1. CHAPTER 1
1. Business Types, Forms, and its Requirements
Introduction
A business entity is an organization that uses
economic resources to provide goods or services
to customers in exchange for money or other
goods and services.
It is a person or organization engaged in the
regular conduct of commercial, industrial or
professional activities, whether for profit or not, in
order to fulfill a purpose, goal, mission or cause.
It is the regular conduct or pursuit of a commercial
activity or an economic activity, including
transactions incidental thereto, by any person
regardless of whether or not the person is engaged
therein is a non-stock, non-profit private
organization or government entity. (Sec 105, NIRC)
Key Notes
Business:
Person or organization Business
Regular conduct
Commercial, industrial or professional activities
Conducted in the Philippines
Lawful transactions
Whether for profit or not
To fulfill a purpose, goal, mission or cause
Types of Business
There are four major types of businesses:
1. Service Business
A service type of business provides intangible
products (products with no physical form) for a
fee. Service type entities offers professional skills,
expertise, advice, and other similar products.
Examples of service businesses are:
o Business services, such as accounting,
advisory, taxation, legal, auditing firms,
etc.
o Automotive repairs, car rental, car wash,
parking spaces
o Personal services, such as laundry, beauty
salon, photography
o Recreation facilities, amusement parks,
bowling centers, golf courses, theatres
o Hospitals and clinics, schools, museums,
banks
o Hotel and lodging
2. Merchandising Business
A merchandising business buys products and sells
the same at prices higher than their purchase
costs. They are known as "buy and sell" businesses.
A merchandising business buys a product and sells
it without changing its form.
Examples of this type of business are grocery
stores, convenience stores, distributors, and other
resellers.
3. Manufacturing Business
A manufacturing business buys materials and
converts them into a new product.
A manufacturing business combines raw
materials, labor, and overhead costs in its
production process. The goods produced will then
be sold to customers.
Examples of manufacturing businesses are:
o Automobile manufacturing, Aerospace
and Shipbuilding
o Paper industry for producing paper,
cardboard and related products
o Fashion Industry for producing textiles,
clothing, footwear, accessories and
cosmetics
o Consumer Goods production such as
foods, beverages and toiletries
o Printing & Publishing materials and books
4. Mixed/Hybrid Business
These are companies that can be classified in more
than one type of business. They run different
departments or divisions for different purposes.
2. An example of this is a restaurant, combines
ingredients in making a fine meal (manufacturing),
sells a cold bottle of wine (merchandising), and fills
customer orders (service).
Forms of Business Organization
These are the basic forms of business ownership:
1. Sole Proprietorship
The sole proprietorship is the simplest business
form under which one can operate a business. It is
a business owned by only one person and is
personally responsible for its debts. The sole
proprietorship is usually adopted by small business
entities due to its simplicity, ease of setup, and
nominal cost. The owner faces unlimited liability;
meaning, the creditors of the business may go
after the personal assets of the owner if the
business cannot pay them.
The advantages of a sole proprietorship include:
o Owners can establish a sole
proprietorship instantly, easily and
inexpensively.
o Owner has full control over business
decisions
The disadvantages of a sole proprietorship
include:
o Owners are subject to liability for the
debts, losses and liabilities of the business
o Limited source of funds
2. Partnership
A partnership is a business owned by two or more
persons who contribute resources into the entity,
and divide the profits among themselves.
Generally, all partners have unlimited liability. In
limited partnerships, creditors cannot go after the
personal assets of the limited partners.
The advantages of a partnership include:
o Relatively easy to establish compared to a
corporation
o Talents and strengths of each partner can
best be utilized
o Minimal paperwork and legal restrictions
The disadvantages of a partnership include:
o Partners have unlimited liability with
regard to the liabilities and debts of the
business
o Limited ability to raise capital
o Divided authority
3. Corporation
Corporation is a business organization that has a
separate legal personality from its owners. It is
usually adopted by large business organizations.
Ownership is usually represented by shares of
stock.
The advantages of a corporation include:
o Can generate large amounts of capital
from investments
o easy to transfer ownership
The disadvantages of a corporation include:
o not easy to set-up and organize
o owners (stockholders) enjoy limited
liability but have limited involvement in
the company's operations.
