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Mercado INTRODUCTION : INTRODUCTION This presentation covers the concepts and practice of accounting fundamental. From the concepts and information about accounting up to the accounting cycle, which includes journalizing, reversing and closing entries. Accounting is a profession similar to medicine and law. Such profession continually evolve and change as society and the needs of society change. The objective of this presentation is to make people aware of how accounting works in relation to business and also how can it be helpful even in a simple way of living. This also emphasized the importance of accounting in any types of business. Little by little, you will be able to understand how accounting works and you will realize its significance to our daily living. This presentation is based on the book of Bayani D. Edlagan and Ma. Cecilia S. Mercado, “Accounting Fundamental.” CHAPTER 1Introduction to AccountingConcepts and Practice : CHAPTER 1Introduction to AccountingConcepts and Practice CHARACTERISTICS OF ACCOUNTING INFORMATION : CHARACTERISTICS OF ACCOUNTING INFORMATION Accounting information is composed principally of financial data about business transactions, expressed in terms of money. The mere records of transactions are of little use in making “informed judgments and decisions.” The recorded data must be sorted and summarized before significant reports and analyses can be prepared. The “basic raw materials” of accounting are composed of business transaction data. Its “primary end products” are composed of various summaries, analyses, and reports. USERS OF ACCOUNTING INFORMATION : USERS OF ACCOUNTING INFORMATION Accounting provides the techniques for accumulating and the language for communicating economic data to various categories of individuals and institutions. Investors in a business enterprise need information about its financial status and its future prospects. The government agencies are concerned with the financial activities of business organizations for purposes of taxation and regulation. The individuals most dependent upon and most involved with the end products of accounting are those charged with the responsibility for directing the operations of enterprises. USERS OF ACCOUNTING INFORMATION : USERS OF ACCOUNTING INFORMATION For example, in the conduct of day-to-day operations, management relies upon accounting to provide the amount owed to each creditor and by each customer and the date each payment is due. The relevant information for one category of users may differ markedly from that needed by other users. Once the user groups are identified, however, and the nature of the relevant data determined, the accountant is able to establish an information network to assist each group in forming judgments and making decisions regarding future actions. RELATIONSHIP OF ACCOUNTING TO OTHER FIELDS : RELATIONSHIP OF ACCOUNTING TO OTHER FIELDS Everyone engaged in business activities, from the youngest employee to the manager and owner, comes into contact with accounting. The higher the level of authority and responsibility, the greater is the need for an understanding of accounting concepts and terminology. The importance of understanding accounting is not limited to the business world. Many employees with specialized training in non-business areas also make use of accounting data and should understand accounting principles and terminology. PROFESSION OF ACCOUNTANCY : PROFESSION OF ACCOUNTANCY Accountancy is a profession with stature comparable to that of engineering or law. The rapid development of accounting theory and technique during the current century has been accompanied by an expansion of the career opportunities in accounting and an increasing number of professionally trained accountants. Accountants who render accounting services on a fee basis, and staff accountants employed by them, are said to be engaged in public accounting. Accountants employed by a particular business enterprise or not-for-profit organization, as chief accountant, controller, or financial vice-president, are said to be engaged in private accounting. PUBLIC ACCOUNTING : PUBLIC ACCOUNTING The practice of public accounting is generally restricted to licensed CPA’s. Recognizing the need for reliable professional accounting service, the Philippine Legislature passed the Accountancy Act in March 1923. This act created the Board of Accountancy which was given the power among other, to issue the certificate of Certified Public Accountant, abbreviated as CPA. In May 1975, The revised Accountancy Law was released which define the practice of accountancy to include not only CPAs in public practice, but also those in private accounting, in government services and in education, and increased the contents and coverage of subjects in the CPA examinations. PUBLIC ACCOUNTING : PUBLIC ACCOUNTING In Section 10 of the Law, it is provided that: an applicant for the CPA certificate must be a Filipino citizen (or a citizen of foreign country granting reciprocal privileges, by law, to Filipino with respect to the practice of accountancy), of good moral character and at least twenty one year of age. He/she must be a holder of a degree of Bachelor of Science in Commerce or its equivalent from any college or university recognized by the government. The CPA candidate is required to successfully pass a written examination, given by the Board of Accountancy, covering theory of accounts, business law, taxation, management advisory services, auditing theory, auditing theory, auditing problems, practical accounting problem1, problem 2. To practice public accountancy, CPAs and firms or partnerships, including partners and staff members must register with the Professional Regulation Commission, such registration to be made annually. PRIVATE ACCOUNTING : PRIVATE ACCOUNTING The scope of activities and duties of private accountants varies widely. Private accountants are frequently called management accountants. If they are employed by a manufacturing concern, they may be call industrial or cost accountants. The chief accountant in a business may be call controller. Various governmental units and other not-for-profit organizations also employ accountants. Internal auditors are accountants who review the accounting and operating procedures prescribed by their companies. Accountants who specialize in internal auditing may be granted the Certified Internal Auditor (CIA) certificate. RELATIONSHIP OF ACCOUNTING TO OTHER FIELDS : For example, an engineer responsible for selecting the most desirable solution to a technical manufacturing problem may consider cost accounting data to be the decisive factor. Lawyers use accounting data in tax cases and in lawsuits involving property ownership and damages from breach of contract. Governmental agencies rely on accounting data in evaluating the efficiency of government operations and for appraising the feasibility of proposed taxation and spending programs. Accounting plays an important role in modern society and, broadly speaking, all citizens are affected by accounting in some way. RELATIONSHIP OF ACCOUNTING TO OTHER FIELDS SPECIALIZED ACCOUNTING FIELD : SPECIALIZED ACCOUNTING FIELD FINANCIAL ACCOUNTING It is concerned with the recording of transactions for a business enterprise or other economic unit and the periodic preparation of various reports from such records. Corporate enterprise must employ such principles in preparing their annual reports on profitability and financial status for their stockholders and the investing public. SPECIALIZED ACCOUNTING FIELD : SPECIALIZED ACCOUNTING FIELD AUDITING It is a field of activity involving an independent review of the accounting records. In conducting an audit, public accountants examine the records supporting financial reports of an enterprise and express an opinion regarding their fairness and reliability. COST ACCOUNTING It emphasizes the determination and control of costs. It is concerned primarily with the costs of manufacturing processes and of manufactured products, but increasing attention is being given to distribution costs. In addition, one of the principal functions of cost accountants is to assemble and interpret cost data, both actual and prospective for the use of management in controlling current operations and in planning for the future. SPECIALIZED ACCOUNTING FIELD : SPECIALIZED ACCOUNTING FIELD MANAGEMENT ACCOUNTING It employs both historical and estimated data in assisting management in daily operations and in planning future operations. It deals with the specific problems that confront enterprise managers at various organizational levels. The management accountant is frequently concerned with identifying alternative courses of action and in helping to select the best one. TAX ACCOUNTING It encompasses the preparation of tax returns and the consideration of the tax consequences of proposed business transactions or administrative courses of action. Accountants specializing in this field, particularly in the area of tax planning, must be familiar with tax statutes affecting their employer or clients and also must keep up to date on administrative regulations and court decisions on tax cases. SPECIALIZED ACCOUNTING FIELD : SPECIALIZED ACCOUNTING FIELD ACCOUNTING SYSTEM It is the special field concerned with the design and implementation of procedures for the accumulation and reporting of financial data. The systems accountant must devise appropriate “checks and balances” to safeguard business assets and provide for information flow that will be efficient and helpful to management. BUDGETARY ACCOUNTING It presents the plan of financial operations for a period and, through records and summaries provides comparisons of actual operations with the predetermined plans. A combination of planning and controlling future operations, it is sometimes concerned to be a part of management accounting. SPECIALIZED ACCOUNTING FIELD : SPECIALIZED ACCOUNTING FIELD INTERNATIONAL ACCOUNTING It is concerned with the special problems associated with the international trade of multinational business organizations. Accountants specialized in this area must be familiar with the influences of customs law, and taxation of various countries bear on international operations and accounting principles. NOT-FOR-PROFIT ACCOUNTING It specializes in recording and reporting the transactions of various governmental units and other not-for-profit organizations such as church, charities, and educational institutions. An essential element in an accounting system that will insure strict adherence on the part of management to restrictions and other requirements imposed by law, by other institutions, or by individual donors. SPECIALIZED ACCOUNTING FIELD : SPECIALIZED ACCOUNTING FIELD SOCIAL ACCOUNTING It is the newest field of accounting and is the most difficult to describe concisely. One of the engagement in this field involved measurement of traffic patterns in a densely populated section of the nation (like Metro Manila) as part of a government study to determine the most efficient use of transportation funds, not only in terms of facilitating trade but also of assuring a good environment for the area’s residents. BOOKKEEPING AND ACCOUNTING : BOOKKEEPING AND ACCOUNTING BOOKKEEPING is the recording of business data in a prescribed manner. A bookkeeper may be responsible for keeping all the records of a business or only a minor segment, such portion of customer accounts in department store. Much of the work of the bookkeeper is critical in nature and increasingly being accomplished through the use of mechanical and electronic equipment. ACCOUNTING is primarily concerned with the design of the system of records, the preparation of reports based on the recorded data, and the interpretation of the reports. Accountants often direct and review the work of bookkeeper. In event, the accountant must possess a much higher level of knowledge, conceptual understanding, and analytical skill than is required of the bookkeeper. BUSINESS ENTITY CONCEPT : BUSINESS ENTITY CONCEPT The business entity concept is based on identifying the individual economic units for which economic data are needed. Once the entity is identified, the accountant can determine which economic data and activities should be analyzed, recorded, and summarized in reports. The business entity concept is based on the applicability of accounting to individual economic units in society. These individual economic units include all business enterprises organized for profit, numerous governmental units, such as provinces, cities, and towns, other bit-for-profit units like church and clubs, and individual persons and family units. The basic economic data for a unit must first be recorded, followed by analysis and summarization, and finally by periodic reporting. Thus, accounting applies to each separate economic unit. BUSINESS ENTITY CONCEPT : BUSINESS ENTITY CONCEPT This subject is concerned primarily with the accounting principles and techniques applicable to profit making businesses. Such businesses are customarily organized as a sole proprietorship, partnerships, or corporations. A sole proprietorship is owned by one individual. And is owned by two or more individual in accordance with a contractual agreement. A corporation, organized in accordance with the Corporation Law, is a separate legal entity in which ownership is divided into shares of stock. ACTIVITIES PERFORMED BY BUSINESS ORGANIZATION : ACTIVITIES PERFORMED BY