 3-19 17,000 3-9 25,000

3-4 18,000 3-5 145,000
3-11 88,000 3-16 18,000
3-19 17,000

Assets are decreased by credits while liabilities are decreased by debits. The transaction is
recorded by debiting accounts payable and crediting cash for P17,000 each.

Mar. 20 Received checks totaling P25,000 from clients for billings dated Mar. 17.

Assets (Increase) = Assets (Decrease)

Cash Accounts Receivable

Debit Credit Debit Credit

(+) (-) (+) (-)

3-1 350,000 3-3 15,000 3-17 35,000 3-20 25,000

3-4 18,000 3-5 145,000
3-11 88,000 3-16 18,000
3-20 25,000 3-19 17,000

Collections on account reduced the asset-accounts receivable but increased the asset-cash.
Assets are increased by debits and decreased by credits; thus, a debit to cash for P25,000
and a credit to accounts receivable for P25,000 is made.

Mar. 21 Del Mundo withdrew P20,000 from the business for his personal use.

Assets (Decrease) = Owner's Equity (Decrease)

Cash Del Mundo, Withdrawals

Debit Credit Debit Credit

(+) (-) (+) (-)

3-1 350,000 3-21 20,000

3-4 18,000 3-3 15,000

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 3-11 88,000 3-5 145,000
3-20 25,000 3-16 18,000
3-19 17,000
3-21 20,000

Withdrawals are reductions of owner's equity but are not expenses of the business entity. A
withdrawal is a personal transaction of the owner that is exactly the opposite of an
investment.

This transaction increased the withdrawals account but reduced cash. Debits record
increases in the withdrawals account and credits record decreases in asset accounts; thus, a
debit to withdrawals and a credit to cash for P20,000 each is necessary.

Mar. 27 Warlito Blanche billed Del Mundo for P8,000 ads. Del Mundo will pay next month.

Liabilities (Increase) = Owner's Equity (Decrease)

Accounts Payable Advertising Expense

Debit Credit Debit Credit

(-) (+) (+) (-)

3-19 17,000 3-9 25,000 3-27 8,000

3-27 8,000

This transaction increased the expense-advertising expense and increased the liability-
accounts payable by P8,000. Expenses are increased by debits while liabilities are
increased by credits, hence, an entry to debit advertising expense and to credit accounts
payable for P8,000 is needed.

Mar. 31 Del Mundo paid his assistant designer salaries of P15,000 for the month.

Assets (Decrease) = Owner's Equity (Decrease)

Cash Salaries Expense

Debit Credit Debit Credit

(+) (-) (+) (-)

3-3 15,000 3-31 15,000

3-1 350,000 3-5 145,000
3-4 18,000 3-16 18,000
3-11 88,000 3-19 17,000
3-20 25,000 3-21 20,000
3-31 15,000

Expenses are increased by debits and assets are decreased by credits. Hence, salaries
expense is debited for P15,000 and cash credited for the same amount. Increases in
salaries expense decrease owner's equity.

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Module 3: Accounting Process

Learning Objectives:

● To learn the whole accounting process

Weather or not! The moral of the following story is to look for a potentially prosperous
technology gathering dust and exploit it in a good way. That's what Frederic Fox, 34, did
when he bought a business that supplied advisory services to large corporations.

After renaming the acquired company as Strategic Weather Services (SWS) Inc., Fox
expanded his core business-patented technology that forecasts weather 12 months advance
in North America and Europe, and analyzes business techniques to predict a company's
success. Today, his 90-employee firm projects 1999 sales of US$13.0 million from its three
divisions. One division helps retailers and manufacturers plan sales based on long-range
weather data: Another division helps utility companies plan operations. Launched late last
year, the third division offers consumers the popular WeatherPlanner, the long-range
weather forecasting via a web site.

Fox did not know if the Weather Planner concept would prosper. He seriously considered
starting the business only after consulting SWS meteorologists in 1993 to plan his wedding.
His fiancée's requirement was for Fox to ensure that their wedding would be free from rain. It
was rain-free. In 1994, WeatherPlanner hit the drawing board. Adapted from: Business Start-
Ups, April 1999,

Fox provides people with valuable information-weather forecasts twelve months in advance
in North America and Europe. His weather services help businesses plan their operations.
Fox is using data to study the weather cycle in that part of the world. In parallelism, entities
also have their own "weather" cycle-the accounting cycle.

Source Documents

Transactions and events are the starting points in the accounting cycle. By relying on source
documents, transactions and events can be analyzed as to how they will affect performance
and financial position. Source documents identify and describe transactions and events
entering the accounting process. These original written evidences contain information about
the nature and the amounts of the transactions These are the bases for the journal entries;
some of the more common source documents are sales invoices, cash register tapes, official
receipts, bank deposit slips, bank statements, checks, purchase orders, time cards and
statements of account.

Accounting Cycle

The accounting cycle refers to a series of sequential steps or procedures performed to

accomplish the accounting process. The steps in the cycle and their aims follow

Step 1. Identification of Events to be Recorded

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 Aim: To gather information about transactions or events generally through the
source documents,

During the accounting

Step 2 Transactions are Recorded in the Journal

Aim: To record the economic impact of transactions on the firm in a journal,

which is a form that facilitates transfer to the accounts.

Step 3 Journal Entries are Posted to the Ledger

Aim: To transfer the information from the journal to the ledger for classification

Step 4 Preparation of a Trial Balance

Aim: To provide a listing to verify the equality of debits and credits in the
ledger.

Step 5 Preparation of the Worksheet including Adjusting Entries

Aim: To aid in the preparation of financial statements.

Step 6 Preparation of the Financial Statements

Aim: To provide useful information to decision-makers.

At the end of the accounting period

Step 7 Adjusting Journal Entries are Journalized and Posted

Aim: To record the accruals, expiration of deferrals, estimations and other

events from the worksheet.

Step 8 Closing Journal Entries are Journalized and Posted

Aim: To close temporary accounts and transfer profit to owner's equity.

Step 9 Preparation of a Post-Closing Trial Balance

Aim: To check the equality of debits and credits after the closing entries.

At the start of the next period

Step 10 Reversing Journal Entries are Journalized and Posted

Aim: To simplify the recording of certain regular transactions in the next

accounting period.

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This cycle is repeated each accounting period. The first three steps in the accounting cycle
are accomplished during the period. The fourth to the ninth steps generally occur at the end
of the period. The last step is optional and occurs at the beginning of the next period.

The Journal

The journal is a chronological record of the entity's transactions. A journal entry shows all
the effects of a business transaction in terms of debits and credits. Each transaction is
initially recorded in a journal rather than directly in the ledger. A journal is called the book of
original entry. The nature and volume of transactions of the business determine the number
and type of journals needed. The general journal is the simplest journal.

Format

The standard contents of the general journal are as follows

1. Date. The year and month are not rewritten for every entry unless the month
changes or a new page is needed.
2. Account Titles and Explanation. The account to be debited is entered at the
extreme left of the first line while the account to be credited is entered slightly
indented on the next line. A brief description of the transaction is usually
made on the line below the credit. Generally, skip a line after each entry.
3. P. R. (posting reference). This will be used when the entries are posted, that
is, until the amounts are transferred to the related ledger accounts. The
posting process will be described later.
4. Debit. The debit amount for each account is entered in this column.
5. Credit. The credit amount for each account is entered in this column.

Assume that Maria Concepcion Jennifer Perez-Manalo established her own wedding
consultancy with an initial investment of P250,000 on May 1.

The journal entry is shown below:

Journal page 1

Date Account Titles and Explanation. P. R. Debit Credit

1 2018

2 May 1 Cash 250,000

3 Perez-Manalo, Capital 250,000

4 Initial Investment.

Simple and Compound Entry

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In a simple entry, only two accounts are affected-one account is debited and the other
account credited. An example of this is the entry to record the initial investment of Perez-
Manalo. However, some transactions require the use of more than two accounts.

When three or more accounts are required in a journal entry, the entry is referred to as a
compound entry.

Transaction Analysis (Step 1).

The analysis of transactions should follow these four basic steps:

1. Identify the transaction from source documents.

2. Indicate the accounts-either assets, liabilities, equity, income or expenses- affected

by the transaction.

3. Ascertain whether each account is increased or decreased by the transaction.

4. Using the rules of debit and credit, determine whether to debit or credit the account to
record its increase or decrease.