Not considered engaged in business:
Government agencies and
instrumentalities
Pure compensation employment (local or
abroad, private or government)
Directorship in a corporation
Gratuitous transfer of properties by
succession or donation
Isolated or casual transactions by persons
not engaged in trade or business
Also considered engaged in business:
Freelancers, agents and consultants
Broadcast media talents and artists
3. Legal Requirements
1. Business Name and Entity Registration:
Depending on the form of the business, it must
register with the following government agencies:
1. Sole Proprietorship -
Department of Trade and
Industry (Business Name
Registration)
2. Partnership or Corporation -
Securities and Exchange
Commission (Registration
System)
2. Secure Business Permits and Licenses
Depending on the nature of its activities, the
business must secure its permits and licenses in
the city or municipality where it conducts its
business. Generally, the following will be obtained:
1. Business Permit - from the
Mayor's Office
2. Fire Safety Inspection Certificate
- from the Bureau of Fire
Protection
3. Barangay Clearance and
Community Tax Certificate -
from the barangay where the
business is operating
4. Employer Registration - SSS,
HDMF, PHIC, DOLE (if applicable)
3. Comply with BIR Requirements:
The business entity must also comply with the
following requirements of the Bureau of Internal
Revenue:
1. Business registration
2. Issuance of receipts and invoices
3. Keeping of tax and accounting
records
4. Withholding of taxes on certain
payments
5. Filing and payment of taxes
However profitable or noble the purpose of the
business may be, the failure of the business entity
to comply with any of these requirements might
lead to penalties, fines, surcharges or, at worst,
closure of the business.
After the registration and securing all the
necessary certificates and permits, the company
needs to maintain its accounting records.
Summary Notes
Business - organization that uses economic
resources to provide goods or services to
customers in exchange for money or other
goods and services.
Types of Business:
1. Service Business - provides intangible
products for a fee.
2. Merchandising Business - buy and sell
merchandise
3. Manufacturing Business - buys
materials and converts to a new
product
4. Mix/Hybrid Business - more than one
type of business
Forms of Business:
1. Sole proprietorship - owned and
controlled by only one person
2. Partnership - owned by partners who
agree to undertake business to make
profit
3. Corporation - a legal entity owned by
shareholders
Legal Requirements
1. Business Name and Entity Registration
2. Secure Business Permits and Licenses
3. Comply with BIR requirements
4. 2.Introduction to Accounting
Accounting is commonly known as the "language
of business". It provides financial information
about the organization through financial reports to
different users to help them in making decisions.
By learning this language, you can communicate
and understand the financial operations of any and
all types of organizations. It means that accounting
allows us to see things like how much money the
business is earning, how much money the business
spend and more.
Definition
Accounting is a service activity. Its
function is to provide quantitative
information, primarily financial in nature,
about economic entities that is intended
to be useful in making economic decisions
(Accounting Standards Council).
Accounting is an information system that
measures, processes and communicates
financial information about an
identifiable economic entity.
Accounting is the process of identifying,
measuring and communicating economic
information to permit informed judgment
and decision by users of the information
(American Accounting Association).
Accounting is the art of recording,
classifying, and summarizing in a
significant manner and in terms of money,
transactions and events which are, in part
at least of financial character, and
interpreting the results thereof (American
Institute of Certified uublic Accountants).
Purpose of Accounting
The purpose of accounting is to provide financial
information about the business that will be useful
in making economic decisions of the users of the
information.
Let's have a simple illustration:
Mr. Juan Dela Cruz started a Repair Service Shop.
Initially, he invested Php 25,000 to open a mini
repair shop. There are many customers and the
business went well. One day, one of his primary
equipment was broken and decided to buy a more
advanced equipment. He then applies for a loan in
a bank to buy a new equipment. The bank officer
asked Mr. Juan how much profit did he made for
the year, how much his assets are worth, how
much debt he has, what his cash flow is each
month. With no recording of transactions, Mr.
Juan wasn't able to answer the questions and
consequently, the bank officer did not approve Mr.
Juan's loan application.
We can easily answer the bank officer's questions
if we kept track of the company's transactions. If
we used Php 15,000 to buy equipment and Php
2,000 to pay rents, then we'd have Php 8,000 cash
left. If we collected Php 10,000 from our
customers, then we would have Php 18,000.
Accounting is important to keep track of business
transactions. It is clear that the ultimate purpose
of accounting is to provide information to different
users. The users utilize the information in making
economic decisions.
Financial Statements
Accounting information is data about a business
entity’s transactions. Once identified and
analyzed, the information is then recorded,
classified, and it eventually finds its way into
various reports commonly called Financial
Statements. Financial Statements are summary
accounting reports prepared periodically to inform
interested parties as to the financial condition and
operating results of the business. The following are
the Financial Statements generally prepared to
provide information to different users.
1. Statement of Financial Performance (Income
Statement) - The financial statement that
summarizes revenues and expenses for a specific
period of time, usually a month or a year. Income
statements are always prepared for a period of
time and the term “for the period ended” is
included in the title.
2. Statement of Changes in Owner's Equity - The
financial report that summarizes all the changes in
5. owner’s equity (capital) that occurred during a
specific period.