BUSINESS ORGANIZATION SERVICE Companies perform services for a fee. Example: Accounting firms, law firms, and other service establishments MERCHANDISING Companies purchase goods that are ready for sale and then sell these goods to customers. MANUFACTURING Companies buy raw materials, convert them into another form of products and the sell the products to other companies or to final consumers. BUSINESS TRANSACTIONS : BUSINESS TRANSACTIONS A business transaction is the occurrence of an event or of a condition that must be recorded. A particular business transaction may lead to an event or condition that constitutes another transaction. ASSETS, LIABILITIES, AND CAPITAL : ASSETS, LIABILITIES, AND CAPITAL The properties owned by a business enterprise are referred to as assets and the rights or claims to the properties are referred to as equities. If the assets owned by the business amount to P1,000,000, the equities on the assets must also amount to P1,000,000. The relation between the two may be stated in the form of an equation, as follows: Assets = Equities ASSETS, LIABILITIES, AND CAPITAL : ASSETS, LIABILITIES, AND CAPITAL Equities may be subdivided into two types: the right of creditors and the rights of owner. The equities of creditors represents debts of the business and are called liabilities. The equity of the owners is called capital or owner’s equity. Expansion of the equation to give recognition to the two basic types of equities yields the following, which is known as the accounting equation: Assets = Liabilities + Capital (or Owner’s Equity) ASSETS, LIABILITIES, AND CAPITAL : ASSETS, LIABILITIES, AND CAPITAL It is customary to place “ Liabilities” before “Capital” in the accounting equation because creditors have preferential rights to the assets. The residual claim of the owner or owners is sometimes given greater emphasis by transposing liabilities to the other side of the equation, yielding: Asset - Liabilities = Capital Every business transaction affects the assets, liabilities and/or capital of the business. However, the changes in these items are such that the equality of two sides of the accounting equation is always maintained. RULES OF DEBIT AND CREDIT : RULES OF DEBIT AND CREDIT Based on the positions of increases and decreases in an account for an asset, liability, or capital item, the rules of debit and credit may be stated as follows: TABLE 1.1 : TABLE 1.1 TRANSACTIONS AND THE ACCOUNTING EQUATION : TRANSACTIONS AND THE ACCOUNTING EQUATION All business transactions, from the simplest to the most complex, can be stated in terms of the resulting change in the three basic elements of the accounting equation. Before a transaction can be recorded in the book of accounts, it must be analyzed into its debit and credit elements. The following questions will be helpful in analyzing a business transaction; Which item (items) is/are affected – Assets, Liabilities, Capital? How is each item affected – it is increased or decreased? According to the rules of debit and credit, is the increase or the decrease in the item to be debited or credited? What account titles should be used to record the debit or credit item? DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING Every business transaction has two-fold effect on the assets, liabilities, and/or capital of the business. For every debit element, there is a corresponding credit element. The money values of these two elements are equal. The manner of recording both the debit and credit elements of each transaction is referred to as double-entry bookkeeping. The double-entry bookkeeping is preferred because it generally result in more accurate accounting records and statements. Moreover, it affords numerous checks and safeguard which reduce to a minimum the chances of loss through intentional r unintentional errors committed by personnel. DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING The effect of these changes on the accounting equation can be demonstrated by studying some typical transactions using the analysis sheet as follows: Table 1.2 : Table 1.2 DOUBLE ENTRY BOOKKEEPING : As the basis of this illustration, assume that on September 1, 19xx Nick Requijo establishes a sole proprietorship to be known as Requijo Taxi. Each transaction or group of similar transactions during the first month of operations is described followed by an illustration of its effect(s) on the accounting equation and the corresponding two-column journal entry and explanation of entry for each give transaction. DOUBLE ENTRY BOOKKEEPING DOUBLE ENTRY BOOKKEEPING : TRANSACTION ONE Nick Requijo deposited P500,000 in a bank account in the name of Requijo Taxi. The effect of this transaction is to increase the asset cash by P500,000 and to increase capital, on the other side of the equation, by the same amount. After the transaction, the equation for Requijo Taxi will appear as follows: DOUBLE ENTRY BOOKKEEPING Table 1.3 : Table 1.3 DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING It should be noted that the equation relates only to the business enterprise. Nick Requijo’s personal assets, such as his home, car, his personal bank account, and his personal liabilities are excluded from consideration. The business is treated as a distinct entity, with cash of P500,000 and the owner’s equity of P500,000. Table 1.4 : Table 1.4 DOUBLE ENTRY BOOKKEEPING : The explanation of each debit or credit entry on the journal is based on the rules of debit and credit. Cash was debited because of increase in asset while Capital was credited because of increase in capital due to investment of the owner. DOUBLE ENTRY BOOKKEEPING DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING TRANSACTION TWO Requijo’s next transaction on September 5 is to purchase land as a future building site, for which P100,000 cash is paid. This transaction changes the composition of the assets but does not change the total amount. The items in the equation prior to this transaction, the effects of this transaction, and the new balance after the transaction are as follow: Table 1.5 : Table 1.5 DOUBLE ENTRY BOOKKEEPING : After the transaction, there is a land costing P100, 000 but the balance is reduced to P400, 000. The total assets composed of cash and land total to P500, 000. Notice that there is no change in the liability and capital items. DOUBLE ENTRY BOOKKEEPING Table 1.6 : Table 1.6 DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING In the transaction recorded, there was a change in the asset element. Land was debited because of increase in assets while Cash was credited because of decrease in assets. The reason for the debit and credit comes from the rules of debit and credit. DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING TRANSACTION THREE Requijo’s current plans are to lease cars and other equipment from California Bus Company for several months until he can arrange financing for the purchase of cars and other equipment and for the construction of garage and storage facilities. On September 7 Requijo purchases P60, 000 of parts and other supplies from various suppliers, agreeing to pay in the near future. This type of transaction is called purchase of supplies on account and the liability created is termed accounts payable. Consumable commodities acquired, such as supplies, are considered to be prepaid expenses. Prepaid expenses are expenses paid in advance and are classified as asset. DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING In actual practice, each purchase would be considered and recorded as it occurred and a separated record would be maintained for each creditor. In this illustration, however, the purchases are recorded as a group. The effect is to increase the assets and liabilities by P600, 000, as indicated below: Table 1.7 : Table 1.7 DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING After this transaction, the total assets amount to P560, 000 composed of Cash P400, 000, Land P100, 000, and Supplies P60, 000. The total equity is also P560, 000 composed of Accounts Payable P60, 000 and Capital of P500, 000. The total of the two column, debit and credit, still balance. Table 1.8 : Table 1.8 Slide 49: In the transaction recorded, Supplies (unused) was debited because of increase in assets while Accounts Payable is credited because of increase in liability. DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING TRANSACTION FOUR On September 9, P10,000 is paid to creditors on account, thereby reducing both assets and liabilities. The effect on the equation is as follows: Table 1.9 : Table 1.9 DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING After this transaction, the total assets amount to P550, 000 composed of Cash P390, 000, Land P100, 000, and Supplies P60, 000. The total equity is also P550, 000 composed of Accounts Payable P50, 000 and Capital P500, 000. The equation is still balance. Table 1.10 : Table 1.10 Slide 54: In the transaction recorded, Accounts Payable was debited because of decrease in liability while cash was credited because of decrease in assets. DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING TRANSACTION FIVE The principal objective of the owner of a business enterprise is to increase capital through earnings. For Nick Requijo, this means that the cash and other assets acquired through the sale of taxi services must be greater than the cost of the gasoline and other supplies used, the wages of drivers, the rent, and all of the other expenses of operating the business. In general, the amount charged to customers for goods or services sold to them is called revenue. Alternative terms may be used for particular types of revenue, such as sales for the sale of merchandise or business services, fees earned for charges by a physician to patients, rent revenue for the use of real estate or other property, and fares earned for Requijo Taxi. DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING In a broad sense, the amount of assets consumed or services used in the process of earning revenue is called expense. Expenses would include supplies used, salaries and wages of employees, and other assets and services used in operating the business. The excess of the revenue over the expenses incurred in earning the revenue is called net income or net profit. If the expenses of the enterprise exceed the revenue, the excess is a net loss. Since it is ordinarily impossible to determine the exact amount of expense incurred in connection with each revenue transactions, it is considered satisfactory to determine the net income or the net loss for a specified period of time, such as a month, or a quarter, a semester, or a year, rather than each of small group of sales. DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING During the first month of operations Requijo Taxi earned fares of P150, 000, receiving the amount in cash. The total effect of these transactions is to increase cash by P150, 000 and to yield revenue in the same amount. The revenue can be viewed as though it affected a P150, 000 increases in capital. At the time expenses of the business are incurred, they are treated as offsets against revenue and hence as reduction in capital. In terms of the accounting equation, the effect of the receipt of cash for services performed follows: Table 1.11 : Table 1.11 DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING After this transaction, the total assets amount to P700, 000 composed of Cash P540, 000, Land P100, 000, and Supplies P60, 000. The total equities are also P700, 000 composed of Accounts Payable P50, 000 and Capital of P650, 000 (including the fare earned). Instead of requiring payment of cash at the time goods or services are sold or rendered, a business may make sales of goods or services on account, allowing customer to pay later. In such cases, the business acquires a claim against the customer, called an account receivable. An account receivable is as much an asset as cash, and the revenue is realized in exactly the same manner as if cash had been immediately received. At a later date, when the money is collected, there is only an exchange of one asset for another, with cash increasing and accounts receivable decreasing. In the transaction recorded, Cash was debited because of increase in assets while Fares Earned was credited because of increase in capital due to increase in revenue. Table 1.12 : Table 1.12 DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING TRANSACTION SIX Various business expenses incurred and paid during the month were as follow: wages, P40, 000; rent, P20, 000; gas and oil, P50, 000; miscellaneous expenses, P10, 000. The effect of this group of transaction is to reduce cash and to reduce capital, as indicated in the following manner in the equation: Table 1.13 : Table 1.13 DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING After this transaction, the total asset amount to P580, 000 composed of Cash P420, 000, Land P100, 000, and Supplies of P60, 000. The total equities are also P580, 000 composed of Accounts Payable P50, 000 and Capital of P530, 000. It should be remembered that revenue and expense accounts are temporary capital accounts; these items are closed to capital at the end of the accounting period. Table 1.14 : Table 1.14 DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING In the transaction recorded, Wages Expense, Rent Expense, Gas and Oil Expense, Miscellaneous Expense were debited because of decrease in capital due to increase in expenses while cash was credited because of decrease