Transactions are Journalized (Step 2)

After the transaction or event has been identified and measured, it is recorded in the journal.
The process of recording a transaction is called journalizing. The following are the
transactions for Weddings "R" Us during the month of May. The double-entry system will be
used.

To understand the nature of the affected accounts, the letter A (for asset), L (liability) or OE
(owner's equity) is inserted after each entry. In addition, owner's equity is further classified
into OE: I (income) and OE: E (expenses).

Note that the rules of double-entry system are observed in each transaction:

1. Two or more accounts are affected by each transaction.

2. The sum of the debits for every transaction equals the sum of the credits.
3. The equality of the accounting equation is always maintained.

Initial Investment (Source of Assets)

May 1 Dr. Rose Besaro is a social entrepreneur from the South. She is into a lot of interesting causes. Her fine taste is preeminent such that she
is considered an authority in planning weddings. She does not intend to "charge much". Upon the advice and prodding of an esteemed
colleague. Dr. Yolanda Sayson, Besano decided to organize her wedding consultancy. She invested P250,000 into this entity.

Analysis Assets increased. Owner's equity increased

Rules Increases in assets are recorded by debits. Increases in owner's equity is recorded by credits.

Entry Increase in assets is recorded by a debit to cash. Increase in owner's equity is recorded by a credit to Besano Capital What is the journal
entry?

Dr Cr

Rent Paid in Advance (Exchange of Assets)

May 1 Rented office space and paid two months rent in advance, P8,000

Analysis Assets increased. Assets decreased.

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Rules Increases in assets are recorded by debits. Decreases in assets are recorded by credits.

Entry Increase in assets is recorded by a debit to prepaid rent. Decrease in assets is recorded by a credit to cash. What is the journal entry?

Dr Cr

Note Issued for Cash (Source of Assets)

May 2 Rose Besario issued a promissory note for a P210,000 loan from Metrobank. This availment will be used for the acquisition of a service
vehicle. The note carries a 20% interest per annum The arrangement with the bank is that both the interest and the principal are payable in
full in one year.

Analysis Assets increased. Liabilities increased.

Rules Increases in assets are recorded by debits. Increases in liabilities are recorded by credits.

Entry Increase in assets is recorded by a debit to cash. Increase in liabilities is recorded by a credit to notes payable. What is the journal entry?

Dr Cr

May 2 Hired an office assistant and an account executive each with a P7.800 monthly salary Or, each is to receive P300 per day for the 26-day
work month. What is the journal entry?

Service Vehicle Acquired for Cash (Exchange of Assets)

May 4 Acquired service vehicle for 20,000

Analysis Assets increased. Assets decreased.

Rules Increases in assets are recorded by debits. Decreases by credits.

Entry Increase in assets is recorded by a debit to service vehicle. Decrease in assets is recorded by a credit to cash. What is the journal entry?

Dr Cr

Insurance Premium Paid (Exchange of Assets)

May 4 Paid Prudential Guarantee and Assurance, Inc. P14,400 for a one-year comprehensive insurance coverage on the service vehicle.

Analysis An asset increased. Another asset decreased.

Rules Increases in assets are recorded by debits. Decreases in assets are recorded by credits.

Entry Increase in assets is recorded by a debit to prepaid insurance. Decrease in assets is recorded by a credit to cash. What is the journal
entry?

Dr Cr

Office Equipment Acquired on Account (Exchange and Source of Assets)

May 5 Acquired office equipment from Fair and Square Emporium for P60,000; paying P15,000 in cash and the balance next month. Note: A
compound entry is needed for this transaction.

Analysis Assets increased. Assets decreased. Liabilities increased.

Rules Increases in assets are recorded by debits. Decreases in assets are recorded by credits. Increases in liabilities are recorded by credits.

Entry Increase in assets is recorded by a debit to office equipment. Decrease in assets is recorded by a credit to cash. Increase in liabilities is
recorded by a credit to accounts payable. What is the journal entry?

Dr Cr

Supplies Purchased on Account (Source of Assets)

May 8 Purchased supplies on credit for P18,000 from San Jose Merchandising.

Analysis Assets increased. Assets decreased. Liabilities increased.

Rules Increases in assets are recorded by debits Increases in liabilities are recorded by credits.

Entry Increase in assets is recorded by a debit to supplies. Increase in liabilities is recorded by a credit to accounts payable.

Dr Cr

Accounts Payable Partially Settled (Use of Assets)

May 9 Paid San Jose Merchandising P10,000 of the amount owed.

Analysis Assets decreased. Liabilities decreased

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Rules Decreases in assets are recorded by credits. Decreases in liabilities are recorded by debits.

Entry Decrease in abilities is recorded by a debit to accounts payable. Decrease in assets is recorded by a credit to cash.
What is the journal entry?

Dr Cr

Revenues Earned and Cash Collected (Source of Assets).

May 10 Coordinated and finalized simple bridal arrangements for three couples and collected fees of P8,800 per couple.
Services include prospecting and selecting the church and reception location, couturier, caterer, car service, flowers
souvenirs and invitations.

Analysis Assets increased. Owner's equity increased.

Rules Increases in assets are recorded by debits.

Entry Increases in owner's equity are recorded by credits Increase in assets is recorded by a debit to cash increase in
owner's equity in recorded by a credit to consulting revenues What is the journal entry?

Dr Cr

Salaries Paid (Use of Assets)

May 13 Paid salaries, P6,600. The entity pays salaries every two Saturdays

Analysis Assets decreased. Owner's equity decreased.

Rules Decreases in assets are recorded by credits. Decreases in owner's equity are recorded by debts.

Entry Decrease in owner's equity is recorded by a debit to salaries expense Decrease in assets is recorded by a credit to
cash. What is the journal entry?

Dr Cr

Unearned Revenues Collected (Source of Assets)

May 15 The entity is earning additional revenues by referring consulting clients to friendly hotels, caterers, printers, and
couturiers. Received P10,000 advance fees for three clients referred.

Analysis Assets increased. Liabilities increased.

Rules Increases in assets are recorded by debits. Increases in abilities are recorded by credits.

Entry Increase in assets is recorded by a debit to cash. Increase in liabilities is recorded by a credit to unnamed referral
revenues. What is the journal entry?

Dr Cr

Revenue Earned on Account (Source of Assets)

May 19 Coordinated and finalized elaborate bridal arrangements for three couples and billed fees of P12,000 per couple.
Additional services include documents preparation, consultation with a feng shui expert as to the ideal wedding date
for prosperity and harmony, provision for limousine service and honeymoon trip.

Analysis Assets increased. Owner's equity increased.

Rules Increases in assets are recorded by debits. Increases in owner's equity are recorded by credits.

Entry Increase in assets is recorded by a debit to accounts receivable. Increase in owner's equity is recorded by a credit to
consulting revenues. What in the journal entry?

Dr Cr

Withdrawal of Cash by Owner (Use of Assets)

May 25 Besario withdrew P14,000 for personal expenses.

Analysis Assets decreased. Owner's equity decreased.

Rules Decreases in assets are recorded by credits. Decreases in owner's equity are recorded by debits.

Entry Decrease in owner's equity is recorded by a debit to Besario, Withdrawals. Decrease in assets is recorded by a credit
to cash. What is the journal entry?

Dr Cr

30
 Salaries Paid (Use of Assets)

May 27 Paid salaries P7,200

Analysis Assets decreased. Owner's equity decreased.

Rules Decreases in assets are recorded by credits. Decreases in owner's equity are recorded by debits.

Entry Decrease in owner's equity is recorted by a debit to salaries expense. Decrease in annets in recorded by a credit to
cash What is the journal entry?

Dr Cr

Expenses Incurred but Unpaid (Exchange of Claims)

May 30 Received the ICC-BayanTel telephone bill, P1,400.

Analysis Liabilities increased. Owner's equity decreased.

Rules Increases in liabilities are recorded by credits. Decreases in owners equity are recorded by debits.

Entry Decrease in owner's equity is recorded by a debit to utilities expense. Increase in liabilities is recorded by a credit to
utilities payable. What is the journal entry?

Dr Cr

Accounts Receivable Partially Collected (Exchange of Assets)

May 30 Received P24,000 from two clients for services billed last May 19.

Analysis An asset increased. Another asset decreased.

Rules Increases in assets are recorded by debits. Decreases as credits.

Entry Increase in assets is recorded by a debit to cash. Decrease in assets is recorded by a credit to accounts receivable.
What is the journal entry?