3. Statement of Financial Position (Balance
Sheet) - shows the amount and nature of business
assets, liabilities, and owner’s equity (capital) as of
a specific point in time. The account balances at
the end of accounting year will carry forward to
become the beginning balances of the subsequent
year
4. Statement of Cash Flow - The financial
statements also show the inflows and outflows of
cash in the different activities of the business
(operating, investing, and financing activities).
5. Notes to the Financial Statements -Qualitative,
quantitative, and financial information that could
affect the decisions of users are included in the
notes to financial statements.
Users of Accounting Information
We learned that the whole purpose of accounting
is to provide information that is useful and
relevant for interested users when making
decisions regarding the company and its
operations. Who are these users of financial
information? What information do they need?
Key Notes
Users can be grouped into two categories namely internal users and external users
Internal Users (within the business organization)
o Owners
o Managers
o Employees
o Officers
o Internal Auditors
External Users (outside the business organization)
o Customers
o Suppliers
o Creditors
o Investors
o External Auditors
o Government Agencies
o Industrial Organizations
o uublic
Branches of Accounting
1. Financial Accounting - a systematic method of
recording business transactions in accordance to
the accounting principles.
2. Management Accounting - provides
information to management for better
administration of the business.
3. Cost Accounting - Cost accounting deals with
evaluating the cost of a product or service offered.
4. Tax Accounting - deals with the preparation and
filing of various tax returns and dealing with their
legal implications.
5. Auditing - It is where an external certified public
accountant known as an Auditor inspects and
certifies the accounts of the business for their
accuracy and consistency.
Summary Notes
Accounting - is the art of recording, classifying, and
summarizing in a significant manner and in terms of
money, transactions and events which are, in part at
least of financial character, and interpreting the
results thereof (American Institute of Certified Public
Accountants)
Purpose of Accounting - to provide financial
information about the business that will be useful in
making economic decisions of the users of the
information.
Financial Statements:
1. Statement of Financial Performance (Income
Statement)
2. Statement of Changes in Owner's Equity
3. Statement of Financial Position (Balance
Sheet)
4. Statement of Cash Flows
5. Notes to Financial Statements
Users of Accounting Information
1. Internal Users (Owners, Managers,
Employees, Officers, Internal Auditors, etc.)
2. External Users (Customers, Suppliers,
Creditors, Investors, Government Agencies,
etc.)
6. 3. Introduction to Bookkeeping
Bookkeeping is the recording of financial
transactions and is part of the process of
accounting in business (Financial Accounting 2003,
Weygandt; Kieso; Kimmel). It is largely concerned
with the implementation of the accounting
procedures manual and maintenance of the
accounting records. Bookkeeping is the procedural
implementation of accounting.
Bookkeeper is the person who keeps and
maintains the books of accounts of the business
organization. The bookkeeper is responsible for
recording the transactions of the business.
Functions of a Bookkeeper
General Accounting
o Verify deposit of cash collections
o Verify petty cash disbursements
o urepare bank reconciliation
o uost to the subsidiary and
general ledgers
o Reconcile general and subsidiary
ledgers
o urepare a draft of the Trial
Balance
o Assist the Accountant in the
closing of the accounts and
finalization of the financial
statements.
o Maintain proper filing and
retrieval of accounting records
Accounts Receivable
o Record sales invoices
o Record cash receipts from
customers
o Record sales returns, account
adjustments and credit memos
from suppliers
o Issue Statement of Accounts to
customers
o Reconcile accounts receivable
ledger balance with unpaid
customer invoices.
o Maintain Accounts Receivable
Subsidiary Ledger
o urepare Accounts Receivable
reports
Accounts Payable
o Record purchase invoices
o Record payments to suppliers
o Record purchase returns,
account adjustments and debit
memos from suppliers
o Receive Statement of Accounts
from suppliers
o Reconcile accounts payable
ledger balance with unpaid
customer invoices.
o Maintain Accounts uayable
Subsidiary Ledger
o urepare Accounts uayable
reports
Inventory Accounting
o Record receipts of inventory
from suppliers.
o Record release of inventory to
customers
o Record inventory returns and
adjustments
o urepare purchase requests and
Inventory issuance slips
o Reconcile physical count of
inventory to ledger balances
o Maintain inventory subsidiary
ledgers
o urepare Inventory reports
The Bookkeeper may also be assigned to handle
other functions, such as:
o uroperty control and monitoring
o uayroll preparation
o Remittance of statutory
deductions and reports
o Tax bookkeeping
o Treasury and banking
o Audit assistance
o Managerial and administrative
functions.