in assets. DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING TRANSACTION SEVEN At the end of the month it is determined that the cost of supplies on hand is P40, 000, the remainder of P20, 000 (P60, 000- P40, 000) have been used in the operations of the business. This deduction of P20, 000 in supplies and capital may be shown as follows: After this transaction, the total assets amount to P560, 000 composed of Cash P420, 000, Land P100, 000, and Supplies of only P40, 000. The total equities are also P560, 000 composed of Accounts Payable of P50, 000 and Capital of P510, 000. Table 1.15 : Table 1.15 DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING Table 1.16 Slide 70: In the transaction recorded, Supplies Expense was debited because of decrease in capital due to increase in expenses while Supplies (Unused) was credited because of decrease in assets. Note to Students – The terms “unused”, “unexpired”, “inventory”, and “prepaid” denote asset. DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING TRANSACTION EIGHT At the end of the month, Nick Requijo withdraws from the business P20, 000 in cash for his personnel use. This transaction, which affects a decrease in cash and a decrease in capital, is the exact opposite of an investment in the business by the owner. The withdrawal is not a business expense, and it should be excluded from consideration in determining the net income from operations of the enterprise. The effect of the P20, 000 withdrawals on the equation is as follows: After this transaction, the total assets amount to P540, 000 composed of Cash P400, 000, Land P100, 000, and Supplies of P40, 000. The total equities are also P540, 000 composed of Accounts Payable P50, 000 and Capital P490, 000. Table 1.17 : Table 1.17 DOUBLE ENTRY BOOKKEEPING : DOUBLE ENTRY BOOKKEEPING Table 1.18 . Slide 74: In the transaction recorded, Requijo, Drawing was debited because of decrease of capital due to withdrawal and cash was credited because of decreases in assets SUMMARY : SUMMARY The business transactions of Requijo Taxi are summarized in tabular form below. The transactions are identified by transaction numbers and the balance of each item is shown after each transaction. The following observations, which apply to all types of businesses, should be noted: The effect of every transaction can be stated in terms of increases and/or decreases in one or more of the accounting elements. The equality of the two sides o the accounting equation is always maintained. Table 1.19 : Table 1.19 ACCOUNTING STATEMENTS : ACCOUNTING STATEMENTS BALANCE SHEET A kind of financial statement that list the assets, liabilities, and capital of a business entity as of a specific dated, usually at the close of the last day of a month or of a year. It is a kind of financial statement that shows the financial position of the business entity as of a given date, usually the end of the year. The amount of Requio Taxi’s assets, liabilities, and capital at the end of the first month of operation appears on the last line of the summary in the preceding page. Minor arrangements of these data and the addition of a heading yield the balance sheet illustrated below. This form of balance sheet, with the liability and capital section presented below the asset section, is called the report form. Another arrangement in common use lists the assets on the left and the liabilities and capital on the right. Because of its similarity to the account, a basic accounting device described earlier in the chapter, it is referred to as the account form of the balance sheet. Requijo TaxiBalance SheetSeptember 30, 19xx : Requijo TaxiBalance SheetSeptember 30, 19xx Assets Cash P400, 000 Supplies 40, 000 Land 100, 000 Total Assets P540, 000 Liabilities Accounts Payable P 50, 000 Capital Capital 490, 000 Total Liabilities and Capital P540, 000 Slide 79: It is customary to begin the asset section with cash, which is followed by receivables, inventory (for trading business), supplies, prepaid expense items, and other assets that will be converted into cash or consumed in the near future. The assets of a relatively permanent nature, such as land, buildings, and equipment, follow in that order. Note that in the balance sheet presented the total assets and the total of liability and capital are equal. The balance sheet shows the liquidity (solvency) and stability of as enterprise. Solvency refers to the ability of the business to pay currently maturing liabilities while stability refers to the ability of the enterprise to pay maturing obligations and give return on the investment of the owner(s). Slide 80: In the liabilities and capital section of the balance sheet, it is customary to present the liabilities first followed by capital. In the illustration for Requijo Taxi the liabilities are composed entirely of accounts payable. When there are two or more categories of liabilities, each should be listed and the total amount of liabilities presented in the following manner: ACCOUNTING STATEMENTS : ACCOUNTING STATEMENTS Liabilities Accounts Payable P150, 000 Notes Payable 50, 000 Salaries Payable 6, 000 Total Liabilities P206, 000 ACCOUNTING STATEMENTS : ACCOUNTING STATEMENTS INCOME STATEMENT A kind of financial statement that shows the summary of the revenue and the expenses of a business entity for a specific period of time, such as a month or a year. It is a kind of financial statement that shows result of business operations for a period of time, usually a year. Revenue earned and expenses incurred during the month were recorded in the equation as increases and decreases in capital, respectively. The details together with net income in the amount of P10, 000, are reported in the income statement presented below. Requio TaxiIncome StatementFor the Month Ended September 30, 19xx : Requio TaxiIncome StatementFor the Month Ended September 30, 19xx Fares Earned P150, 000 Operating Expenses Gas & Oil Expense P 50, 000 Wages Expense 40, 000 Rent Expense 20, 000 Supplies Expense 20, 000 Miscellaneous Expense 10, 000 Total Operating Expenses 140,000 Net Income P 10, 000 Slide 84: The order in which the operating expenses are presented in the income statement varies among businesses. One of the arrangements commonly followed is to list them in the order of size, beginning with the larger items. Miscellaneous expenses is usually shown as the last item regardless of the amount. In the income statement, users will know if the operation of the business is profitable. Profitability refers to the ability of the business to increase owner’s capital. If the total net asset inflow is more than the net asset outflow, the resulting effect is net income. If the net asset outflow is more than the net asset inflow, it is a net loss. ACCOUNTING STATEMENTS : ACCOUNTING STATEMENTS CAPITAL STATEMENT (Statement of Owner’s Equity) It is a statement that shows the summary of the changes in capital of a business entity that have occurred during a specific period of time, such a month or a year. Comparison of the original investment of P500, 000 at the beginning of the month with the P490, 000 of capital reported in the balance sheet at the end of the month reveals a decrease of P10, 000. This net decrease is composed of two significant changes in capital that occurred during the period: (1) the net income of P10, 000, and (2) a withdrawal of P20, 000 by the owner. This information is presented in the capital statement, which serves as a connecting link between the balance sheet and the income statement. Requijo TaxiCapital StatementFor the Month Ended September 30, 19xx : Requijo TaxiCapital StatementFor the Month Ended September 30, 19xx Capital, September 1, 19xx P500, 000 Net Income P10, 000 Withdrawal 20, 000 Decrease in Capital 10, 000 Capital, September 30, 19xx P490, 000 Slide 87: Basically, there are two accounting period, the calendar year and the fiscal year. A calendar year is a twelve-month period that ends on December 31 while the fiscal year is a twelve-month period that ends at the end of any month other than December. In the Philippines, only partnership and corporation are allowed to use fiscal year, single proprietorship is allowed only to use calendar year. ACCOUNTING STATEMENTS : ACCOUNTING STATEMENTS STATEMENT OF CASH FLOWS The statement of cash flows consists of three sections: (1) operating activities, (2) financing activities, and (3) investing activities. Each of these sections is described below: Cash Flows form Operating Activities This section reports a summary of cash receipts and cash payments from operations. The net cash flow from operating activities will normally differ from the amount of net income for the period. This difference occurs because revenues and expenses may not be recorded at the same time that cash is received from customers and cash is paid to creditors. ACCOUNTING STATEMENTS : ACCOUNTING STATEMENTS Cash Flows from Financing Activities This section reports the cash transactions related to cash investments by the owner, borrowing, and cash withdrawals by the owner. Cash Flow from Investing Activities This section reports the cash transactions for the acquisition and sale of relatively long-term or permanent-type assets. The preparation of the statement of cash flow is required by pronouncement, every year that the income statement is presented. Preparing the statement of cash flows requires an understanding of concepts that we will not discuss in the chapter. But a simple illustration will be given to be able to illustrate how statement of cash flow is prepared. Requijo TaxiStatement of Cash FlowsFor the Month Ended September 30, 19xx : Requijo TaxiStatement of Cash FlowsFor the Month Ended September 30, 19xx Cash Flows from Operating Activities: Net Income P10, 000 Add: Increase in Supplies 40, 000 Total P50, 000 Less: Increase in Accounts Payable 50, 000 Cash from Operating Activities P 0 Cash Flows from financing Activities Investment of Owner 500, 000 Cash Flows from Investing Activities Acquisition of Land (100, 000) Increase in Cash P400, 000 CHAPTER 2The Accounting Cycle : CHAPTER 2The Accounting Cycle THE ACCOUNTING CYCLE : THE ACCOUNTING CYCLE The double entry accounting system provides a basic framework for the analysis of business activities. Now we wish to go into greater detail about the accounting procedures used to account for the operations of a business during a specific period. The accounting procedures of most businesses involve certain basic steps that are accomplished in a given order. This sequence of operations is known as the accounting cycle. THE ACCOUNTING CYCLE : THE ACCOUNTING CYCLE The steps of the accounting cycle are listed below: 1. Gather documents and analyze transactions from source documents. 2. Record transactions in journals. 3. Post journal entries to general ledger accounts. 4. Prepare a trial balance. 5. Prepare adjusting entries and adjust the general ledger accounts. 6. Prepare financial statements. 7. Journalize closing entries. 8. Prepare post-closing trial balance. 9. Journalize reversing entries. Slide 94: The annual period adopted by a business enterprise is known as fiscal year. Business enterprises whose fiscal year ends in December are said to be on a calendar-year basis. Many enterprises prefer to have their accounting year coincide with their “natural” business year; that is, the fiscal year ends when business is slow and inventory quantities are small and easy to count. STEP 1ANALYZING TRANSACTIONS FROM SOURCE DOCUMENTS : STEP 1ANALYZING TRANSACTIONS FROM SOURCE DOCUMENTS Source documents are printed or written forms that generate when the enterprise engages in business transactions. Even a brief source document usually specifies the peso amount involved, the date of transaction, and possibly the party dealing with the enterprise. Some examples of source documents are (1) a purchase or seller’s invoice showing evidence of a purchase of merchandise (or supplies) on account, (2) a bank check indicating the payment of obligation, (3) a deposit slip showing the amount of funds turned over to the bank, (4) a cash receipt indicating funds received from a customer, and (5) a cash register tape listing a day’s over-the-counter sales to customers. BUSINESS PAPERS : BUSINESS PAPERS All business transactions are evidenced supported by printed forms or documents, called business papers. These business papers furnish the information needed in recording business transactions. Without business papers, it would be difficult to keep accurate record of business transactions. The following are good example of business papers commonly used in a business: BUSINESS PAPERS : BUSINESS PAPERS 1. Sales or Service Invoice – after the sale of goods of service has taken place, a business form called invoice is prepared. The invoice shows the date of sale/service rendered, list of the articles sold or list of services rendered, and other information. Invoices are prenumbered and usually made out in triplicate or quadruplicate depending upon the need of the business. The original of the invoice is given to the buyer of goods or services. In a merchandising business, from the point of vies of the seller, the invoice is called sales invoice; from the point of view of the buyer, it is a purchase invoice. The sample of an invoice is given below. Table 2.1 : Table 2.1 BUSINESS PAPERS : BUSINESS PAPERS 2. Official Receipt – official receipt are issued every time the business receives cash. The receipt shows the date on which the cash is received, the party from