Dr Cr

WEDDING "R" Us
Chart of Accounts

Balance Sheet Accounts Income Statement Accounts

Assets Income
110 Cash 410 Consulting Revenues
120 Accounts Receivable 420 Referral Revenues
130 Supplies
140 Prepaid Rent Expenses
150 Prepaid Insurance 510 Salaries Expense
160 Service Vehicle 520 Supplies Expense
165 Accumulated Depreciation 530 Rent Expense
170 Office Equipment 540 Insurance Expense
175 Accumulated Depreciation 550 Utilities Expense
Liabilities 560 Depreciation Expense-Service Vehicle
210 Notes Payable 570 Depreciation Expense - Office Equipment
220 Accounts Payable 580 Miscellaneous Expense
230 Salaries Payable 590 Interest Expense
260 Unearned Referral Revenues
Owner's Equity
310 Besario, Capital
320 Besario, Withdrawals
330 Income Summary

31
Posting (Step 3)

Posting means transferring the amounts from the journal to the appropriate accounts
in the ledger. Debits in the journal are posted as debits in the ledger, and credits in the
journal as credits in the ledger. The steps are illustrated as follows:

1. Transfer the date of the transaction from the journal to the ledger.
2. Transfer the page number from the journal to the journal reference (J.R.) column of
the ledger.
3. Post the debit figure from the journal as a debit figure in the ledger and the credit
figure from the journal as a credit figure in the ledger.
4. Enter the account number in the posting reference column of the journal once the
figure has been posted to the ledger.

The Journal

Date Account Titles and Explanation. P. R. Debit Credit

1 2020

2 May 1 Cash 110 250,000

3 Besario, Capital 310 250,000

4 Initial Investment.

3.3 Posting

Ledger - A grouping of the entity's accounts is referred to as a ledger. Although some firms
may use various ledgers to accumulate certain detailed information, all firms have a general
ledger. A general ledger is the "reference book" of the accounting system and is used to
classify and summarize transactions, and to prepare data for basic financial statements.

The accounts in the general ledger are classified into two general groups:

1. balance sheet or permanent accounts (assets, liabilities and owner's equity).

2. income statement or temporary accounts (income and expenses). Temporary or
nominal accounts are used to gather information for a particular accounting period. At
the end of the period, the balances of these accounts are transferred to a permanent
owner's equity account.

Each account has its own record in the ledger. Every account in the ledger maintains
the basic format of the T-account but offers more information (e.g., the account number at
the upper right corner and the journal reference column). Compared to a journal, a ledger
organizes information by account.

Chart of Accounts

32
 A listing of all the accounts and their account numbers in the ledger is known as the
chart of accounts. The chart is arranged in the financial statement order, that is, assets first,
followed by liabilities, owner's equity, income and expenses. The accounts should be
numbered in a flexible manner to permit indexing and cross-referencing.

When analyzing transactions, the accountant refers to the chart of accounts to identify
the pertinent accounts to be increased or decreased. If an appropriate account title is not
listed in the chart, an additional account may be added. Presented below is the chart of
accounts for the illustration:

The Ledger

Account: Cash

Date Account Titles and P. R. Debit Credit Credit

Explanation.

1 2020

2 May 1 Cash J-1 250,000 250,000

Account: Besario, Capital

Date Account Titles and P. R. Debit Credit Credit

Explanation.

1 2020

2 May 1 Cash J-1 250,000 250,000

Ledger Accounts After Posting

At the end of an accounting period, the debit or credit balance of each account must be
determined to enable us to come up with a trial balance.

● Each, account balance is determined by footing (adding) all the debits and credits.
● If the sum of an account's debits is greater than the sum of its credits, that account
has a debit balance.
● If the sum of its credits is greater, that account has a credit balance.

Illustration. The ledger accounts of Weddings "p" Us after posting are shown below. The
account numbers and journal reference columns are purposely omitted. The balance of each
account has been determined.

Cash Notes Payable

May 1 250,000 May 1 8,000 May 2 210,000
2 210,000 4 420,000 Balance 210,000
10 26,400 4 14,400
15 10,000 5 15,000 Accounts Payable
30 24,000 9 10,000 May 9 10,000 May 5 45,000

33
 13 6,600 8 18,000
25 14,000 10,000 63,000
27 7,200 Balance 53,000
31 3,000 Utilities Payable
520,400 498,200 May 30 1,400
Balance 22,200 Balance 1,400

Unearned Referral Revenues

May 15 10,000
Accounts Receivable Balance 10,000
May 19 36,000 May 31 24,000
Balance 12,000
Besario, Capital
Supplies May 1 250,000
May 8 18,000 Balance 250,000
Balance 18,000

Prepaid Rent Besario, Withdrawals

May 1 8,000 May 25 14,000
Balance 8,000 Balance 14,000

Prepaid Insurance Consulting Services

May 4 14,000 May 10 26,400
Balance 14,000 19 36,000

Balance 62,400

Service Vehicle Salaries Expense

May 4 420,000 May 13 6,600
Balance 420,000 7,200
13,800
Office Equipment Balance 13,800
May 5 14,000
Balance 14,000
Utilities Expense

May 30 1,400

31 3,000

Balance 4,400

3.4 Trial Balance (Step 4)

Trial Balance - is a list of all accounts with their respective debit or credit balances. It is
prepared to verify the equality of debits and credits in the ledger at the end of each
accounting period or at any time the postings are updated

34
The procedures in the preparation of a trial balance follow:

1. List the account titles in numerical order.

2. Obtain the account balance of each account from the ledger and enter the debit
balances in the debit column and the credit balances in the credit column.
3. Add the debit and credit columns.
4. Compare the table.

The trial balance is a control device that helps minimize accounting errors. When the
totals are equal, the trial balance is in balance. This equality provides an interim proof of the
accuracy of the records but it does not signify the absence of errors For example, if the
bookkeeper failed to record payment of rent expense is understated and cash is overstated.

The trial balance for the illustration follows:

Weddings "R" Us
Trial Balance
May 31, 2020
Cash P 22,200

Accounts Receivable 12,000

Supplies 18,000

Prepaid Rent 8,000

Prepaid Insurance 14,400

Service Vehicle 420,000

Office Equipment 60,000

Notes Payable P 210,000

Accounts Payable 53,000

Utilities Payable 1,400

Unearned Referral Revenue 10,000

Besario, Capital 250,000

Besario, Withdrawals 14,000

Consulting Revenues 62,400

Salaries Expense 13,800

Utilities Expense 4,400

586,800 586,800
Locating Errors

An inequality in the totals of the debits and credits would automatically signal the presence
of an error. These errors include:

1. Error in posting a transaction to the ledger.

● an erroneous amount was posted to the account
● a debit entry was posted as a credit or vice versa.

35
 ● a debit or credit posting was omitted.
2. Error in determining the account balances.
● a balance was incorrectly computed.
● a balance was entered in the wrong balance column.
3. Error in preparing the trial balance:
● one of the columns of the trial balance was incorrectly added.
● the amount of an account balance was incorrectly recorded on the trial balance.
● a debit balance was recorded on the trial balance as a credit or vice versa, or a
balance was omitted entirely.

What is the most efficient approach in locating an error? The following procedures when
done in sequence may save considerable time and effort in locating errors:

1. Prove the addition of the trial balance columns by adding these columns in the
opposite direction.

2. If the error does not lie in addition, determine the exact amount by which the trial
balance is out of balance. The amount of the discrepancy is often a clue to the
source of the error If the discrepancy is divisible by 9, this suggests either a
transposition (reversing the order of numbers)
error or a slide (moving of the decimal point). For example, assume that the cash
account balance is P21,750, but in copying the balance into the trial balance the
figures are transposed and written as P21,570. The resulting error amounted to P180
and is divisible by 9. Another common error is the slide, or incorrect placement of the
decimal point, as when P21,750.00 is copied as P2, 175.00. The resulting
discrepancy in the trial balance will also be an amount divisible by 9.

Assume that the office equipment account has a debit balance of P42,000 but it is
erroneously listed in the credit column of the trial balance. This will cause a
discrepancy of two times P42,000 or P84,000 in the trial balance totals. Since such
errors as recording a debit in a credit column are common, it is advisable, after
determining the discrepancy in the trial balance totals, to scan the columns for an
amount equal to exactly one-half of the discrepancy.

It is also advisable to look over the transactions for an item of the exact amount of
the discrepancy. An error may have been made by recording the debit side of the
transaction and forgetting to enter the credit side.