7. CHAPTER 2
Introduction
The accounting cycle is a series of procedures that
involves specific steps in recording, classifying,
summarizing, and interpreting transactions and
events for a business entity. This is commonly
called as accounting process. It is the process of
keeping track of business transactions by
recording and reporting them.
Key Notes:
Recording
1. Identification of Accountable
Transactions. Business transactions or events are
analyzed and identified whether they are
accountable or not.
2. Journalizing. The transactions are recorded in
the book of original entry known as the journal.
The transactions are recorded chronologically
with the appropriate accounts and amounts.
3. Posting. The transactions from the journal are
classified in the book of final entry known as the
ledger. The ledger classifies the transactions
effecting the increases and decreases for each
account.
Summarizing
4. Trial Balance. The summary of accounts
balances from the ledger is prepared in the list of
accounts known as the trial balance. This is the
proof that the ledger debit balance and credit
balances are equal and is in balance.
5. Adjusting Entries. Adjusting journal entries are
made at the end of the accounting period to assign
revenues to the period in which they are earned
and expenses to the period in which they are
incurred.
Reporting
6. Financial Statements. The following financial
statements are prepared: statement of financial
position, statement of financial performance,
statement of changes in equity, statement of cash
flows and the notes to the financial statements.
These financial statements provide useful
information to interested parties for their
decision-making.
7. Closing Entries. The temporary nominal
accounts are eliminated from the accounts by
recording and posting the closing entries. This will
prepare the accounting records for the next
accounting period.
8. Post-Closing Trial Balance. After the closing
entries are posted, the post-closing trial balance is
prepared to check that the debit and credit
balances of the remaining accounts are correct.
Optional
9. Recording of Reversing Entries. At the
beginning of the next accounting period, selected
adjusting journal entries made at the previous
accounting period are reversed to “normalize” the
recording of the related actual transactions.
8. 2. Identifying and Analyzing Business
Transactions
Business transactions or events are analyzed
whether they are accountable or not. Only
transactions which are identified to be
accountable transactions are recorded in the
accounting records. A transaction or event is
accountable when it meets the following criteria:
a. It affects the business entity.
b. It can be measured in terms of money.
c. It occurred on a specific date or for a
specific period.
d. It affects the assets, liabilities or equity of
the business.
e. It is supported by a document.
Examples of accountable transactions:
Mr. Luca Pacioli established Pacioli General
Services and had the following transactions:
√ Investment of u100,000 capital funds
by Mr. uacioli into the business
√ Receipt of a Charge Invoice from a
supplier for the purchase of a desktop
computer amounting to u30,000.
√ uurchase of supplies amounting to
u8,000 in cash.
√ Issuance of a Service Invoice for an
amount of u40,000 to a customer for
services rendered on account.
√ Receipt of u28,000 cash from
customers in payment of their account.
√ uayment in cash and receipt of an
official receipt from supplier for payment
of accounts, u22,000.
√ Cash payment of u12,000 for the
salary of an employee.
√ Mr. uacioli withdrew u10,000 cash
from the business.
Examples of non-accountable transactions:
The owner of the business spent u80,000
for his wedding.
A secretary was hired for u15,000
monthly salary.
The company has been using the
electricity for the first month of its
operations but has not yet received the
electric bill.
The company has been recognized by the
local government unit as the best service
provider in the locality. It is foreseen to
grow into a u10 million company in the
next few years.
Business Documents
The business documents forms serve as evidence
to support the accountable transactions or events.
These documents provide the data concerning the
parties involved, the exchange made, the date and
the money value of the exchange made. Some of
the common business documents include the
following:
1. Sales Invoice – document issued
to customer for specific
materials or supplies furnished
or services rendered. It is called
uurchase Invoice from the point
of view of the customer.
2. Delivery Receipt – document
signifying delivery of goods and
receipt of inventory.
3. Official Receipt – document
issued to acknowledge receipt of
cash.
4. Deposit Slip – document used to
deposit cash and cheques to a
bank.
5. Purchase Invoice – a bill from a
vendor for specific materials or
supplies furnished or services
rendered. It is called Sales
Invoice from the point of view of
the supplier.
6. Disbursement Voucher – a
written, approved record of
payment of cash.
7. Withdrawal Slip – document
used to withdraw cash from a
bank.
8. Cheque Issuance Record – a
record of cheques issued by the
company.
9. Promissory Notes – a written
promise to pay a certain sum of
money to the payee. It may
sometimes bear an interest over
a period of time.
9. 10. Bank Statement – a document
listing the bank transactions of
the depositor.
11. Billing Statement or Statement
of Account – document listing
the unpaid invoices of a
customer. Oftentimes, it lists
chronologically the invoices,
payments and adjustments to
the account of the company.