whom the cash is received, the amount of cash received, the explanation of the transaction, and the signature of the personnel who issued the receipt. Table 2.2 : Table 2.2 BUSINESS PAPERS : BUSINESS PAPERS 3. Statement of Accounts – many business like Meralco, P.L.D.T., M.W.S.S., SMART Communication, Inc., and others send bills to their customers to inform them of the amount they have to pay. Thus, there are electric bills, light bills, water bills, telephone bills, and many others. These bills sent by these companies are called Statement of Account. A sample of statement of account is given below. Table 2.3 : Table 2.3 BUSINESS PAPERS : BUSINESS PAPERS 4. Deposit Slip – at present, many businesses have current account or checking accounts with the banks. They deposit their money in the bank and the payment from their deposit are made by means of issuing checks. Deposit slip is filled up every time money is deposited in the bank. The deposit slip shows the date of the deposit , the name if the depositor, the account number of the depositor, the amount of cash deposited, and the signature of the depositor. BUSINESS PAPERS : BUSINESS PAPERS 5. Check – a check is an order to the bank signed by the person issuing it (the depositor), to pay the bearer or order a certain sum of money. After the bank have paid the payee, the amount is deducted from the deposit of the person who issued the check. BUSINESS PAPERS : BUSINESS PAPERS 6. Cash Voucher – the cash voucher is the document prepared every time payment of an obligation is made. The voucher is a business’ preprinted form that is prenumbered, and should include the following information; date of payment, name of the payee, address of the payee, description of the obligation to be paid, amount paid, approval of payment\, and signature of the payee. A sample of cash voucher is presented below. Table 2.4 : Table 2.4 BUSINESS PAPERS : BUSINESS PAPERS 7. Cash Register Slip – in many businesses, like in restaurants, cash registers are used. Strip of paper comes out as evidence of the money received by the cashier. The slip shows the date, items ordered, amount paid, and other information. 8. Other Business papers – there are many other documents that are used by accountant to obtain information regarding business transactions. When buyer/customer is given allowance, returned the goods purchased, or discovered error in the invoice, the seller of the goods or services should be notified. If the claim is valid, the seller of goods or services sends a credit memorandum which shows the amount by which account is reduced. When the depositor obtains a checkbook from the bank and the depositor did not pay it, the bank charges the depositor a debit memorandum. Promissory Notes may be received by the business from its debtors, or the business may give it to its creditors. A promissory note is a written promise to pay signed by one party, called the maker, to pay a certain specified sum to another. The note may or may not be interest bearing. The amount to be paid not including the interest, is called the face of the note. The amount to be paid including the interest is called the maturity value. STEP 2JOURNALIZING : STEP 2JOURNALIZING Journalizing is the process of recording business transactions to the book of original entry called journals. Journals, or records of original entry, are tabular records in which business activities are analyzed in terms of debits and credits and recorded in chronological order before they are entered in the general ledger. An accounting journal may be one of a group of special journals, or it may be a general journal. STEP 2JOURNALIZING : STEP 2JOURNALIZING A special journal is designed to record a specific type of frequently occurring business transactions. For example, a business with 100 employees who are paid every two weeks would probably use a special journal for payrolls. Because two paydays would normally occur in a month, at least 200 payroll transaction would be recorded. Special journals are used to facilitate the recording of business transactions in the book of accounts. Other types of transactions that are often recorded in special journals are cash receipts, cash disbursements, sales of goods or services, and purchases of goods or services. STEP 2JOURNALIZING : STEP 2JOURNALIZING In contrast to the special journals, the general journals (two-column journal) is a relatively simple record in which any type of business transaction may be recorded. All businesses, even those using many special journals, have a general journal. Transactions that do not occur often enough to warrant entry in a special journal are recorded in the general journal. STEP 2JOURNALIZING : STEP 2JOURNALIZING The procedure for recording entries in the general journal is as follows: Indicate the year, month, and date of the entry. Usually the year and month are rewritten only at the top of each journal or at the point where they change. Enter titles of the accounts affected in the description column. Accounts debited are entered close to the left-hand margin and are traditionally recorded first. Accounts credited are then recorded, indented one-half inch to the right. Place the appropriate money amounts in the left-hand (debit) and right (credit) money columns. Write an explanation of the transaction below the account titles, indented one-half inch from margin. The explanation should be as brief as possible, disclosing the information necessary to understand the event being recorded. STEP 2JOURNALIZING : STEP 2JOURNALIZING Each transaction entered in the journal should stated in terms of equal debits and credits. The account titles cited in the description column should correspond to those used for the related general ledger accounts. To separate clearly the various entries, we should leave a line blank between entries. We will explain the use of the column headed “Post Ref.” (posting reference) later in step 3 of the accounting cycle. Table 2.5 : Table 2.5 STEP 2JOURNALIZING : STEP 2JOURNALIZING Compound Journal Entries A journal entry that involves more than just two accounts is called a compound entry. The last journal entry in Exhibit 1-2 is an example of compound journal entry involving three accounts. The debit of P9,600 to Test Equipment is offset by credits of P5,000 to Cash and P4,600 to Accounts Payable. Any number of accounts may appear in a compound entry; but regardless of how many accounts are used, the total of the debit amounts must always equal the total of the credit amounts. STEP 2JOURNALIZING : STEP 2JOURNALIZING Correction of Journal Errors Certain procedures should be followed when errors are found in journal entries. Errors should not be erased, because erasures completely remove the original recording. As you might imagine, the acceptance of erasures might allow someone to falsify accounting records; consequently, other procedures are used. If an error journal entry has not been transferred to the general ledger, a single line is drawn through the erroneous amount or accounts title, and the correction is entered on the same line just above the error. Often the person correcting the entry must place his or her initials near the correction. This facilitated any further inquiry about the nature of or reason for the correction. Once an erroneous journal entry has been transferred to the ledger accounts, both records contain error. The recommended procedures for correcting this situation are discussed in step 3 below. STEP 3POSTING TO THE LEDGER : STEP 3POSTING TO THE LEDGER After transactions have been journalized, the next step in the accounting cycle is to transfer the debits and credits in each journal entry to the appropriate general ledger accounts. Thus, data from the journal that stresses the total of particular transaction (such as collection of accounts receivable) are transcribed to a ledger that stresses the total effect of many business transactions on a particular business variable (such as cash, accounts receivable, and so on). This type of data is specifically needed for the preparation of financial statements. STEP 3POSTING TO THE LEDGER : STEP 3POSTING TO THE LEDGER Posting References It is important to be able to trace any entry in a ledger account to the journal from which it was posted. Consequently, accounting records use a system of references. Both journals and accounts have posting reference columns. Entries in the posting reference columns of journals indicate the account to which the related debit and credit has been posted. Posting references appearing in ledger accounts identify the journal from which the related entry was recorded. The posting references in the journals and ledger accounts are entered when the journal entries are posted to the ledger accounts. STEP 3POSTING TO THE LEDGER : STEP 3POSTING TO THE LEDGER Chart of Accounts A chart of accounts is usually prepared in order to facilitate the analysis of activities and the formulation of journal entries. The chart of accounts is a list of the titles and numbers of all accounts found in the general ledger. The account titles should be grouped by, and in order of, the five major sections of the general ledger (assets, liabilities, owner’s equity, revenue, and expenses). Exhibit 1-3 shows a chart of accounts for Dalay TV Service, indicating the account numbers that will now be used. Table 2.6 : Table 2.6 STEP 3POSTING TO THE LEDGER : STEP 3POSTING TO THE LEDGER Illustration Of Posting. Exhibit 1-4 of Dalay TV Service’s December transactions from the general journal to the ledger accounts. Each debit entry is posted as follows: The date (year, month, and day) is entered in the appropriate account. Note that this is the date of the journal entry, not necessarily the date of the actual posting. As with journals, the year and month are restated only at the top of a new accounts page or at the point where they change. The amount is entered in the account as a debit or a credit, as indicated in the journal’s money columns, and the new balance is calculated. The posting reference from the journal (both symbol and page number) is placed in the posting reference column of the ledger account. The account number is placed in the posting reference column of the journal. STEP 3POSTING TO THE LEDGER : STEP 3POSTING TO THE LEDGER Regardless of the type of journals or the number of entries involved, the total debit posted should equal the total credit posted. Exhibit 1-4 (see following pages) is a comprehensive illustration of the journalizing and posting of the December transactions of Dalay TV Service. You should review each transaction in the illustration form. the nature of the transaction the related journal entry, and the subsequent postings. Bear in mind that the account numbers in the posting reference of the journal are not entered when the journal entry in recorded; they are inserted when the entry is posted. Table 2.7 : Table 2.7 STEP 3POSTING TO THE LEDGER : STEP 3POSTING TO THE LEDGER The foregoing should have been noted in the illustration; in every entry in the journal the debit amount equal the credit amount. Debit amount in the journal are posted to the debit side of the corresponding accounts in the general ledger. In like manner, credit amounts in the journal are posted to the credit side of the corresponding accounts in the general ledger. Therefore, it follows that the sum of the debit amounts and that of the credit amounts would also be equal in the ledger. STEP 3POSTING TO THE LEDGER : STEP 3POSTING TO THE LEDGER Correction Erroneous Postings Even the most carefully kept accounts will occasionally contain posting errors. An error involving only the wrong amount being posted may be corrected by drawing a line through the incorrect amount, entering the correct amount above, and initialing the correction. When an amount has been posted to the wrong account, however, the correction should be made with a journal entry. Some common errors are as follows: transposition (transfer of position) which means that there was a change in the position of numbers, e.g. 936 was written as 396; slide (transplacement) which means that the decimal point was placed in wrong position, e.g. 10,000 was written as 1,000 or 100,000. more detailed discussion on this matter is provided in the section of adjusting entry. STEP 4PREPARATION OF A TRIAL BALANCE : STEP 4PREPARATION OF A TRIAL BALANCE After the journal entries have been posted to the general ledger accounts, a trial balance is prepared from the general ledger. Periodically, a test of the equality of the debit amounts and credit amounts in the general ledger is made. The test is known as the trial balance. It is usually prepared at the end of a month, a quarter, a semester, or a year. Preparatory to the setting of the trial balance, each general ledger account with more than one entry on either side is footed. Pencil footing means that the temporary total of the amounts of each side of the account is taken. Each of the debit totals and credit totals of the accounts are written (in pencil) just below the last entry on the particular side. This facilitate the determination of the account balance after transactions have been posted. Accounts with only one entry on either side need not be footed. STEP 4PREPARATION OF A TRIAL BALANCE : STEP 4PREPARATION OF A TRIAL BALANCE Open and Closed Accounts The difference between a debit total and a credit total of an account is called account balance. When the debit total and credit total of an account are not equal, the account