3. Compare the accounts and amounts in the trial balance with that in the ledger. Be
certain that no account is omitted.

4. Recompute the balance of each ledger account.

5. Trace all postings from the journal to the ledger accounts. As this is done, place a
check mark in the journal and in the ledger after each figure is verified. When the
operation is completed, look through the journal and the ledger for unchecked
amounts. In tracing postings, be alert not only for errors in amount but also for debits
entered as credits, or vice versa

Note that even when a trial balance is in balance, the accounting records may still contain
errors A balanced trial balance simply proves that, as recorded, debits equal credits. The
following errors are not detected by a trial balance:

1. Failure to record or post a transaction.

2. Recording the same transaction more than once.
3. Recording an entry but with the same erroneous debit and credit amounts.

36
 4. Posting a part of a transaction correctly as a debit or credit but to the wrong account.

ADJUSTING THE ACCOUNTS

ACCRUAL BASIS

The financial statements, except for the cash flow statement, are prepared on the accrual
basis of accounting in order to meet their objectives. Under the accrual basis, the effects of
transactions and other events are recognized when they occur and not as cash is received
or paid. This means that the accountant records revenues as they are earned and expenses
as they are incurred. The timing of cash flows is relatively immaterial for determining when to
recognize revenues and expenses.

Financial statements prepared on the accrual basis inform users not only of past
transactions involving the payment and receipt of cash, but also of obligations to pay cash in
the future, and of

37
resources that represent cash to be received in the future. Generally accepted accounting
principles require that a business use the accrual basis.

In cash basis accounting, however, the accountant does not record a transaction until cash
is received or paid. Generally, cash receipts are treated as revenues and cash payments as
expenses Cash basis income is the difference between operating cash receipts and
disbursements. These cash flows necessarily exclude investments by and distributions to
the owner in the computation of income.

Illustration. A client paid the Sea Wind Resort in Boracay Island P7,000 on April 8, 2020 for a
one- day super deluxe accommodation on May 13, 2020. Under accrual basis of accounting,
the receipt of P7,000 will be considered as revenues when the business has rendered its
services on May 13.

In contrast, if cash basis is used, the hotel will recognize revenues on April 8: Expenses
related to this revenue transaction will be incurred on May 13. Suppose a financial report is
prepared at the end of April, under accrual basis, no revenue or expense will be reported,
under cash basis, revenues of P7,000 will be reported but the related expenses will be
recognized when incurred on May 13. Observe that the accrual basis provided a better
measure of the results of transactions.

PERIODICITY CONCEPT

The only way to know how successfully a business has operated is to close its doors, sell all
its assets, pay the liabilities and return any excess cash to the owners. This process of going
out of business is called liquidation This, however, is not a practical way of measuring
business performance.

Accounting information is valued when it is communicated early enough to be used for

economic decision-making. To provide timely information, accountants have divided the
economic life of a business into artificial time periods. This assumption is referred to as the
periodicity concept

Accounting periods are generally a month, a quarter or a year. The most basic accounting
period is one year. Entities differ in their choice of the accounting year-fiscal, calendar or
natural. A fiscal year is a period of any twelve consecutive months. A calendar year is an
annual period ending on December 31. A natural business year is a twelve-month period
that ends when business activities are at their lowest level of the annual cycle. A period of
less than a year is an interim period. Some even adopt an annual reporting period of 52
weeks.

Businesses need periodic reports to assess their financial condition and performance. The
periodicity concept ensures that accounting information is reported at regular intervals. It
interacts with the recognition and derecognition principles to underlie the use of accruals. To
measure profit in a fair manner, entities update the income and expense accounts
immediately before the end of the period.

RECOGNITION AND DERECOGNITION

Per 2018 Conceptual Framework, recognition is the process of capturing for inclusion in the
statement of financial position or the statement(s) of financial performance an item that
meets the definition of an asset, a liability, equity, income or expenses. The amount at which
an asset, a

38
liability or equity is recognized in the statement of financial position is referred to as its
"carrying amount".

The statement of financial position and statement(s) of financial performance depict an

entity's recognized assets, liabilities, equity, income and expenses in structured summaries
that are designed to make financial information comparable and understandable.

Recognition links the elements, the statement of financial position and the statement(s) of
financial performance. The statements are linked because the recognition of one item (or a
change in its carrying amount) requires the recognition or derecognition of one or more other
items (or changes in the carrying amount of one or more other items). For example:
(a) the recognition of income occurs at the same time as:
(i) the initial recognition of an asset, or an increase in the carrying amount of an asset, or (ii)
the derecognition of a liability, or a decrease in the carrying amount of a liability.
(b) the recognition of expenses occurs at the same time as:
(i) the initial recognition of a liability, or an increase in the carrying amount of a liability; or (ii)
the derecognition of an asset, or a decrease in the carrying amount of an asset.
The initial recognition of assets or liabilities arising from transactions or other events may
result in the simultaneous recognition of both income and related expenses. For example,
the sale of goods for cash results in the recognition of both income (from the recognition of
one asset-the cash) and an expense (from the derecognition of another asset-the goods
sold). The simultaneous recognition of income and related expenses is sometimes referred
to as the matching of costs with income.

Recognition is appropriate if it results in both relevant information about assets, liabilities,

equity, income and expenses and a faithful representation of those items, because the aim is
to provide information that is useful to investors, lenders and other creditors.
Derecognition is the removal of all or part of a recognized asset or liability from an entity's
statement of financial position. Derecognition normally occurs when that item no longer
meets the definition of an asset or of a liability:
(a) for an asset, derecognition normally occurs when the entity loses control of all or part of
the recognized asset; and
(b) for a liability, derecognition normally occurs when the entity no longer has a present
obligation for all or part of the recognized liability.

DEFERRALS AND ACCRUALS

Accountants use adjusting entries to apply accrual accounting to transactions that cover
more than one accounting period. There are two general types of adjustments made at the
end of the accounting period-deferrals and accruals.

Each adjusting entry affects a balance sheet account (an asset or a liability account) and an
income statement account (income or expense account).

Deferral is the postponement of the recognition of "an expense already paid but not yet
incurred," or of "revenue already collected but not yet earned". This adjustment deals with an
amount already recorded in a balance sheet account, the entry, in effect, decreases the
balance sheet account and increases an income statement account. Deferrals would be
needed in two cases:
1. Allocating assets to expense to reflect expenses incurred during the accounting period
(e.g. prepaid insurance, supplies and depreciation).
2. Allocating revenues received in advance to revenue to reflect revenues earned during the
accounting period (e.g. subscriptions).

39
Accrual is the recognition of "an expense already incurred but unpaid", or "revenue earned
but uncollected". This adjustment deals with an amount unrecorded in any account, the
entry, in effect, increases both a balance sheet and an income statement account. Accruals
would be required in two cases:

1. Accruing expenses to reflect expenses incurred during the accounting period that are
unpaid and unrecorded.
2. Accruing revenues to reflect revenues earned during the accounting period that are
uncollected and unrecorded.

THE NEED FOR ADJUSTMENTS

Accountants make adjusting entries to reflect in the accounts information on economic

activities that have occurred but have not yet been recorded. Adjusting entries assign
revenues to the period in which they are earned, and expenses to the period in which they
are incurred. These entries are needed to measure properly the profit for the period, and to
bring related asset and liability accounts to correct balances for the financial statements.
In short, adjustments are needed to ensure that the recognition and derecognition principles
are followed thus resulting to financial statements reporting the effects of all transactions at
the end of the period.

Adjusting entries involve changing account balances at the end of the period from what is
the current balance of the account to what is the correct balance for proper financial
reporting. Without adjusting entries, financial statements may not fairly show the solvency of
the entity in the balance sheet and the profitability in the income statement.

40
ADJUSTMENTS FOR DEFERRALS

Allocating Assets to Expenses Entities often make expenditures that benefit more than one
period. These expenditures are generally debited to an asset account. At the end of each
accounting period, the estimated amount that has expired during the period or that has
benefited the period is transferred from the asset account to an expense account. Two of the
more important kinds of adjustments are prepaid expenses, and depreciation of property and
equipment.