12. Business Letters
– correspondences to other
companies, organizations or
government entities which may
serve as a basis in recording an
accountable transaction or
event.
3. Record transactions in the Journal
This is also known as journalizing. The transactions
are chronologically recorded in the journal.
General Journal are also known as the Books of
Original Entry.
The transactions are recorded through a journal
entry. A Journal Entry shows the record of the
effects of a transaction or an event expressed in
terms of debit and credit. An entry with one debit
and one credit is a simple journal entry, while an
entry with one or more debits and credits is a
compound journal entry. A journal entry has the
following elements:
1. The date of the transaction
2. The accounts debited and credited
3. The monetary values of the accounts
debited and credited
4. The posting reference code of the
destination ledger account
5. A brief and clear explanation of the
transaction
A sample journal entry are as follows:
Note: Throughout the course, you will notice that
we always use the word “account”. An account can
be thought of as a collection of related entries. For
example, every entry that relates to our receivables
from customers will be recorded in the “Accounts
Receivable account”.
The specific account titles and codes to use are
maintained in a Chart of Accounts. It is a list of the
account codes and titles that must be used in
recording transactions in the Journal. It shall be
maintained and updated for necessary changes,
like additions of new accounts, change of titles and
codes and removal of accounts that will no longer
be used.
The accounts are normally listed in the order in
which they appear in the financial statements. An
account code identifies the account which will
serve as its cross-reference in the journal and
ledger.
A sample is as follows:
The accountable transactions are recorded in the
general journal following the Basic Accounting
Equation:
Assets = Liabilities + Equity
This equation will guide the bookkeeper in
recording the transaction. After the recording of
each transaction using a journal entry, the
accounting equation will maintain its equality. This
is possible under the double-entry accounting
system.
Under the Double Entry Accounting System, at
least two accounts will be recorded for each
10. accountable transaction. The amount in every
transaction must be entered in one account as
a debit (left side of the account) and in another
account as a credit (right side of the account).
Because of the two-fold effect of transactions, the
total effect on the left (Debit) will always be equal
to total the effect on the right (Credit).
Effect of Accounting Entries to the Accounts
Note: It's easier to remember the above effects
when you familiarize yourself with the increase
effect on accounts. The side where the account
increases its amount/value is actually the Normal
Balance of that account.
4. Posting to the Ledger
After the entries are recorded in the journal, the
entries are posted into the ledger. A ledger is a
collection of all of the accounts of the company,
the debits and credits under each account, and the
resulting balances. For example, the cash ledger
will summarize all the transactions that involved
cash. In bookkeeping, Ledgers are important
because they summarize all transactions to show
the running/ending balance of a specific account.
Posting to the ledger is the classifying phase of
accounting. Posting refers to the process of
transferring entries in the journal into the
accounts in the ledger. While journal is called the
Books of Original entry, because journal entries are
transferred in the ledger, the general ledger is
often called the book of final entry.
Each account has an assigned account number and
the individual accounts are properly arranged.
Each journal entry is posted into the related ledger
account indicating the following:
Date
Description
uosting Reference - serves as the cross-
reference between the journal entry and
the ledger account posting.
Debit and Credit amount
Running Balance of the account
Sample General Ledger:
The Posting Reference GJ-1 refers to:
GJ-General Journal
1-Page 1
5. Preparing Trial Balance
After the recording phase (Analyzing, Journalizing,
and Posting), we enter the next step of the
accounting cycle, the preparation of trial balance.
Trial balance is a listing of all the balances of the
different accounts as of a given date. The account
names are listed as arranged in the ledger and the
balances are placed either on the debit or credit
column. The total of all accounts with debit
balances must equal to the total of all accounts
with credit balances after the posting
process. This trial balance is called an unadjusted
trial balance (no adjustments yet).
11. There is other two types of trial balance:
the adjusted trial balance which is prepared after
adjusting entries, and the post-closing trial
balance which is prepared after closing entries.
Purpose of Trial Balance:
a. To check the accuracy of posting in the
ledger by testing the equality of the debits
and credits.
b. It aids in locating errors in posting.
c. It serves as the basis in the preparation of
the financial statements.
Errors in the Accounting Process
When the total debits and total credits are not
equal, this automatically signifies that there is an
error in the recording or posting of entries. Some
of the errors that could occur are the following:
o Journal entry with unequal debit
and credit.
o uosting to the incorrect debit or
credit of an account.
o Incorrectly footing the account
balance, or trial balance.
o Forwarding the wrong amount
from the ledger to the trial
balance.
o Listing the account balance to
the wrong side of the trial
balance.