is said to be an open account (with balance). When the debit total and credit total of an account are equal, the account is said to be, closed account ( without balance). STEP 4PREPARATION OF A TRIAL BALANCE : STEP 4PREPARATION OF A TRIAL BALANCE Types of Trial Balance Trial balance could either be trial balance of totals or trial balance of balances. The trial balance of totals is a list of all accounts (that have entry, whether open or closed) in the general ledger with their total debit amounts and total credit amounts. For this reason, it is called trial balance of totals. The trial balance of balances is a list of the open accounts in the general ledger and their balances. Only open accounts are included when preparing trial balance of balances, closed accounts are excluded. The conventional way is the preparation of trial balance of balances rather than the trail balance of totals. This type of trial balance is commonly used because it gives the detailed information needed in the other steps of the accounting cycle. The preparation of the trial balance is more of a check on the arithmetical accuracy of the accounting records rather than an absolute guarantee that all generally accepted accounting principles, practices, and procedures have been complied accurately. STEP 4PREPARATION OF A TRIAL BALANCE : STEP 4PREPARATION OF A TRIAL BALANCE Steps in Preparing Trial Balance Prepare the trial balance in a two-column journal. Heading should be written on top of the page. The heading shows the name of the business on the first line. Trial balance on the second line, and the date on the third line. Each line of the heading must be centered on the page. Write the title of each open account on the Account Titles column. If the account has a debit balance, write the balance in the debit column of the trial balance. If it has a credit balance, write the balance on the credit amount column. All the account titles in the trial balance are written with the same margin from the left side of the page, that is, credit account titles should not be indented. Add each amount column to prove that the two totals are equal. If the two totals are equal, draw lines under the totals. STEP 4PREPARATION OF A TRIAL BALANCE : STEP 4PREPARATION OF A TRIAL BALANCE The trial balance of the Dalay TV Service at December 31 is shown in Exhibit 1-5. showing all the general ledger account balances in one report, as is done in this trial balance, makes it easier to review the accounts and determine which account balances need to be adjusted before preparing the financial statements. Table 2.8 CHAPTER 3Adjusting Entries and the Preparation of the Financial Statements : CHAPTER 3Adjusting Entries and the Preparation of the Financial Statements Adjusting Entries and the Preparation of the Financial Statements : Adjusting Entries and the Preparation of the Financial Statements Before the books of accounts are adjusted at the end of the accounting period, the accounts may be classified into real, nominal, and mixed. Real accounts are the asset, liability, and the capital accounts. Nominal accounts are the expense and income accounts. Mixed accounts are those which contain both real and nominal elements and which are adjusted at the end of the period so that their balances become either purely real or purely nominal. Thus, after the accounts have been adjusted, only real and nominal accounts exist; the real and nominal elements contained in the mixed accounts have been recorded in separate accounts. STEP 5: GATHERING DATA TO ADJUST THE ACCOUNTS AND PREPARATION OF A WORKSHEET : STEP 5: GATHERING DATA TO ADJUST THE ACCOUNTS AND PREPARATION OF A WORKSHEET ADJUSTING ENTRIES UNDER THE ACCRUAL BASIS OF ACCOUNTING The extent and nature of adjusting entries depend on the basis on which the books are kept by the enterprise. There are generally two methods of keeping accounting records; the cash basis and the accrual basis. Under the cash basis of accounting revenues are recognized as expense on the period of payment. In the accrual basis of account, revenues are recognized are recognized as income on the period that revenue is earned not in the period of collection, while expenses are recognized as expense on the period that it was incurred not on the period of payment. STEP 5: GATHERING DATA TO ADJUST THE ACCOUNTS AND PREPARATION OF A WORKSHEET : STEP 5: GATHERING DATA TO ADJUST THE ACCOUNTS AND PREPARATION OF A WORKSHEET The application of the accrual basis of accounting necessitates adjusting entries for the following seven items: Doubtful Accounts Depreciation Accrued Expenses Accrued Revenue Prepaid Expenses Unearned Revenue (Deferred Revenue) Ending Merchandise Inventory DOUBTFUL ACCOUNT : DOUBTFUL ACCOUNT DOUBTFUL ACCOUNTS When a business allows customers to avail services on credit, it maybe inevitable that some of the receivables will not be collected. The loss which is a result of worthless or bad accounts is referred to as doubtful accounts expense. For proper income measurement, it is important that a provision for the uncollectible accounts be provided during the same period that the income from services is recognized. This produces a better matching of revenues and expenses and, therefore, a better income measurement procedure. Using this procedure, operations are charged with estimated expenses, and receivables are reduced by means of a contra asset account – Allowance for Doubtful Accounts. DOUBTFUL ACCOUNT : DOUBTFUL ACCOUNT The provision for doubtful accounts is based on estimate and is computed usually as a percentage of credit revenues or as a percentage of outstanding accounts receivable. The purposes of the adjustment are: (1) to record the doubtful account expense during the same period that the related revenue is recognized, and (2) to report the accounts receivable at the approximate collectible amount. DOUBTFUL ACCOUNT : DOUBTFUL ACCOUNT ADJUSTING ENTRY FOR DOUBTFUL ACCOUNTS The pro-forma adjusting journal entry for the estimated loss on uncollectible account is: Table 3.1 Slide 139: To illustrate, let us assume the following data as part of the trial balance of an enterprise rendering repair services for home appliances: Table 3.2 DOUBTFUL ACCOUNT : DOUBTFUL ACCOUNT Percentage Revenue Assume it was provided that the expected uncollectible account during the year would be equal to 1% of the Service Income earned during the period, the adjusting entry for doubtful accounts would be: Table 3.3 : Table 3.3 DOUBTFUL ACCOUNT : DOUBTFUL ACCOUNT Percentage Receivable When the provision for doubtful accounts is based on percentage of receivable, it may based on the following estimates of computation: (1) allowance for doubtful accounts increased (decreased) by percentage of outstanding receivable, or (2) allowance for doubtful accounts increased (decreased) to percentage of outstanding receivable. It should be noted that the difference of the two methods is only the words by and to, but it should be remembered because it makes a lot of difference. DOUBTFUL ACCOUNT : DOUBTFUL ACCOUNT Allowance for Doubtful Accounts Increased BY percentage of receivable Assume that it was agreed that the allowance for doubtful accounts will be increased by 1% of the outstanding receivable. The adjusting journal entry will be: Table 3.4 Slide 144: Note that if the allowance for doubtful accounts will be increased by percentage of receivable, the doubtful accounts expense is computed by multiplying the receivable by the given percentage. DOUBTFUL ACCOUNT : DOUBTFUL ACCOUNT Allowance for Doubtful Accounts Increase TO percentage of receivable Assume that it was agreed that the allowance for doubtful accounts will be increased to 1% of the outstanding receivable. The adjusting journal entry will be: Slide 146: Table 3.5 DOUBTFUL ACCOUNT : DOUBTFUL ACCOUNT Computation: Balance after adjustment (P50,000 x 1%) P500 Less: Balance before adjustment 200 Amount of adjustment for Doubtful Accounts 300 Note that if the allowance for doubtful account will be increased to percentage of receivable, the doubtful account expense is computed by multiplying the receivable by the given percentage to compute for the desired balance of the allowance after adjustment, then the balance before the adjustment is deducted from it to arrive at the amount of doubtful accounts to be provided. DEPRECIATION : DEPRECIATION DEPRECIATION When the business entity acquired tangible fixed assets such as delivery equipment, furniture, computer, machines, building, and other long-life assets, it is basically paying in advance for the usefulness of such asset. These assets help generate revenue for the entity. Each accounting period in which such assets are used should share a portion of their cost as expense. Proper accounting requires the systematic allocation (assignment) of the cost of the assets over its estimated useful life. Depreciation is the assignment of part of the cost of the asset over the period it was used to properly match the revenue and cost of that period. The following three factors are considered in the computation of depreciation: Cost of the fixed asset The estimated useful life The estimated scrap value of the asset Slide 149: Table 3.6 Adjusting Entry for Depreciation DEPRECIATION : DEPRECIATION The account Depreciation is an expense account while the account Accumulated Depreciation is a contra asset account which is deducted from the appropriate fixed asset account when preparing a balance sheet. To illustrate, assume that an equipment was purchased on January 1 of the year for P1,000,000. It has an estimated life of 10 years and a scrap value of P100, 000 after its useful life. At the end of the year, before the financial statements are prepared, annual depreciation should be adjusted. The annual depreciation is computed as follows: Formula to Compute Annual Depreciation: Cost of Asset - Scrap Value Estimated Useful Life DEPRECIATION : DEPRECIATION At the end of the accounting period, the depreciation to be provided would amount to P90, 000 (P1,000,000 – P100, 000 ÷ 10 years ). Accordingly, the adjustment would be: Table 3.7 Slide 152: The method used in computing depreciation for the equipment is the straight-line method. This is the simplest and the most commonly used method in computing depreciation. DEPRECIATION : DEPRECIATION Depreciation expense is the assigned portion of the cost of the fixed asset to the periods during which it is used. Accumulated depreciation is the total accumulated amount of depreciation that has been recorded for the fixed asset. The difference between the cost of the fixed asset and the accumulated depreciation is the book value of the asset. The book value represent the portion of the cost of the fixed asset that has not yet been recorded as depreciation expense. In the illustration provided above, the equipment would be presented in the balance sheet as follows: Equipment P1,000,000 Less: Accumulated Depreciation 90,000 Book Value P 910,000 The accumulated depreciation account is known as the contra-asset account, since it is presented as a deduction from the asset account. DEPRECIATION : DEPRECIATION Fractional Depreciation In the illustration given, it was assumed that the asset is used for one year. Let us assume now that the equipment was acquired only July 1 (not January 1) and was used only for six months. How much depreciation should be provided as of December 31 of the year? Formula to Compute Fractional Depreciation Cost of Asset – Scrap Value x ½ = Fractional Depreciation Estimated Useful Life DEPRECIATION : DEPRECIATION Following the given formula, the depreciation to be provided at the end of the year would be P45, 000 (P1,000,000 – P100, 000 ÷ 10 years x ½ ). The adjusting entry to record the depreciation of the above equipment would be: Slide 156: Table 3.8 ACCRUED EXPENSES : ACCRUED EXPENSES 3. ACCRUED EXPENSES Accrued Expenses are expenses already incurred but not yet paid. The business usually incurs expenses but may take time before it could pay them. Usually expenses is recorded when payment is made. If at the end of the period the expense is not yet paid, it may therefore still be unrecorded. This situation creates understatement of expenses on the income statement which will overstate the net income and understate liabilities in the balance sheet. Consequently, an adjustment is needed to up-date the accounts for proper financial statement presentation. The accrued expenses are usually incurred on various continuing services provided to the business such as electricity, water, telephone, taxes, rental, interest, salaries and many others. Adjusting Entry for Accrued Expenses The pro-forma adjusting journal entry for accrued expense is: Table 3.9 : Table 3.9 ACCRUED EXPENSES : ACCRUED EXPENSES Illustration. Assume Nikko Jay Service Co. is renting a shop location at the rate of P20, 000 per month. Its lease agreement provides that payment of rental should be made on or before the 5th day of every month for the month after the facility was used. Meaning, October rental should be paid by November 5, November rental should be paid December 5, and so on. At December 31, when the business will prepare the financial statements, the December rental is still unpaid although they have use the facility. Correspondingly, because rent expense is understated and liability is understated too, an adjusting entry as follows is necessary: Table 3.10 : Table 3.10 ACCRUED REVENUE : ACCRUED REVENUE ACCRUED REVENUE Accrued revenues are revenue already earned but collection has