Prepaid Expenses

Some expenses are customarily paid in advance. These expenditures (e.g. supplies, rent
and insurance) are called prepaid expenses. Prepaid expenses are assets, not expenses. At
the end of an accounting period, a portion or all of these prepayments may have expired.
The portion of an asset that has expired becomes an expense. Prepaid expenses expire
either with the passage of time or through use and consumption. The flow of costs from the
balance sheet to the income statement is illustrated below:

Cost of As insurance
insurance Balance Sheet policies expire and Income Statement
policies and supplies used
supplies ==>
that will Assets ==============> Revenues
benefit future Prepaid Expenses
periods Insurance Insurance Expense
Supplies Supplies Expense

If adjustments for prepaid expenses are not made at the end of the period, both the balance
sheet and the income statement will be misstated. First, the assets of the entity will be
overstated; second, the expenses of the company will be understated. For this reason,
owner's equity in the balance sheet and profit in the income statement will both be
overstated. Besides prepaid rent, Weddings. "R" Us has prepaid expenses for supplies and
insurance, both accounts need adjusting entries

The Weddings "R" Us case is continued to illustrate the adjustment process. The letters A, L,
OE, OE:l and OE E are still used to ensure a better understanding of the nature of the
accounts affected.

41
Prepaid Rent (Adjustment a). On May 1, Weddings "R" Us paid P3,000 for two months'
rent in Pent advance. This expenditure resulted to an asset consisting of the right to occupy
the office for two months. A portion of the asset expires and becomes an expense each day.
By May 31, one-half of the asset had expired, and should be treated as an expense. The
analysis of this economic event is shown below:
Transaction Expiration of one month's rent.

Analysis Assets decreased. Owner's equity decreased.

Rules Decreases in assets are recorded by credits. Decreases in owner's equity are recorded by debits.

Entries Decrease in owner's equity is recorded by a debit to rent expense. Decrease in assets is recorded by a
credit to prepaid rent.

Dr. Cr.

Rent Expense (OE:E) 4,000

Prepaid Rent (A) 4,000

After adjustments, the prepaid rent account has a balance of P4,000 (May 1 prepayment of
P8,000 less the P4,000 expired portion); the rent expense account reflects the P4,000
expense for the month.
Prepaid Insurance (Adj. b) Weddings "R" Us acquired a one-year comprehensive
insurance coverage on the service vehicle and paid P14,400 premiums. In a manner similar
to prepaid rent, prepaid insurance offers protection that expires daily. The adjustment is
analyzed and recorded as shown below:
Transaction Expiration of one month's insurance.

Analysis Assets decreased. Owner's equity decreased.

Rules Decreases in assets are recorded by credits. Decreases in owner's equity are recorded by debits.

Entries Decrease in owner's equity is recorded by a debit to insurance expense; decrease in assets as a credit
to prepaid insurance.

Dr. Cr.

Insurance Expense (OE:E) 1,200

Prepaid Insurance (A) 1,200

The prepaid insurance account has a balance of P13,200 (May 4 prepayment of P14,400
less P1,200) and insurance expense reflects the expired cost of P1,200 for the month. As a
matter of company policy, the period May 4 to 31 is considered a month.

Supplies (Adjustment c). On May 8, Weddings "R" Us purchased supplies, P18,000,

During the month, the entity used supplies in the process of performing services for clients.
There is no need to account for these supplies every day since the financial statements will
not be prepared until the end of the month. At the end of the accounting period, Besario
makes a careful physical inventory of the supplies. The inventory count showed that supplies
costing P15,000 are still on hand. This transaction is analyzed and recorded as follows:
Transaction Consumption of supplies.

Analysis Assets decreased. Owner's equity decreased.

Rules Decreases in assets are recorded by credits. Decreases in owner's equity are recorded by debits.

42
 Entries Decrease in owner's equity is recorded by a debit to supplies expense Decrease in assets is recorded
by a credit to supplies.

Dr. Cr.

Supplies Expense (OE:E) 3,000

Supplies (A) 3,000

The asset account supplies now reflect the adjusted amount of P15,000 (P18,000 less P3,000) In
addition, the amount of supplies expensed during the accounting period is reflected as P3,000.

Depreciation of Property and Equipment

When an entity acquires long-lived assets such as buildings, service vehicles, computers or
office furniture, it is basically buying or prepaying for the usefulness of that asset. These
assets help generate income for the entity. Therefore, a portion of the cost of the assets
should be reported as expense in each accounting period. Proper accounting requires the
allocation of the cost of the asset over its estimated useful life. The estimated amount
allocated to any one accounting period is called depreciation or depreciation expense. Three
factors are involved in computing depreciation expense:

1. Asset cost is the amount an entity paid to acquire the depreciable asset.
2. Estimated salvage value is the amount that the asset can probably be sold for at the end
of its estimated useful life.
3. Estimated useful life is the estimated number of periods that an entity can make use of the
asset. Useful life is an estimate, not an exact measurement.

As insurance policies
Cost of a Balance Sheet expire and supplies Income Statement
depreciable used
asset ===>
Assets ===============> Revenues
Service Vehicle Expenses
Office Equipment Depreciation

Accountants estimate periodic depreciation. They have developed a number of methods for
estimating depreciation. The simplest procedure is called the straight-line method. The
formula for determining the amount of depreciation expense for each period using this
method is:

Asset cost xx
Less: Estimated salvage value xx
Depreciable cost xx
Divided by: Estimated useful life xx
Depreciation Expense for each time period xx

The asset account is not directly reduced when recording depreciation expense. Instead, the
reduction is recorded in a contra account called accumulated depreciation. A contra account
is used to record reductions in a related account and its normal balance is opposite that of

43
the related account. Use of the contra account- accumulated depreciation-allows the
disclosure of the original cost of the related asset in the balance sheet. The balance of the
contra account is deducted from the cost to obtain the book value of the property and
equipment.

Service Vehicle and Office Equipment (Adjs. d and e). Suppose that Weddings "R" Us
estimated that the service vehicle, which was bought on May 4, will last for seven years
(eighty-four months) and with a salvage value of P84,000. The office equipment that was
acquired on May 5 will have a useful life of five years (sixty months) and will be worthless at
that time. Substitution of the pertinent amounts into the basic formula will yield depreciation
for service vehicle and office equipment for the month as P4,000 [(P420,000 P84,000)/84
months] and P1,000 (P60,000/60 months), respectively. These amounts represent the cost
allocated to the month, thus reducing the asset accounts and increasing the expense
accounts. As a matter of company policy, the period May 4 to 31 is considered a month. The
analysis follows:

Transaction Recording depreciation expense.

Analysis Assets decreased. Owner's equity decreased.

Rules Decreases in assets are recorded by credits. Decreases in owner's equity are recorded by debits.

Entries Owner's equity is decreased by debits to depreciation expense-service vehicle and depreciation
expense-office equipment. Assets are decreased by credits to contra-asset accounts accumulated
depreciation-service vehicle and accumulated depreciation-office equipment.

Dr. Cr.

Depreciation Expense-Service Vehicle (OE:E) 4,000

Accumulated Depreciation-Serv. Vehicle (A) 4,000

Depreciation Expense-Office Equipt. (OE:E) 1,000

Accumulated Depreciation-Office Equipt. (A) 1,000

After adjustments, the property and equipment section of the balance sheet for Weddings
"R" Us will be:
Weddings "R" Us
Partial Balance Sheet
May 31, 2020
Property and Equipment (Net):
Service Vehicle P420,000
Less: Accumulated Depraciation 4,000 416,000

Office Equipment P60,000

Less: Accumulated Depraciation 1,000 59,000
P 475,000

Allocating Revenues Received in Advance to Revenues

There are times when an entity receives cash for services or goods even before service is
rendered or goods are delivered. When such is received in advance, the entity has an
obligation to perform services or deliver goods. The liability referred to is unearned
revenues.

44
For example, publishing companies usually receive payments for magazine subscriptions in
advance. These payments must be recorded in a liability account. If the company fails to
deliver the magazines for the subscription period, subscribers are entitled to a refund. As the
company delivers each issue of the magazine, it earns a part of the advance payments. This
earned portion must be transferred from the unearned subscription revenues account to the
subscription revenues account.

Value of As the goods

goods or Balance Sheet or services Income Statement
services are provided
to be ===>
provided in Liabilities ==========> Revenues
future Unearned Revenues from
periods Revenues ___________

Unearned Referral Revenues (Adj. f). On May 15, Weddings "R" Us received P10,000 as
an advance payment for referrals made. Assume that by the end of the month, one of the
three couples referred has already taken their marriage vows and as a result the amount of
P4,000 pertaining to the referred event has been realized. This transaction is analyzed as
follows:

Transaction Recognition of income where cash is received in advance.

Analysis Liabilities decreased. Owner's equity increased.

Rules Decreases in liabilities are recorded by debits. Increases in owner's equity are recorded by credits.