The trial balance does not guarantee that the
records are accurate even if the total of debits and
total of credits are equal. The following errors will
not be detected by the preparation of a trial
balance:
o Failing to record a transaction or
event.
o Multiple recording and posting
of a transaction or event.
o Entries or posting to the wrong
account.
o Recording and posting of
amounts with transposition and
trans-placement errors.
Here is an example of a Trial Balance:
CHAPTER 3
1. Introduction to Adjusting Entries
Adjusting entries are made to update the accounts
and bring them to their correct balances. The
purpose of adjusting entries is to match costs
against revenues. The expenses incurred during
the period, whether paid or not, are matched
against the revenue earned for the same period,
whether collected or not, for the correct
determination of the profit for the period.
Key Notes
Types of Adjusting Entries
o Deferrals
urepaid Expense - expenses paid
but not yet incurred
Deferred/Unearned Revenue -
income received but not yet earned
o Accruals
Accrued Expense - expenses
incurred but not yet paid
Accrued Revenue - income earned
but not yet received
o Other Adjustments:
Unused supplies at the end of the
period
Depreciation Expense
Doubtful Account/Bad Debt
Expense
12. Steps for Recording Adjusting Entries
1. Identify what type of Adjusting
Entries is involved
2. Identify what method is
used (for Deferrals)
3. Calculate the amounts for the
adjustments:
Take note of the start
date and end date
4. Designate what accounts to be
debited and credited
All adjusting entries include at least a nominal
account and a real account. In the next pages, we
will illustrate how to prepare adjusting journal
entries for each type and provide example.
Examples:
1. Of the purchased P8,000 supplies, P6,000
worth of supplies remains on hand at the end of
the period.
2. The equipment purchased for P30,000 has an
estimated useful life of five (5) years and a salvage
value of P3,000.
2. Prepaid Expense
Prepaid expenses (Prepayments) represent
payments made for expenses which have not yet
been incurred or used. It is a future expense that
a company has paid for in advance.
Expenses are recognized when they are incurred
regardless of when paid. Expenses are
considered incurred when they are used,
consumed, utilized or has expired. Since
prepayments are not yet incurred, they should not
be classified as expenses. Rather, they are
classified as current assets, since they relate to
expenditures which have some future economic
benefit to the company.
Some examples are the following:
Rent paid in advance is a prepaid expense
which allows the company to utilize a
premises for many months into the
future.
Insurance policies are typically paid in
advance and can be enforced for many
months into the future.
Advertising subscriptions
Unused supplies.
There are two methods in recording prepaid
expenses: (1) the asset method, and (2) the
expense method. The adjusting entry for prepaid
expense will depend upon the initial journal entry
based on what method is used.
Asset Method
Under the asset method, a prepaid expense
account (an asset) is recorded when the amount is
paid. (e.g., Supplies, Prepaid Rent, Prepaid
Insurance, Prepaid Interest, etc.)
Original Entry:
Prepaid Expense xx
Cash xx
Adjusting Entry Should be:
Expense xx
Prepaid Expense xx
Example:
Mr. Pacioli started his general service business. On
the start of the operation, Mr. Pacioli, purchase
supplies amounting to P8,000 in cash. At the end
of the period, 70% of the supplies has been used.
On the start of the operation, the supplies bought
are not yet incurred (used). Under Asset Method,
it is proper to record it as current asset.
Original Entry:
Supplies 8,000
Cash 8,000
13. At the end of the period, since 70% has been used,
under asset method, the incurred expense should
be recognized.
Supplies Used: 8,000 x 70% = 5,600
Adjusting Entry:
Supplies Expense 5,600
Prepaid Supplies 5,600
Expense Method
Under the expense method, an expense account is
recorded when the amount is paid. (e.g., Supplies
Expense, Rent Expense, Insurance Expense,
Interest Expense, etc.)
Original Entry:
Expense xx
Cash xx
Adjusting Entry Should be:
Prepaid Expense xx
Expense xx
Example:
Mr. Pacioli started his general service business. On
the start of the operation, Mr. Pacioli, purchase
supplies amounting to P8,000 in cash. At the end
of the period, 70% of the supplies has been used.
On the start of the operation, under Expense
Method, the entire amount is recorded as
expense.
Original Entry:
Supplies Expense 8,000
Cash 8,000
At the end of the period, since only 70% has been
used, under expense method, the unused supplies
(30%) should be recognized as asset.
Unused Supplies: 8,000 x 30% = 2,400
Adjusting Entry:
Prepaid Supplies 2,400
Supplies Expense 2,400
The purpose of this adjusting entry is to make sure
that the incurred (used/expired) portion is treated
as expense and the unused part is in assets. The
adjusting entry will always depend upon the
method used when the initial entry was made.