not yet been received. Many kinds of revenues like revenue from interest, revenue from commission, from rental on property, are recorded only when received. It goes to say, therefore, that when no collection is received these revenues are not yet recorded. This results in the understatement of revenue account on the income statement and subsequently understatement of receivable account in the balance sheet. Consequently, an adjusting entry is necessary to up-date and correct the accounts to be able to present reliable financial statements. Adjusting Entry for Accrued Revenue The pro-forma adjusting entry for accrued revenue is: Table 3.11 : Table 3.11 ACCRUED REVENUE : ACCRUED REVENUE Illustration: In the preceding illustration for Nikko Jay Co. above, was analyzed on the point of view of the lessee. Let us now analyze it from the point of view of the owner of the owner of the property. If you were the owner of the property, at the end of December, you have already earned your rent revenue because they have already used the property but you have not received their payment. This is a good example of accrued revenue. For this illustration, the necessary adjusting entry is: Table 3.12 : Table 3.12 PREPAID EXPENSES : PREPAID EXPENSES PREPAID EXPENSES Prepaid expenses are expenses already paid but not yet incurred. Expenses could be paid in advance. Some example of prepaid expenses are rent paid in advance, advertising paid in advance, interest on discounted notes, purchase of supplies, and insurance premium paid on the beginning of the policy period. Prepaid expenses are assets, not expenses. The terms prepaid, unexpired, unused, on hand, and inventory denotes assets. At the end of the accounting period, when the portion of these assets have been used or expired, they become expense that requires adjustment. Advance payment of expenses (Prepaid expense) could be recorded in the accounting records under any one of the two methods: (1) the asset method, and (2) the expense method. PREPAID EXPENSES : PREPAID EXPENSES The Asset Method The asset method is the procedure of recording the advance payment of expenses by debiting an asset account. At the end of the accounting period, the asset recorded could have been partly used up, rendering the asset account debited to be overstated while the expense account is understated. This situation requires the preparation of an adjusting entry to correct and up-date the accounts for proper financial statement presentation. Entry for Prepaid Expenses using Asset Method The journal entry to record the payment of expenses using the asset method is: Table 3.13 : Table 3.13 Note that asset account is debited to record the advance payment of expenses. For this reason, it is called asset method. PREPAID EXPENSES : PREPAID EXPENSES Adjusting Entry for Prepaid Expenses using Asset Method The pro-forma adjusting journal entry for prepaid using the asset method is: Table 3.14 : Table 3.14 PREPAID EXPENSES : PREPAID EXPENSES Illustration. Assume that on September 1 if the current year, Ma. Gina Trucking Service paid six-month advertising amounting to P120, 000 to Ace Advertising Company. If the asset method of recording is used, then the entry on September 1 will be: Table 3.15 Slide 171: Analysis. The rate of advertising per month is P20, 000 (P120, 000 ÷ 6). At December 31, the end of the accounting period, P80, 000 (P20, 000 x 4 months) of the advertising applicable to the months of September to December have expired while P40, 000 (P20, 000 x 2 months) the portion applicable to the months of January and February (next year) remains unused. At December 31, the recorded prepaid advertising is P120, 000, when it should only be P40, 000. PREPAID EXPENSES : PREPAID EXPENSES The asset is overstated by P80, 000, the same amount of understatement of the advertising expense account. At December 31, the adjusting entry should be: Table 3.16 Slide 173: It should be noticed in the analysis, that the account debited in the original entry (upon payment) is the account credited on the adjustment. It is so because the account debited in the recording of the payment is overstated at the end of the period. PREPAID EXPENSES : PREPAID EXPENSES The Expense Method The expense method is the procedure of recording the advance payment of expenses by debiting an expense account. At the end of the accounting period, the expense recorded could not have been used up, rendering the expense account debited to be overstated while the asset is account understated. This situation requires the preparation of adjusting entry to correct and up-date the accounts for proper financial statement presentation. Original Entry for Prepaid Expenses using Expense Method The journal entry to record the payment of expenses using the expense method is: Table 3.17 : Table 3.17 Note that expense account is debited to record the advance payment of expenses. For this reason, it is call expense method. PREPAID EXPENSES : PREPAID EXPENSES Adjusting Entry for Prepaid Expenses using Expense Method The pro-forma adjusting journal entry for prepaid expenses using the expense method is: Table 3.18 PREPAID EXPENSES : PREPAID EXPENSES Illustration. We will be using the same data for asset method, on the P120, 000 advertising paid by Ma. Gina Trucking Service to Ace Advertiser Company for the period September 1 (current year) to February (next year). If the expense method of recording is used, then the entry for September 1 would be: Table 3.19 Slide 180: Analysis. The analysis made using the asset method is still valid. But, because the expense account was debited and the P120, 000 is not all used up, the expense account is overstated by P40, 000, the portion applicable to the months of January and February (next year). It is the same amount of understatement of the asset (prepaid) account. Table 3.20 PREPAID EXPENSES : PREPAID EXPENSES It should be noticed in the analysis, that the account debited in the original entry (upon payment) is the account credited on the adjustment. It is so because the account debited in the recording of the payment is overstated at the end of the period. In the two analysis provided, both for the asset method and the expense method, it should be noted that after the adjustment have been recorded in the accounts the resulting balance for both accounts will be the same, P80, 000 for Advertising Expense and P40, 000 for Prepaid Advertising. The amounts represent the correct balances in our analysis. UNEARNED REVENUE (Deferred Revenue) : UNEARNED REVENUE (Deferred Revenue) Unearned revenues are revenues already received (collected) but not yet earned. Sometimes the business receives payment for the services (or goods) before service is actually rendered. When such revenues are received in advance, the enterprise has an obligation to perform services (or delivery of goods). The liability is referred to as unearned revenue. Like in prepaid expenses, advance receipt of revenue (Unearned revenue) may be recorded in the accounting records under any one of the two methods: Liability Methods Revenue Methods UNEARNED REVENUE (Deferred Revenue) : UNEARNED REVENUE (Deferred Revenue) The Liability Method The liability method is the procedure of recording the advance receipt of revenue by crediting a liability account. At the end of the accounting period, the liability recorded could have been partially earned rendering the liability account credited to be overstated and the revenue account understated. This situation requires the preparation of adjusting entry to correct and up-date the accounts for proper financial statement presentation. Original Entry for Unearned Revenue using Liability Method The journal entry to record the receipt of revenue in advance using the liability method is: Table 3.21 : Table 3.21 UNEARNED REVENUE (Deferred Revenue) : UNEARNED REVENUE (Deferred Revenue) Adjusting Entry for Unearned Revenue using Liability Method The pro-forma adjusting journal entry for unearned revenue using the liability method is: Table 3.22 Table 3.22 : Table 3.22 UNEARNED REVENUE (Deferred Revenue) : UNEARNED REVENUE (Deferred Revenue) Illustration. Assume that on August 1, the business received P72, 000 from a tenant, representing 6-month advance rental, covering the period from August (current year) to January (next year). If the liability method is used, the entry on August 1 would be: Table 3.23 : Table 3.23 UNEARNED REVENUE (Deferred Revenue) : UNEARNED REVENUE (Deferred Revenue) Analysis. The rate of the monthly rental is P12, 000 (P72, 000 ÷ 6). At December 31, the end of the accounting period, P60, 000 (P12, 000 x 5 months) of the rent applicable to the months of August to December have been earned while P12, 000 the rent applicable to the month of January (next year) remains unearned. At December 31, the recorded unearned rent per record before any adjustment is P72, 000, when it should only be P12, 000. The liability account is overstated by P60, 000, the same amount of understatement of the rent revenue account. At December 31, the adjusting entry should be: It should be noted in the analysis, that the account credited in the original entry (upon receipt of revenue) is the account debited on the adjustment. It is so because the account credited in the recording of the receipt of revenue is overstated at the end of the period. Table 3.24 : Table 3.24 UNEARNED REVENUE (Deferred Revenue) : UNEARNED REVENUE (Deferred Revenue) The Revenue Method The revenue method is the procedure of recording the advance receipt of revenue by crediting a revenue account. At the end of the accounting period, the revenue recorded could not have been all earned, rendering the revenue account credited to be overstated and the liability account understated. This situation requires the preparation of an adjusting entry to correct and up-date the accounts for proper financial statement presentation. Original Entry for Unearned Revenue using Revenue Method The journal entry to record the receipt of revenue in advance using the revenue method is: Table 3.25 : Table 3.25 UNEARNED REVENUE (Deferred Revenue) : UNEARNED REVENUE (Deferred Revenue) Adjusting Entry for Unearned Revenue using Revenue Method The pro-forma adjusting journal entry for unearned revenue using the revenue method is: Table 3.26 : Table 3.26 Slide 196: Illustration. Applying the same example in the liability method, that on August 1, the business received P72, 000 from a tenant, representing a 6-month advance rental covering the period from August (current year) to January (next year), if the revenue method is used, the entry would be: Table 3.27 UNEARNED REVENUE (Deferred Revenue) : UNEARNED REVENUE (Deferred Revenue) Analysis. The rate of the monthly rental is P12, 000 (P72, 000 ÷ 6). At December 31, the end of the accounting period, only P60, 000 (P12, 000 x 5 months) of the rent applicable for the months of August to December have been earned while P12, 000 the rent applicable to the months of January (next year) remains unearned. At December 31, the recorded rent revenue before any adjustment is P72, 000, when it should only be P60, 000. The revenue account is overstated by P12, 000, the same amount of understatement of the unearned rent account. At December 31, the adjusting entry should be: Table 3.28 : Table 3.28 UNEARNED REVENUE (Deferred Revenue) : UNEARNED REVENUE (Deferred Revenue) It should be noticed in the analysis, that the account credited in the original entry (upon receipt of revenue) is the account debited on the adjustment. It is so because the account credited in the recording of the receipt of revenue is overstated at the end of the period. PREPARATION OF THE WORK SHEET : PREPARATION OF THE WORK SHEET The work sheet is also a tool used by the accountant to facilitate the preparation of adjusting entries, closing entries, and financial statements. It is a columnar paper which can be used for the following purposes: Compute adjustments and the adjusted balances of the accounts. Classify the accounts into income statement accounts (nominal accounts) and balance sheet accounts (real accounts) for financial statements preparation. Determine net income (or loss). PREPARATION OF THE WORK SHEET : PREPARATION OF THE WORK SHEET Accountants often use work sheet to facilitate preparation of financial statements. The financial statements maybe prepared directly from the trial balance if the business has relatively few accounts and if it shows the correct balances of the accounts. If not, adjustments must therefore be posted to the general ledger to bring the balances to correct amounts. To facilitate such work, the trial balance may be prepared on a work sheet (may be called analysis sheet), a multi-column document which provides efficient way of summarizing necessary data for the financial statements preparation. Using the work sheet, the accountant is assured of the mathematical accuracy of his work. PREPARATION OF THE WORK SHEET : PREPARATION OF THE WORK SHEET The following steps are followed when preparing the work sheet: Place the heading at the center of the columnar form: Name of the Company, Work Sheet, and, the period covered. Place the trial balance on the first section (first two column). List the accounts as they appear in the general ledger. See to it that the debit and credit totals are balanced. Enter all the adjustments in the next section (third and fourth columns). Use numbers or letters to identify each entry. Prove equality of the debit and credit amounts, double-rule if equal. New account