Entries Decrease in liabilities is recorded by a debit to unearned referral revenues. Increase in owner's equity is
recorded by a credit to referral revenues.

Dr. Cr.

Unearned Referral Revenues (L) 4,000

Referral Revenues (OE:I) 4,000

The liability account unearned referral revenues reflects the referral revenues still to be
earned, P6,000. The referral revenues account reflects the amount of referrals already
completed and considered as revenues during the month, P4,000..

ADJUSTMENTS FOR ACCRUALS (Step 5)

Accrued Expenses

An entity often incurs expenses before paying for them. Cash payments are usually made at
regular intervals of time such as weekly, monthly, quarterly or annually if the accounting
period ends on a date that does not coincide with the scheduled cash payment date, an
adjusting entry is needed to reflect the expense incurred since the last payment. This
adjustment helps the entity avoid the impractical preparation of hourly or daily journal entries
just to accrue expenses. Salaries, interest, utilities (e.g., electricity, telecommunications and
water) and taxes are examples of expenses that are incurred before payment is made.

45
Accrued Salaries (Adj. g). Entities pay their employees at regular intervals. It can be
weekly, semi-monthly or monthly. Weekly payrolls are usually made on Fridays (for a five-
day workweek) or Saturdays (for a six-day workweek). Weddings "R" Us pays salaries every
two Saturdays. Assume that the calendar for May appears as follows:

May

Su M T W Th F Sa

1 2 3 4 5 6

7 8 9 10 11 12 13

14 15 16 17 18 19 20

21 22 23 24 25 26 27

28 29 30 31

The office assistant and the account executive were paid salaries on May 13 and 27. At
month- end, the employees have worked for three days (May 29, 30 and 31) beyond the last
pay period. The employees have earned the salary for these days, but it is not due to be
paid until the regular payday in April. The salary for these three days is rightfully an expense
for May, and the liabilities should reflect that the entity owes the employees salaries for
those days.

Each of the employee's salary rate is P7.800 per month or P300 per day (P7.800/26 working
days). The expense to be accrued is P1,800 (P300 x 3 days x 2 employees). This accrued
expense can be analyzed as shown:

Transaction Accrual of unrecorded expense.

Analysis Liabilities increased. Owner's equity decreased.

Rules Increases in liabilities are recorded by credits. Decreases in owner's equity are recorded by debits.

Entries Decrease in owner's equity is recorded by a debit to salaries expense. Increase in liabilities is recorded
by a credit to salaries payable.

Dr. Cr.

Salaries Expense (OE:E) 1,800

Salaries Payable (L) 1,800

The liability of P1,800 is now correctly reflected in the salaries payable account. The actual
expense incurred for salaries during the month is P15,600.

Accrued Interest (Adj. h). On May 2, Besario borrowed P210,000 from Metrobank. She
issued a promissory note that carried a 20% interest per annum. Both the interest and
principal will be payable in one year. The note issued to the bank accrues interest at 20%
annually. At the end of May, Besario owed the bank P3,500 (see computation below) for
interest in addition to the P210,000 loan. Interest is a charge for the use of money over time.
Interest expense is matched to a particular period during which the benefit-the use of
borrowed money-is received. The interest is a fixed obligation and accrues regardless of the
results of the entity's operations

Interest rates are expressed at annual rates, so if interest is being calculated for less than a
year, the calculation must express time as a portion of a year. Thus, the interest expense
(simple) incurred on this note during the month is determined by the following formula:

46
 Interest = Principal x Interest Rate x Length of Time
= P210,000 x 20% per year x 1/12 of a year
= P210,000 x 20 x 1/12
= P3,500

The adjusting entry to record the interest expense incurred in May is as follows:

Transaction Accrual of unrecorded expense.

Analysis Liabilities increased. Owner's equity decreased.

Rules Increases in liabilities are recorded by credits. Decreases in owner's equity are recorded by debits.

Entries Decrease in owner's equity is recorded by a debit to interest expense; increase in liabilities as credit to
interest payable.

Dr. Cr.

Interest Expense (OE:E) 3,500

Interest Payable (L) 3,500

Salaries, interest, utilities (e.g., electricity, telecommunications and water) and taxes are
examples of expenses that are incurred before payment is made.

Accrued Revenues

An entity may provide services during the period that are neither paid for by clients nor billed
at the end of the period. The value of these services represents revenue earned by the
entity. Any revenue that has been earned but not recorded during the accounting period
calls for an adjusting entry that debits an asset account and credits an income account

Accrued Consulting Revenues (Adj. i). Suppose that Weddings "R" Us agreed to arrange
a rush but simple civil wedding for a madly-in-love couple in the afternoon of May 31. The
entity intended to charge fees of P5,300 for the services, which is earned but unbilled. This
should be recorded as shown below.

Transaction Accrual of unrecorded revenue.

Analysis Assets increased. Owner's equity increased.

Rules Increases in assets are recorded by debits. Increases in owner's equity are recorded by credits.

Entries Increase in assets is recorded by a debit to accounts receivable. Increase in owner's equity as a credit
to consulting revenues.

Dr. Cr.

Accounts Receivable (A) 5,300

Consulting Revenues (OE:I) 5,300

A total of P67,700 in consulting revenues was earned by the entity during the month.

47
The Weddings "R" Us illustration did not tackle entries related to uncollectible accounts
Hence, the ensuing discussion on the accrual of uncollectible accounts is not in any way
related to the Weddings "R" Us illustration. This is to complete the illustrations on
adjustments for accruals.

ACCRUAL FOR UNCOLLECTIBLE ACCOUNTS

Entities often allow clients to purchase goods or avail of services on credit. Some of these
accounts will never be collected: hence, there is a need to reflect these as charges against
income. In practice, an expense is recognized for the estimated uncollectible accounts in the
current period, rather than when specific accounts actually become uncollectible. This
practice produces a better matching of income and expenses. Estimates of uncollectible
accounts may be based on credit sales for the period or on the accounts receivable balance.

Assume that an entity made credit sales of P1,100,000 in 2020 and prior experience
indicates an expected 1% average uncollectible accounts rate based on credit sales. The
contra account- Allowance for Uncollectible Accounts has a normal credit balance and is
shown in the balance sheet as a deduction from Accounts Receivable. The allowance
account need to be increased by P11,000 (P1,100,000 x 1%) because accounts receivable
in that amount is doubtful of collection. The adjustment will be:

Dr. Cr.

Uncollectible Accounts Expense (OE:E) 11,000

Allowance for Uncollectible Accounts (A) 11,000

Throughout the accounting period, when there is positive evidence that a specific account is
definitely uncollectible, the appropriate amount is written off against the contra account. For
example, if a P1,500 receivable were considered uncollectible, that amount would be written
off as follows:

Dr. Cr.

Allowance for Uncollectible Accounts (A) 1,500

Accounts Receivable (A) 1,500

No entry is made to Uncollectible Accounts Expense, since the adjusting entry has already
provided for an estimated expense based on previous experience for all receivables. A more
detailed discussion of this topic is found in Part Four of this book.

EFFECTS OF OMITTING ADJUSTMENTS

When an accountant failed to include the proper adjusting entries, the resulting financial
statements will not accurately reflect the financial position and the performance of the entity.
Inaccuracies in one accounting period can cause further inaccuracies in the statements of
subsequent periods.

Illustration. On July 1, 2020, Cabuyao Manpower Services owned by Warlito Blanche

borrowed P100,000 by signing an 18-month note at 16% interest per annum. The principal
and interest are to be repaid when the note matures on Dec. 31, 2021.

48
As at Dec. 31, 2020, the entity has incurred interest expense of P8,000 (P100,000 x 16% x
6/12). The accountant did not record the adjustment for the accrued interest. The entry
should have been a debit to Interest Expense and a credit to Interest Payable for P8,000.

The effects of the omission in the 2020 financial statements are as follows:

> In the 2020 income statement, interest expense is understated by P8,000 and, therefore,
profit is overstated by P8,000.

>In the Dec. 31, 2020 balance sheet, owner's equity is overstated by P8,000 because of the
overstatement in profit. Total liabilities is understated because of the omission of the P8,000
interest payable.

On Dec. 31, 2021, the maturity date, the note is paid together with interest. Since there was
no adjusting entry made to accrue interest in 2020, the entire interest of P24,000 (P100,000
x 16% x 18/12) was erroneously charged against 2021 profit. The correct interest expense
for 2021 should have been P16,000 (P100,000 x 16% x 12/12).