3. Unearned Revenue
Unearned revenue represents revenue already
collected but not yet earned. Since cash is
received by the company but have not yet
performed its duties, it creates an obligation to
render service or deliver goods to its customers.
(Other terms: unearned income, deferred
revenue, or deferred income)
Income is recognized when earned regardless of
when it is collected. Income is considered earned
when goods or services have been received by the
customer. Since unearned revenue are not yet
earned, they should not be classified as income
rather, they are classified as current liability, since
they relate to an obligation of the company. It will
be recognized as income only when the goods or
services have been delivered or rendered.
Some examples are the following:
Advance rental from customers
A services contract collected in advance
A legal retainer collected in advance
Insurance collected for period-coverage
There are two methods in recording unearned
revenue: (1) the liability method, and (2) the
income method. The adjusting entry for unearned
revenue will depend upon the initial journal entry
based on what method is used.
14. Liability Method
Under the liability method, an unearned revenue
account (a liability) is recorded when the amount
is collected. (e.g., Unearned Rent Revenue,
Unearned Interest, etc.)
Original Entry:
Cash xx
Unearned Revenue xx
Adjusting Entry Should be:
Unearned Revenue xx
Revenue Account xx
Example:
Mr. Pacioli started his general service business.
During the operation, Mr. Pacioli, received 8,000
advance collections from customers. At the end of
the period, 70% of the unearned revenue has been
rendered.
Upon collection of the amount, service is not yet
rendered(earned). Under Liability Method, it is
proper to record it as current liability.
Original Entry:
Cash 8,000
Unearned Service Revenue 8,000
At the end of the period, since 70% has been
rendered, under liability method, the revenue
earned should be recognized.
Revenue earned: 8,000 x 70% = 5,600
Adjusting Entry:
Unearned Service Revenue 5,600
Service Revenue 5,600
Income Method
Under the income method, an income account is
recorded when the amount is collected. (e.g., Rent
Revenue, Interest Income, etc.)
Original Entry
Cash xx
Revenue Account xx
Adjusting Entry Should be:
Revenue Account xx
Unearned Revenue xx
Example:
Mr. Pacioli started his general service business.
During the operation, Mr. Pacioli, received 8,000
advance collections from customers. At the end of
the period, 70% of the unearned revenue has been
rendered.
Upon collection of the amount, under Income
Method, the entire amount is recorded as Income.
Original Entry:
Cash 8,000
Service Revenue 8,000
At the end of the period, since only 70% has been
rendered, under income method, service not yet
rendered (30%) should be recognized as liability.
Unearned Revenue: 8,000 x 30% = 2,400
Adjusting Entry:
Service Revenue 2,400
Unearned Service Revenue 2,400
The purpose of this adjusting entry is to make sure
that the earned (rendered/delivered/performed)
portion is treated as income and the unearned part
15. is in liability. The adjusting entry will always
depend upon the method used when the initial
entry was made.
4. Accruals (Accrued Expense and Accrued
Income)
Accrued Expense
Accrued Expense (also called accrued liabilities)
refers to an expense that the company has already
incurred but not yet paid. Since expense accruals
represent a company's obligation to make future
cash payments, they are shown on a company's
balance sheet as a liability (payable).
At the end of the period, an adjusting entry is
necessary if expenses incurred are not recognized.
Some examples are the following:
Interest expense that are owed but
unpaid.
Utilities used for the month but an invoice
has not yet been received before the end
of the period
Wages that are incurred but payments
have yet to be made to employees
Services received, for which no supplier
invoice has yet been received
Adjusting Entry Should be:
Expense Account xx
Liability Account xx
Example:
Mr. Pacioli borrows a 1,000,000 loan on July 1 for
business purpose from the bank. The loan
agreement requires Mr. Pacioli to repay the
1,000,000 loans on July 1 next year along with a
12,000 interest for 12 months.
At the end of the period, it is necessary to adjust
for the interest incurred for the current period
Interest Incurred: 12,000x 6/12 = 6,000
Adjusting Entry:
Interest Expense 6,000
Accrued Interest Payable 6,000
The purpose of this adjusting entry is to make sure
that the incurred expense is recognized at the end
of the period even if it is not yet paid.
Accrued Income
Accrued Income (also called accrued revenue)
refers to income that the company has already
earned but not yet collected. Since income
accruals represent a company's right to make
future cash inflows, they are shown on a
company's balance sheet as an asset(receivable).
At the end of the period, an adjusting entry is
necessary if income earned are not recognized.
Some examples are the following:
Interest Income that are earned but
uncollected.