titles are placed below, in the appropriate account title column. Complete the next section (fifth and sixth columns), extend the adjusted balances of all accounts to the adjusted trial balance columns. PREPARATION OF THE WORK SHEET : PREPARATION OF THE WORK SHEET Complete the statement sections, extend the fourth section (seventh and eight columns) all income statement accounts (nominal accounts), and to the fifth section (ninth and tenth columns) all balance sheet accounts (real accounts). Determines the net income (or net loss) by analyzing the column totals of the income statement columns. If the credit column total exceed the debit column total, it represent net income. If the debit column total exceed the credit column total, it represent a net loss. PREPARATION OF THE WORK SHEET : PREPARATION OF THE WORK SHEET Illustrative Problem – Preparation of Work Sheet. Sagum Laboratory began operation on January 1, 19xx, and provides various diagnostic services for physicians and clinics. Its accounting period ends December 31 and the accounts are adjusted annually on this date. Its unadjusted trial balance at December 31, 19xx, is as follows: Slide 205: Sagum Laboratory Trial Balance December 31, 19xx Account Titles Debit Credit Cash 1, 000 Accounts Receivable 9, 200 Medical Supplies 31, 300 Prepaid Insurance 6, 000 Laboratory Equipment 270, 000 Accumulated Depreciation – Laboratory Equipment 60, 000 Accounts Payable 3, 000 Unearned Diagnostic Fees 4, 000 Cecil Sagum, Capital 110, 000 Diagnostic Fees 220, 000 Salaries and Wages Expense 58, 000 Rent Expense __________________ Total 397, 500 397, 500 Table 3.29 : Table 3.29 STEP 6PREPARATION OF FINANCIAL STATEMENTS : STEP 6PREPARATION OF FINANCIAL STATEMENTS After the worksheet has been completed, the formal financial statements are prepared. The kind of financial statements have been illustrated, the nature and form of the income statement and the balance sheet have been taken up in Chapter 1. The financial statement of Sagum Laboratory will be prepared with the aid of a worksheet in this chapter. Basically, there are two principal accounting statements for a sole proprietorship: the balance sheet and the income statement. The balance sheet is that kind of financial statement that shows the financial position of the business as of a given date, usually the end of the accounting period. The income statement is the kind of financial statement that shows results of operations for a period of time, usually a year, STEP 6PREPARATION OF FINANCIAL STATEMENTS : STEP 6PREPARATION OF FINANCIAL STATEMENTS Kinds of Income Statement Single-step form – in this type of income statement, all revenues are grouped together in one section, and all expenses in another section. The net income or net loss are determined by deducting the total expenses from the total revenue. Multi-step form Forms of Balance Sheet Report Form - a balance sheet that presents the assets on the top section and the liabilities and owner’s equity at the bottom section of the report. Slide 209: Sagum Laboratory Balance Sheet As of December 31, 19xx ASSETS Current Assets Cash P 1,000 Accounts Receivable P 9,200 Less: Allowances for Doubtful Depreciation P 300 P 8,900 Medical Supplies P 6,300 Prepaid Insurance P 4,500 Total Current Assets P 20,700 Property, Plant, and Equipment Laboratory Equipment P 270,000 Less: Accumulated Depreciation P 90,000 Total Property, Plant, and Equipment 180,000 Total Assets P 200,700 LIABILITIES Current Liabilities Accounts Payable P 3,100 Unearned Diagnostic Fees 1,000 Salaries Payable 600 Rent Payable 2,000 Total Current Liabilities P 6,700 OWNER’S EQUITY Cecil Sagum, Capital (per Capital Statement) 194,000 Total Liabilities and Owner’s Equity P 200,700 Slide 210: Account Form – the balance sheet that is presented in account form presents the assets o the left side and the liabilities and owner’s equity on the right side of the statement. Name of Company Balance Sheet As of December 31, 19xx ASSETS LIABILITIES AND OWNER’S EQUITY Total Current Assets xxx Total Liabilities xxx Total Property, Plant, and Equipment xxx Owner’s Equity xxx Total Assets xxx Total Liabilities and owner’s Equity xxx STEP 6PREPARATION OF FINANCIAL STATEMENTS : STEP 6PREPARATION OF FINANCIAL STATEMENTS Other method of Presentation There is a Form of balance sheet presentation that gives emphasis on the current working capital position of the business, the financial position form. In the first section, the total current liabilities are deducted from the total current assets to arrive at the working capital. In the second section, the total of the property and equipment is added to working capital and the long-term liabilities are deducted to arrive at the net assets and owner’s equity. STEP 6PREPARATION OF FINANCIAL STATEMENTS : STEP 6PREPARATION OF FINANCIAL STATEMENTS Classification of Assets For a service business, assets are normally classified in the balance sheet into the (1) current, and (2) property and equipment. Current Assets includes cash and other assets that will be converted into cash or used up by the business , whichever is longer. Cash is any medium of exchange that the bank accepts at face value. It includes deposits in banks available for current operations at the balance sheet date, plus cash on hand consisting of currency, undeposited checks, drafts, and money orders. These are items without restriction and available for current operations of the business. Accounts Receivable is the amount owed to a business by customers (clients). It is evidenced by an oral promise to pay. Notes Receivable is same as account receivable except that the customer or client gives a promissory note to evidence its obligation. Prepaid Expense is also known as Deferred Expenses which is the expenses paid in advance. It is an asset awaiting assignment to expense. An example is prepaid insurance. STEP 6PREPARATION OF FINANCIAL STATEMENTS : STEP 6PREPARATION OF FINANCIAL STATEMENTS Property, plant and equipment is an asset acquired for use in a business rather than for resale; also called plant assets or fixed assets. Land is the ground on which the business buildings of the enterprise are located. Land can also be used for outside storage space or a parking lot. Building is an edifice or structures constructed on the land, such as office building. Equipments are those items refer to the filing cabinet, calculator, adding machine, cash register, and computer used either in the office, store, or for delivery. Delivery Equipment refers to trucks, cars, motorcycles, and other transportation vehicles used for delivery purposes. Furnitures and Fixtures refers to the tables and chairs, cabinet, counter, and other fixtures used in the business. STEP 6PREPARATION OF FINANCIAL STATEMENTS : STEP 6PREPARATION OF FINANCIAL STATEMENTS Classifications of Liabilities Current Liabilities are debts usually due within one year, the payment of which normally will require the use of current assets. Accounts Payable is the amount owed by the business to creditors for the items or services purchased from them. Notes Payable are unconditional written promises by an enterprise to pay certain sum of money at a determinate future date. Salaries and Wages Payable are amounts owed to employees for services rendered but for which payment has not been made at the balance sheet date. Interest Payable arises when interest has been incurred but not yet paid at the balance sheet date because the amount is not due on Notes Payable until later. Unearned Revenue or Deferred Revenue is payments for services or sale of goods that are received in advance from customer or client. Long-term Liabilities are liabilities not due for a relatively long period of time, usually more than one year. STEP 6PREPARATION OF FINANCIAL STATEMENTS : STEP 6PREPARATION OF FINANCIAL STATEMENTS Classification of Owner’s Equity Owner’s Equity is the claim of the owner over the asset of the business. It is residual claim because it will only be satisfied after the payment of the obligation of the business to its creditors. Owner’s Capital is the investment of the owner of the business. Owner’s Drawing is the withdrawals of the owner on the capital and earnings of the business. Income Summary is an account used in the closing process for transferring the revenue and expense account balances to the owner’s capital account at the end of the period. STEP 6PREPARATION OF FINANCIAL STATEMENTS : STEP 6PREPARATION OF FINANCIAL STATEMENTS Classifications of Revenue Professional Fees is the income or remuneration received by professionals from rendering services to clients. The fee could be described depending upon the line of professional like legal fee for lawyers, dental fee for dentist, medical fee for doctors, and retainer’s fee or audit fee for CPAs. Other Revenues are revenues derived from sources other than the principal line of service rendered like interest, rent, and commission. STEP 6PREPARATION OF FINANCIAL STATEMENTS : STEP 6PREPARATION OF FINANCIAL STATEMENTS Classification of Operating Expenses Operating Expense is the cost of the services that are used or consumed in the operation of the business or practice of profession like salaries and wages, rent, supplies, utilities, taxes, insurance and others. Salaries and Wages Expenses are payments made to employees for the services they rendered to the business. Rent Expenses are expenses incurred for the use of rented facility like building. Supplies Expense is the cost office stationery, envelopes, pencils, pens and other necessary supplies used in the business. Utilities Expense refers to the various expenses incurred by the business on water, electricity, telephone, and other means of communication to customers or clients. Insurance Expense is payment made for the premium of an insurance policy. Advertising Expense is payment made to the advertisement of the business or practice of the profession. CHAPTER 4Completing the Accounting CycleThe Closing Process : CHAPTER 4Completing the Accounting CycleThe Closing Process COMPLETING THE ACCOUNTING CYCLETHE CLOSING PROCESS : COMPLETING THE ACCOUNTING CYCLETHE CLOSING PROCESS Nature of closing process At the end of the accounting period, the revenue and expense account balances are reported in the income statement. The expenses are deducted from revenues to determine the net income or net loss during the period. Since revenues and expenses are reported for each period, the balances of these accounts should be zero at the beginning of the next period. The zero balances allow the next period’s revenues and expenses to be recorded separately from the preceding period. Because the balances of revenue and expense accounts are not carried forward, they are generally called temporary accounts or nominal accounts. The balances of the accounts reported in the balance sheet are carried forward from year to year. Because of their permanent nature, balance sheet accounts are called real accounts. COMPLETING THE ACCOUNTING CYCLETHE CLOSING PROCESS : COMPLETING THE ACCOUNTING CYCLETHE CLOSING PROCESS How are the end-of-period of balances of temporary accounts converted to zero? To begin, the revenue and expense account balances are transferred to an account called Income Summary. The balance of Income Summary is then transferred owner’ capital account and the balance of the owner’s drawing account is transferred to owner’s capital accounts. At the end of an accounting period, the balance of the owner’s drawing account is reported on the statement of owner’s capital (statement of owner’s equity). The owner’s withdrawal are deducted from the net income or added to the net loss for the period to determine the net increase or decrease in owner’ equity. Since withdrawals are reported for each period, the balance of the owner’s drawing accounts should be zero at the beginning of the next period. Thus the owner’s drawing account is also a temporary account. Its balance is transferred to the owner’s capita; account at the end of the period. STEP 7JOURNALIZING AND POSTING CLOSING ENTRIES : STEP 7JOURNALIZING AND POSTING CLOSING ENTRIES Revenue, expense, and drawing account balances are transferred to the owner’s equity account by a series of entries called closing entries. The transfer process is called closing process. Four entries are required at the end of the period. For sole proprietorship, these entries are as follows: Debiting all nominal accounts with credit balances (revenues) and crediting the total to Income Summary account. Crediting all nominal accounts with debit balances (expenses), and debiting the total to Income Summary. the Net Income is transferred to the Capital account by debiting the Income Summary for the amount of its balance and the Capital account is credited for the same amount. (The accounts debited and credited are reversed if there is a net loss). the drawing account is transferred to capital account by debiting the capital account and crediting the drawing account for the same amount. STEP 7JOURNALIZING AND POSTING CLOSING ENTRIES : STEP 7JOURNALIZING AND POSTING CLOSING ENTRIES The account titles and balances in preparing the closing entries may be obtained from either the work sheet, the income statement, the statement of owner’s equity, and or ledger. If a work sheet is used, the date for the first two entries appeared in the Income Statement columns. The amount for the third entry is the net income or net loss appearing at the bottom of the work sheet. The drawing account balance appears in the Balance