The effects of the omissions in the 2021 financial statements are as follows:

> in the 2021 income statement, interest expense is overstated by P8,000 and, therefore,
profit is understated by P8,000.

The Dec. 31, 2021 balance sheet is correctly stated since the note along with its interest has
been settled by year-end. The effect of the omission has counterbalanced by the end of the
second accounting period.

In summary, the omission has produced two erroneous income statements and one
erroneous balance sheet. If the entity should have reported a correct profit of P500,000 in
the 2020 and 2021 income statements. As a result of the omission, the proprietorship's profit
in 2020 is P508,000 and in 2021, P492,000.

ANALYSIS USING T-ACCOUNTS

To recapitulate, each adjusting entry affects a balance sheet account (an asset or a liability
account) and an income statement account (an income or an expense account). Almost
every revenue or expense account on the income statement has one or more related
accounts on the statement of financial position. For instance, rent expense is related to
prepaid rent, supplies expense to supplies, service revenues to unearned service revenues
and salaries expense to salaries payable.

Having been apprised of these relationships, transactions affecting particular accounts can
now be analyzed using T-accounts. This learning will be of use in reconstructing accounts to
derive details like cash inflows, cash outflows, revenues recognized for the period or
expenses charged for the period.

To illustrate, Eco-Tours, established by Galicano Del Mundo at the start of the month,
reported at month-end the following related accounts and account balances: Supplies,
P36,600 and Supplies Expense, P15,400.

Looking at the foregoing. Del Mundo wants to know how much cash was paid out to
purchase supplies. Start by placing the relevant information in a T-account. Input the
beginning balance on the normal balance of the account. In this case, Supplies is debit.
There is no beginning balance since the company just started operations this month. As a

49
technique, the ending balance of an account, here, Supplies for P36,600, is placed opposite
its normal balance. In adjusting for supplies expense, the entry made was debit Supplies
Expense, P15,400 and credit Supplies, P15,400. Total both debit and credit sides. The cash
paid out for supplies can now be derived; it's P52,000 (P52,000- zero), the plug figure. If
there was a beginning balance of P2,000, then cash paid out would have been P50.000
(P52,000-P2,000).

Supplies

Debit Credit
(+) (-)

Beginning Balance -0- 15,400 Exp

Cash Paid for Supplies ^ Plug figure v 36,600 En

Total 52,000 52,000 Tot

<

Assume instead that the P36,600 ending balance for Supplies and the P52,000 cash paid for
supplies were given, using the T-account, supplies expense is P15,400 (P52,000 - P36,600):

Prepaid Insurance

Debit Credit
(+) (-)

Beginning Balance 48,000 12,000 Expense for th

Cash Paid for Insurance ^ Plug figure v 67,000 Ending Balanc

Total 79,000 79,000 Total

<

To illustrate further, a company reported at month-end the following related accounts and
account balances: Prepaid Insurance, End, P67,000; Insurance Expense, P12,000 and
Prepaid Insurance, beginning. P48,000. How much cash was used to pay for insurance this
period? Answer: P31,000

To have an ending balance of P67,000, there must have been a P31,000 debit to the
Prepaid Insurance account. Since a debit to this account is normally offset by a credit to
Cash, the analysis confirms that cash outflows for insurance was P31,000.
SUMMARY OF ADIUSTING ENTRIES

Account Balance Before Adjustment Adjusting Entry

Type of Adjustment

Balance Sheet Income Statement Account Debited Account Credited

Account Account

Prepaid Expenses:

Assets method Assets Overstated Expenses Understated Expense Prepaid Expense (A)

Expense method Assets Understated Expenses Overstated Prepaid Expense (A) Expense

Depreciation Assets Overstated Expenses Understated Expense Contra Asset

Unearned Revenues:

Liability method Liabilities Overstated Income Understated Unearned Revenues (L) Revenues

Income method Liabilities Understated Revenues Overstated Revenue Unearned Revenues (L)

Accrued Expenses Liabilities Understated Expenses Understated Expense Payable (L)

Accrued Revenues Assets Understated Income Understated Receivable (A) Revenues

50
ALTERNATIVE METHODS OF RECORDING DEFERRALS

In the discussions, all the transactions that required adjustments are initially recorded in
balance sheet accounts. A prepaid expense is initially recorded in a prepaid asset account.
Likewise, revenue received in advance is initially recorded in a liability account-unearned
revenues. In the case of a prepaid expense, an adjusting entry is made at the end of the
period to transfer the portion of the expired asset to an expense account. Similarly, an
adjusting entry is made to transfer earned revenues from the liability account to an income
account.

Entities may initially account for deferrals using income and expense accounts. The
alternative approach is illustrated in this appendix.

Prepaid Expenses
On Oct. 1, 2020, Calaguas Company acquired a 3-year insurance policy for P36,000 paid in
advance. Calaguas may record this transaction depending on which of the two accounting
policies. it follows. The P36,000 payment may initially be recorded either as an asset or as
an expense.

Initial entry is recorded as:

1. An asset
2020

Oct. 10 Prepaid Insurance (A) 36,000

Cash 36,000
2. An expense
2020

Oct. 10 Insurance Expense 36,000

(OE:E)

Cash 36,000

At the end of the year, an adjusting entry is needed to establish the proper balances in the
prepaid insurance and insurance expense accounts. On Dec. 31, 2020, three months'
insurance has been consumed, or insurance expense is equal to P3,000 (P36,000/36
months x 3 months). Prepaid insurance equivalent to P33,000 (P36,000-P3,000) remain.
The appropriate adjustment depends on how the initial transaction was recorded.

Adjusting entry required if initial entry is recorded as:

1. An asset
2020

Dec. 31 Insurance Expense 3,000

(OE:E)

Prepaid Insurance (A) 3,000

2. An expense
2020

Dec. 31 Prepaid Insurance (A) 33,000

Insurance Expense 33,000

(OE:E)

51
The effect of the adjusting entries on the ledger accounts after posting is the same
regardless of the initial debits as shown below:

As an Asset
Dec. 31 balances:
Prepaid Insurance 33,000 debit
Insurance Expense 3,000 debit
As an Expense
Dec 31 balances:
Prepaid Insurance 33,000 debit
Insurance Expense 3,000 debit

Unearned Revenues
On July 1, 2020, Marasigan Company received a P48,000 check for 2 years' rent paid in
advance On this date, Marasigan may record a credit in that amount either as unearned
rental revenue or rental revenue, depending on its accounting policy.

Initial entry is recorded as:

1. An asset
2020

July 1 Cash 48,000

Unearned Rent 48,000

Revenues (L)
2. A revenue
2020

July 1 Cash 48,000

Rent Revenues (OE:I) 48,000

At the end of the year, an adjusting entry is needed to establish the proper balances in the
rent revenue and uneamed rent revenue accounts On Dec. 31, 2020, six months' rent has
been earned, or rent revenue is equal to P12,000 (P48,000/24 months x 6 months).
Unearned rent revenues equivalent to P36,000 (P48,000 P12,000) remain. The appropriate
adjustment depends on how the initial transaction was recorded.

Adjusting entry required if initial entry is recorded as:

1. An liability
2020

Dec. 31 Unearned Rent 12,000

Revenues (L)

Rent Revenues (OE:I) 12,000

2. A revenue
2020

Dec. 31 Rent Revenues (OE:I) 36,000

Unearned Rent 36,000

Revenues (L)

52
The effect of the adjusting entries on the ledger accounts after posting is the same
regardless of the initial credits as shown below:

As a Liability
Dec. 31 balances
Unearned Rent Revenues 36,000 credit
Unearned Rent Revenues 36,000 credit

As an Income
Dec. 31 balances:
Rent Revenues 12,000 credit
Rent Revenues 12,000 credit

ADJUSTMENTS ARE JOURNALIZED AND POSTED

The adjustment process is a key element of accrual basis accounting. The worksheet helps
in the identification of the accounts that need adjustments. The adjusting entries are directly
entered in the worksheet. Most accountants prepare the financial statements immediately
after completing the worksheet. The adjustments are journalized and posted as the closing
entries are made. This step in the accounting cycle brings the ledger into agreement with the
data reported in the financial statements.