Rent/Royalties not yet collected
Services rendered, for which customers
are not yet billed
Adjusting Entry Should be:
Receivable Account xx
Income Account xx
Example:
Mr. Pacioli lend 1,000,000 on September 1 to one
of his customers, Mr. Luca. The loan agreement
requires Mr. Luca to repay the 1,000,000 loans on
September 1 next year along with a 12,000 interest
for 12 months.
At the end of the period, it is necessary to adjust
for the interest earned for the current period
16. Interest earned: 12,000x 4/12 = 4,000
Adjusting Entry:
Accrued Interest Receivable 4,000
Interest Income 4,000
The purpose of this adjusting entry is to make sure
that the earned (rendered/delivered/performed)
income is recognized at the end of the period even
if it is not yet received.
5. Depreciation & Doubtful Accounts
Depreciation Expense
Introduction
Fixed Assets are economic resources owned by a
business, which cannot be quickly converted into
cash. When a fixed asset is acquired by a company,
it is recorded at initial cost (generally, the purchase
price of the asset). This cost is recognized as an
asset and not expense. In relation to matching
principle, company must report expenses at the
same time as the revenues they are related to.
Depreciation expense is recorded to allocate costs
to the periods in which an asset is used.
Depreciation Expense
Depreciation is the gradual charging to expense of
an asset's cost over its expected useful life.
Depreciation recognizes a portion of the asset as
expense as the company records the revenue that
was generated by the fixed asset. This is
mandatory under the matching principle as
revenues are recorded with their associated
expenses in the accounting period when the asset
is in use.
Three main inputs in computing depreciation:
Historical Cost: Purchase price and all incidental
cost of the asset
Residual Value or Scrap Value: Estimated value of
the fixed asset at the end of its useful life
Useful Life: Amount of time the fixed asset can be
used (in months or years)
There are several methods in depreciating fixed
assets. The most common and simplest is the
straight-line depreciation method. It involves
simple allocation of an even rate of depreciation
every year over the useful life of the asset. The
formula for straight line depreciation is:
Annual Depreciation = (Cost – Residual Value) /
Useful life
Example:
Mr. Pacioli General Services purchased an
equipment for P120,000 on January 1 and the
useful life of the equipment are 10 years and the
residual value of the machinery is P20,000.
Annual Depreciation = (120,000-20,000)/10
Annual Depreciation = 10,000
Adjusting Entry:
Depreciation Expense 10,000
Accumulated Depreciation 10,000
Within the period
Example:
Mr. Pacioli General Services purchased an
equipment for P120,000 on July 1 and the useful
life of the equipment are 10 years and the residual
value of the machinery is P20,000.
*The total annual depreciation cannot be applied
on the current period because the equipment was
used only for 6 months (July to December) on the
current period.
Annual Depreciation = (120,000-20,000)/10
Annual Depreciation = 10,000
Depreciation for the current period = 10,000 x 6/12
Depreciation for the current period = 5,000
17. Adjusting Entry:
Depreciation Expense 5,000
Accumulated Depreciation 5,000
Note:
Depreciation Expense is shown in the
Income Statement as part of expense.
Accumulated Depreciation is shown in
the Balance Sheet as a contra-asset
account to specific non-current asset.
Doubtful Accounts
Introduction
Providing service or delivering goods to customers
may be made on credit. It is likely to increase sales
when companies start offering credit on its
customers. It will also create a trust between the
parties that leads to better customer loyalty.
However, businesses that provides credit are faced
with the risk of failure to receive payment from
customers.
Doubtful Accounts
A doubtful account is an accounts receivable that
may not be collected in the future. A doubtful
account expense is recognized to estimate the
uncollectible accounts for credit sales made during
the current period. The adjusting entry for
doubtful accounts is:
Doubtful Account Expense xx
Allowance for Doubtful Accounts xx
An allowance for doubtful accounts is recognized
to estimate the percentage of accounts receivable
that are expected to be uncollectible.
There are several methods in estimating doubtful
accounts. The most common is the percentage of
sales method. It applies a flat percentage, based
on estimate, to the total amount of sales for the
period. The formula for computing doubtful
accounts using percentage of sales method is
simply:
Doubtful Account Expense = Total Credit Sales x %
of estimated uncollectible
Example:
Based on previous experience, Mr. Pacioli General
Services estimated that 5% of the total credit sales
are not collectible. The total credit sales for the
period are P100,000.
Doubtful Account Expense = 100,000 x 5%
Annual Depreciation = 5,000
Adjusting Entry:
Doubtful Account Expense 5,000
Allowance for Doubtful Accounts 5,000
Note:
Doubtful Account Expense is shown in the
Income Statement as part of expense.
Allowance for Doubtful Account is shown
in the Balance Sheet as a contra-asset
account to Account Receivable.