Sheet debit column of the work sheet. The closing entries for Sagum Laboratory (See illustration on Chapter 3) is shown below: Table 4.1 Table 4.1 : Table 4.1 STEP 7JOURNALIZING AND POSTING CLOSING ENTRIES : STEP 7JOURNALIZING AND POSTING CLOSING ENTRIES After the closing entries have been posted to the ledger, the balance in the capital account will agree with the amount reported on the statement of owner’s equity and the balance sheet. In addition, the revenue, expense, and drawing accounts will have zero balances. It should be noted that Income Summary is used only at the end of the period. At the beginning of the closing process, Income Summary has no balance. During the closing process, Income Summary will be debited and credited for various amounts. At the end of the closing process, Income Summary will again have no balance. Because income summary has the effect of clearing the revenue and expense accounts of their balances, it is sometimes called a clearing account. Other titles used for this account include Revenue and Expense Summary, Profit and Loss Summary, and Income and Expense Summary. Balancing and ruling After the closing process, a line should be inserted in both balance columns opposite the final entry. If the books will still be used in the next accounting period, the next period’s transaction for the revenue, expense, and drawing will be posted directly below the closing entry. STEP 8POST-CLOSING TRIAL BALANCE : STEP 8POST-CLOSING TRIAL BALANCE The last accounting procedure for a period is to prepare a trial balance after the closing entries have been posted. The purpose of post-closing (after closing) trial balance is to make sure that the ledger is in balance at the beginning of the next period. The accounts and amounts should agree exactly with the accounts and amounts listed on the balance sheet at the end of the period. The post-closing trial balance of Sagum Laboratory is shown in Exhibit 4-1 below. Table 4.2 Table 4.2 : Table 4.2 STEP 8POST-CLOSING TRIAL BALANCE : STEP 8POST-CLOSING TRIAL BALANCE Instead of preparing a formal post-closing balance, it is possible to list the accounts directly from the ledger, using a printing calculator or a computer. The calculator tape or computer printout, becomes the post-closing trial balance. Without such tape or printout, there are no efficient means of determining the cause of inequality. STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES Some of the adjusting entries recorded at the end of the accounting period have an important effect on otherwise routine transactions that occur in the following period. A typical example is accrued wages owed to employees at the end of the period. If there has been an adjusting entry for accrued wages expense, the first payment of wages in the following period will include the accrual. In the absence of some special provision, Wages Payable must be debited for the amount owed for the earlier period, and the Wages Expense must be debited for the portion of the payroll that represents expense for the later period. However, an optional entry --- the reversing entry ---- may be used to simplify the analysis and recording of this first payroll entry in a period. As the tem implies, a reversing entry is the exact reverse of the adjusting entry to which it relates. The amounts and accounts are the same as the adjusting entry; the debits and credits are reversed. Reversing entries are generally made on the first day of the next accounting period. Adjustments that can be reversed are enumerated as follows. Accrued expenses Accrued revenues Prepaid expenses, if expenses method is used Unearned revenues, if the revenue method is used STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES Reversing Entry For Accrued Expenses Accrued expenses of the present period are usually pain in the next period. If the adjusting entries for accrued expenses are not reversed, the accrued expenses paid in the next period necessarily be debited to the accrued liability account. However, if there are reversing entries for these items, all expenses pain in the future, whether accrued or not, can be consistently debited to the expense accounts. Illustration: analysis of the adjusting entry, closing entry and reversing entry for accrued Expense. On December 31, the end of the accounting period, the business have issued a nine-percent, six-month note for P20,000 dated accrued interest on this note is P300 (P20,000 x 9% x 2/12). The adjusting entry for this is: Table 4.3 Table 4.3 : Table 4.3 STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES The closing entry for the Interest Expense account at December 31 is: Table 4.4 Slide 232: On January 1, the Reversing Entry for the accrued interest (expense) is: Table 4.5 STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES After this entry, all interest paid, whether accrued or not could be debited to Interest Expense. The credit to Interest Expense in the reversing entry will serve to adjust the account balance to the amount of interest incurred in the current period. The debit to Interest Payable in the reversing entry closes the credit to the same account in the adjusting entry. Thus, the accounts Interest Expense and Interest payable after the adjusting entry and reversing entries have been posted are as follows: Table 4.6 : Table 4.6 Table 4.7 : Table 4.7 STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES At April 30, the date of maturity of the note, the total interest to be paid in the note is P900 (P20,000 x 9% x 6/12). Upon payment, an entry debiting Interest Expense will be made and if the entry is posted to the Interest Expense account, the account will appear as follows. Table 4.8 This shows that while the interest pain in April amounted to P900, only the balance of the account of P600 (P900 – P300) is the expense incurred and paid in April, and the P300 is payment of accrued interest. Table 4.8 : Table 4.8 STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES Reversing Entry for Accrued Revenue Accrued revenue for the present period is usually collected in the next accounting period. If no reversing entry is made, this accrued revenue when received in the future must necessarily be credited to the accrued revenue account. However, if there is a reversing entry, all revenue in the future, whether accrued or not, can be uniformly credited to the revenue account. STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES Illustration: analysis of the adjusting entry, closing entry and reversing entry for accrued interest revenue. Using the same illustrative example as above, let us now analyze it on the point of view of the recipient of the note. On December 31, the end of the accounting period, the business received a none-percent, six-month note for P20,000 dated November 1 (current year0 collectible April 30 (next year). At December 31, the accrued interest on this note is P300 (P20,000 x 9% x 2/12). The adjusting entry for this is: Table 4.9 Table 4.9 : Table 4.9 STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES The closing entry for the Interest Income at December 31 is: Table 4.10 On January 1, the reversing entry for the accrued interest revenue is: Table 4.11 Table 4.10 : Table 4.10 Table 4.11 : Table 4.11 STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES After this entry, all interest collected, whether accrued or not could be credited to Interest Revenue. The debit to Interest Revenue in the reversing entry will serve to adjust the account balance to the amount of interest earned in the current period. The credit to Interest Receivable in the reversing entry closes the debit to the same account in the adjusting entry. Thus, the accounts Interest Revenue and Interest Receivable after the adjusting entry and reversing entries have been posted are as follows: Table 4.12 Table 4.13 Table 4.12 : Table 4.12 Table 4.13 : Table 4.13 STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES At April 30, the date of maturity of the note, the total interest to be collected on the note in P900 (20,000 x 9% 6/12). Upon collection, a P900 entry to credit Interest Revenue account, the account will appear as follows: Table 4. 14 This shows that while the interest collected in April amounted to P900, only the balance of the account of P600 (P900 – P300) is the revenue earned and collected in April, and the P300 is collection of accrued interest. Table 4. 14 : Table 4. 14 STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES Reversing Entry for Prepaid Expenses Asset Method is when an expense paid in advance is debited to and Asset Account, the adjusting entry to record the expense incurred during the current period need not be reversed because there will be no inconsistency of recording that will occur in the next period. Expense Method is when an expense is paid in advance is debited to an Expense Account, the adjusting entry to record the asset (prepaid) portion of the expense should be reversed on the beginning of the next period, to ensure consistency of the method of recording being used and for proper recognition of the expense on the proper accounting period. STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES Illustration. Analysis of the original entry, adjusting entry, closing entry and reversing entry on Prepaid Expenses, when Expense Method is used. On October 1, current year, the business paid P50,000 to Ace Realty, representing 5-month rent covering the period October (current year) to February (next year). At December 31, only P30,000 for three months (October to December) rental have been used up. The remainder is applicable to the months of January and February next year. The original entry to record transaction, upon payment is: Table 4.15 : Table 4.15 STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES The adjusting entry for the Prepaid Rent at December 31 is: Table 4.16 The closing entry for the Rent Expense at December 31 is as follows: Table 4.17 Table 4.16 : Table 4.16 Table 4.17 : Table 4.17 STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES After these entries are posted, the Prepaid Rent account and the Rent Expense account will be as follows: Table 4.18 Table 4.19 It should be noted that the Prepaid Rent has become a closed account and the Rent Expense account has a debit balance of P20,000. Thus, in the next period, the adjustment under the expense method can be used again. Table 4.18 : Table 4.18 Table 4.19 : Table 4.19 STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES Reversing Entry for Unearned Revenues Liability Method is when a revenues received in advance is credited to a Liability Account, the adjusting entry to record the revenue earned during the current period need not be reversed because there will be no inconsistency of recording that will occur in the next period. Revenue Method is when a revenue received in advance is credited to a Revenue Account, the adjusting entry to record the liability (Unearned) portion of the revenue should be reversed on the beginning of the next period, to ensure consistency of the method of recording being used and for proper recognition of the revenue on the proper accounting period. STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES Illustration. Analysis of the original entry, adjusting entry, closing entry and reversing entry on Unearned Revenue, when Income Method is used. On September 1, current year, the business received P48,000 from a tenant, representing 6-mont rent covering the period September (current year) to February (next year). At December 31, only P32,000 for four months (September to December) rental have been earned, the remainder of P16,000 applicable to the months of January and February next year is still unearned. The original entry to record the transaction, upon collection is: Table 4.20 Table 4.20 : Table 4.20 STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES The adjusting entry for the Unearned Rent at December 31 is: Table 4.21 The closing entry for the Rent Revenue at December 31is: Table 4.22 Table 4.21 : Table 4.21 Table 4.22 : Table 4.22 STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES On January 1, the reversing entry for the Unearned Rent is: Table 4.23 After these entries are posted, the Unearned Rent account and the Rent Revenue account will be as follows: Table 4.24 Table 4.23 : Table 4.23 Table 4.24 : Table 4.24 STEP 9REVERSING ENTRIES : STEP 9REVERSING ENTRIES It should be noted that the Unearned Rent has become a closed account and the Rent Revenue account has a credit balance of P16,000. Thus, in the next period, the adjustment under the revenue method can be used again. The following are the main purposes of reversing entries that should be remembered: (1) consistency in the use of method, and (2) recording of revenues and expenses in the proper accounting period. Thank you! : Thank you! PRESENTED BY: Julie Anne P. Jamora Nancy Bunag Acknowledgment : Acknowledgment Special thanks to the writers of the book “Accounting Fundamental”, Bayani D. Edlagan and Ma. Cecilia S. Mercado, for without them this presentation would not be possible. Polytechnic University of the PhilippinesTaguig Campus : Polytechnic University of the PhilippinesTaguig Campus As partial requirement in the subject OS 341“Web Page Development ”, this project is submitted by Julie Anne Jamora and Nancy Buñag to Prof. Angela David. You do not have the permission to view this presentation. In order to view it, please contact the author of the presentation.