Illustration. The adjustments pertinent to the Weddings "R" Us illustration follow

Journal

Date Account Titles and Explanation P. R. Debit Credit

2020

May 31 Rent Expense 530 4,000

Prepaid Rent 140 4,000

31 Insurance Expense 540 1,200

Prepaid Insurance 150 1,200

31 Supplies Expense 520 3,000

Supplies 130 3,000

May 31 Depreciation Expense-Service Vehicle 560 4,000

Accumulated Depreciation-Serv. Vehicle 165 4,000

31 Depreciation Expense-Office Equipment 570 1,000

53
 Accumulated Depreciation-Off. Equipt. 175 1,000

31 Unearned Referral Revenues 260 4,000

Referral Revenues 420 4,000

31 Salaries Expense 510 1,800

Salaries Payable 230 1,800

31 Interest Expense 590 3,500

Interest Payable 250 3,500

2020

31 Accounts Receivable 120 5,300

Consulting Revenues 410 5,300

CLOSING ENTRIES ARE JOURNALIZED AND POSTED

Income, expense and withdrawal accounts are temporary accounts that accumulate
information related to a specific accounting period. These temporary accounts facilitate
income statement preparation. At the end of each year, the balances of these temporary
accounts are transferred to the capital account. Thus, the balance of the owner's capital
account represents the cumulative net result of income, expense, and withdrawal
transactions. This phase of the cycle is called the closing procedure.

A temporary account is said to be closed when an entry is made such that its balance
becomes zero. Closing simply transfers the balance of one account to another account. In
this case, the balances of the temporary accounts are transferred to the capital account. A
summary account- Income Summary is used to close the income and expense accounts.
The steps in closing the accounts of an entity will be illustrated using the Weddings "R" Us
case.

1. Close the income accounts

Income accounts have credit balances before the closing entries are posted. For this
reason, an entry debiting each revenue account in the amount of its balance is
needed to close the account. The credit is made to the income summary account.
The entry to close the income accounts for the Weddings "R" Us is as follows:

2020 Dr. Cr.

May 31 Consulting Revenues 410 67,700

Referral Revenues 420 4,000

Income Summary 330 71,700

54
The dual effect of the entry is to make the balances of the income accounts equal to zero,
and to transfer the balances in total to the credit side of the income summary account. Note
that the data for closing the income accounts can be found in the credit side of the income
statement columns of the worksheet in Exhibit 5-4.

55
 2. Close the expense accounts

Expense accounts have debit balances before the closing entries are posted. For this
reason, a compound entry is needed crediting each expense account for its balance
and debiting the income, summary for the total. These data can be found in the debit
side of the income statement columns of the worksheet.

2020 Dr Cr

May 31 Income Summary 330 36,700

Salaries Expense 510 15,600

Supplies Expense 520 3,000

Rent Expense 530 4,000

Insurance Expense 540 1,200

Utilities Expense 550 4,400

Depreciation Expense-Service Vehicle 560 4,000 4,000

Depreciation Expense-Office Equipment 570 1,000

Interest Expense 590 3,500

The effect of posting the closing entry is to reduce the expense account balances to
zero and to transfer the total of the account balances to the debit side of the income
summary account.

3. Close the income summary account

After posting the closing entries involving the income and expense accounts, the
balance of the income summary account will be equal to the profit or loss for the
period. A profit is indicated by a credit balance and a loss by a debit balance. The
income summary account, regardless of the nature of its balance, must be closed to
the capital account. For the Weddings "R" Us, the entry is as follows:

2020 Dr Cr

May 31 Income Summary 330 35,000

Besario, Capital 310 35,000

The effect of posting this closing entry is to close the income summary account balance and
to transfer the balance to Besario's capital account for the profit.

4. Close the withdrawal account

The withdrawal account shows the amount by which capital is reduced during the
period by withdrawals of cash or other assets of the business by the owner for

56
 personal use. For this reason, the debit balance of the withdrawal account must be
closed to the capital account as follows:

2020 Dr Cr

May 31 Besario, Capital 310 14,000

Besario, Withdrawals 320 14,000

The effect of posting this closing entry is to close the withdrawal account and to transfer the
balance to the capital account.

PREPARATION OF A POST-CLOSING TRIAL BALANCE

It is possible to commit an error in posting the adjustments and closing entries to the
ledger accounts; thus, it is necessary to test the equality of the accounts by preparing
a new trial balance. This final trial balance is called a post-closing trial balance.

● The post-closing trial balance verifies that all the debits equal the credits in
the trial balance.
● The trial balance contains only balance sheet items such as assets, liabilities,
and ending capital because all income and expense accounts, as well as the
withdrawal account, have zero balances.

Notice that only the balance sheet accounts have balances because at this point, all
the income statement accounts have been closed.

Weddings "R" Us
Trial Balance
May 31, 2020
Cash P 22,200

Accounts Receivable 17,300

Supplies 15,000

Prepaid Rent 4,000

Prepaid Insurance 13,200

Service Vehicle 420,000

Accumulated Depreciation-Service Vehicle P 4,000

Office Equipment 60,000

Accumulated Depreciation-Office Equipment 1,000

Notes Payable 210,000

Accounts Payable 53,000

Salaries Payable 1,800

Utilities Payable 1,400

Interest Payable 3,500

57
 Unearned Referral Revenue 6,000

Besario, Capital - 271,000

P551,700 551,700

REVERSING ENTRIES

Preparing the post-closing trial balance may not be the last step in the accounting cycle.
Some entities elect to reverse certain end-of-period adjustments on the first day of the new
period. A reversing entry is a journal entry which is the exact opposite of a related adjusting
entry made at the end of the period. It is basically a bookkeeping technique made to simplify
the recording of regular transactions in the next accounting period.

It should be emphasized that reversing entries are optional. Also, the act of reversing a
previously recorded adjusting entry should not lead us to the conclusion that the entries
reversed are unnecessary or inaccurate.

Even when an entity follows the policy of making reversing entries, not all adjusting entries
should be reversed. Generally, a reversing entry should be made for any adjusting entry that
increased an asset or a liability account. Therefore, all accruals are reversed but only
deferrals initially recorded in income statement-income or expense-accounts are reversed.

Using the summary of adjusting entries in Chapter 4, the veracity of the general rule, stated
in the previous paragraph can be proven. For example, in the case of a prepaid expense
initially recorded in an expense account, the adjusting entry debited an asset-prepaid
expense. An asset increased, hence, applying the general rule, this adjustment, can be
reversed.

After analyzing the rest of the adjusting entries, the adjustments that can be reversed are as
follows: prepaid expenses (expense method), unearned revenues (income method), accrued
expenses and accrued revenues.

Illustration. To show how reversing entries can be helpful, consider the adjusting entry
made in the records of Weddings "R" Us to accrue salaries expense:

2020 Dr Cr

May 31 Salaries Expense 1,800

Salaries Payable 1,800

When the employees are paid on the next regular payday, the entry would be:

2020 Dr Cr

May 31 Salaries Expense 1,800

Salaries Payable 5,400

Cash 7,200

58
Note that when the payment is made, without a prior reversing entry, the accountant must
look into the records to find out how much of the P7,200 applies to the current accounting
period and how much was accrued at the beginning of the period.

This step may appear easy in this simple case, but think of the problems that may arise if the
company has many employees, especially if some of them are paid on different time
schedules such as weekly or monthly. A reversing entry is an accounting procedure that
helps to solve this difficult problem. As noted above, a reversing entry is exactly what its
name implies. It is a reversal of the adjusting entry made. For example, observe the
following sequence of transactions and their effects on the ledger account-salaries expense:

1. Adjusting Entry

2020 Dr Cr

May 31 Salaries Expense 1,800

Salaries Payable 1,800

2. Closing Entry

2020 Dr Cr

May 31 Income Summary 15,600

Salaries Expense 15,600

3. Reversing Entry

2020 Dr Cr

June 1 Salaries Expense 1,800

Salaries Payable 1,800

4. Payment Entry

2020 Dr Cr

June 10 Salaries Expense 7,200

Cash 7,200

These transactions had the following effects on salaries expense.

a. Adjusted salaries expense to accrue P1,800 in the proper accounting period.

b. Closed the P15,600 in total salaries expense for May to income summary.
c. Established a credit balance of P1,800 on June 1 in salaries expense equal to the
expense recognized through the adjusting entry on May 31. The liability account salaries
payable was reduced to a zero balance.

59
d. Recorded the P7,200 payment of two weeks' salaries in the usual manner. The reversing
entry has the effect of leaving a balance of P5,400 (P7,200-P1,800) in the salaries expense
account. This P5,400 balance represented the salaries expense for the nine workdays in
June.

Making the payment entry was simplified by the reversing entry. Reversing entries apply to
all accrued expenses or revenues.

60