Chapter 1 contribute money, property, or industry

Definition of Accounting to a common fund, with the intention of

dividing the profits among themselves.
Accounting is a service activity. Its Each partner is personally liable for any
function is to provide quantitative debt incurred by the partnership.
information, primarily financial in nature,
about economic entities that is intended to be 3. Corporation. A corporation is a
useful in making economic decisions. business owned by its stockholders. It is
an artificial being created by operation of
Accounting is an information system that law, having the rights of succession and
measures, processes and communicates the powers, attributes and properties
financial information about economic entity. expressly authorized by law or incident to
its existence. The stockholders are not
Accounting is the process of identifying, personally liable for the corporation’s
measuring and communicating economic debts.
information to permit informed judgments
and decisions by users of the information. Fundamental Concepts
Several fundamental concepts
Accounting is the art of recording, underlie the accounting process. In recording
classifying and summarizing in a significant business transactions, accountants should
manner and in terms of money, transactions consider the following:
and events which are, in part at least, of a
financial character, and interpreting the 1. Entity Concept. The most basic
results thereof. concept in accounting is the entity
concept. An accounting entity is an
Types of Business organization or a section of an
1. Services – An entities or individual that organization that stands apart from
provides services to the public. other organizations and individuals as a
Examples are software developer, separate economic unit. Simply put, the
accounting and legal, colleges and transactions of different entities should
universities, barbershop, salon and other not be accounted for together. Each
services. entity should be evaluated separately.
2. Trading – An entities or individual that
buys and sells the products (buying and 2. Periodicity Concept. An entity’s life
selling). Examples are supermarket, can be meaningfully subdivided into
department store and others. equal time periods for reporting
3. Manufacturing – An entities that purposes. It will be aimless to wait for
convert materials into finished products. the actual last day of operations to
Examples are furniture’s production,
perfectly measure the entity’s profit.
noodles production, shoes
This concept allows the users to obtain
manufacturing, garment factories and
food processing. timely information to serve as a basis on
making decisions about future activities.
Forms of Business Organization For the purpose of reporting to outsiders,
1. Sole proprietorship. This business one year is the usual accounting period.
organization has a single owner called the
proprietor who generally is also the 3. Stable Monetary Unit Concept. The
manager. Sole proprietorships tend to be Philippine peso is a reasonable unit of
small service type (e.g., physicians, measure and that its purchasing power is
lawyers, and accountants) businesses and relatively stable. It allows accountants to
retail establishments. The owner receives add and subtract peso amounts as
all profits, absorbs all losses and is solely though each peso has the same
responsible for all debts of the business. purchasing power as any other peso at
any time. This is the basis for ignoring
2. Partnership. A partnership is a the effects of inflation in the accounting
business owned and operated by two or records.
more persons who bind themselves to
4. Going Concern Concept. Financial A present obligation exists as a result of past
statements are normally prepared on the events only if:
assumption that the reporting entity is a a. the entity already obtained economic
going concern and will continue in benefits or taken an action; and
operation for the foreseeable future. b. as a consequence, the entity will or
Hence, it is assumed that the entity has may have to transfer an economic
neither the intention nor the need to resource that it would not otherwise
enter liquidation or to cease trading. have had to transfer.
This assumption underlies the
depreciation of assets over their useful Equity is the residual interest in the assets of
lives. the enterprise after deducting all its liabilities.
In other words, they are claims against the
Elements of Financial Statements entity that do not meet the definition of a
liability.
The elements of financial statements defined
in the March 2018 Conceptual Framework for
financial reporting (2018 Conceptual Equity may pertain to any of the following
Framework) are: depending on the form of business
organization:
• Assets, liabilities and equity – relate
to a reporting entity’s financial
• In a sole proprietorship, there is only
one owner’s equity account because
position; and
there is only one owner.
• Income and expenses – relate to a
• In a partnership, an owner’s equity
reporting entity’s financial account exists for each partner.
performance.
• In a corporation, owners’ equity or
stockholders’ equity consist of share
Asset is a present economic resource capital, retained earnings and
controlled by the entity as a result of past reserves representing appropriations
events. An economic resource is a right that of retained earnings among others.
has the potential to produce economic
benefits. There are three aspects to these Income is increases in assets, or decreases in
definitions: “right”; potential to produce liabilities, that result in increases in equity,
economic benefits”; and “control”. other than those relating to contributions
from holders of equity claims.
A liability is a present obligation of the entity
to transfer an economic resource as a result of
Expenses are decreases in assets, or
past events. For a liability to exists, three
increases in liabilities, that result in decrease
criteria must all be satisfied.
in equity, other than those relating to
a. the entity has an obligation; distributions to holders of equity claims.
b. the obligation is to transfer an economic
resource; and The account
c. the obligation is a present obligation that The basic summary device of
exists as a result of past events. accounting is the account. A separate
account is maintained for each element that
Example: appears in the balance sheet (assets,
a. Obligations to pay cash. liabilities and equity) and in the income
b. Obligations to deliver goods or statement (income and expenses). Thus, an
provide services. account may be defined as a detailed record
c. Obligations to exchange economic of the increases, decreases and balance of
resources with another party on each element that appears in an entity’s
unfavorable terms. financial statements. The simplest form of
d. Obligations to transfer an economic the account is known as the “T” account
resource if a specified uncertain because of its similarity to the letter “T”. The
future event occurs. account has three parts as follows.
e. Obligations to issue a financial
instrument if that financial
instrument will oblige the entity to
transfer an economic resource.
 Account Title The account type determines how
increases or decreases in it are recorded.
Debit Credit Increases in assets are recorded as debits
while decreases in assets are recorded as
side side credits. Conversely, increases in liabilities
Left and owner’s equity are recorded by credits
side Right
and decreases are entered as debits.
Side
The rules of debit and credit for
income and expense accounts are based on
The Accounting Equation
the relationship of these accounts to owner’s
Financial statements tell us how a
equity. Income increases owner’s and
business is performing. They are the final
expense decreases owner’s equity. Hence,
products of the accounting process. But how
increases in income are recorded as credits
do we arrive at the items and amounts that
and decreases as debits. Increases in
make up the financial statements? The most
expenses are recorded as debits and decreases
basic tool of accounting is the accounting
as credit. These are the rules of debit and
equation. This equation presents the
credit. The following summarizes the rules
resources controlled by the enterprise, the
present obligations of the enterprise and the
residual interest in the assets. It states that Normal Balance of an Account
assets must always equal liabilities and The normal balance of any account
owner’s equity. The basic accounting model refers to the side of the account- debit or
is: credit-where increases are recorded. Assets
owner’s withdrawal and expense accounts
normally have debit balances; liability,
Assets = Liabilities + Owner’s Equity
owner’s equity and income accounts normally
have credit balances. This result occurs
Note that the assets are on the left
because increases in an account are usually
side of the equation opposite the liabilities
greater than or equal to decreases.
and owner’s equity. This explains why
increases and decreases in assets are recorded Incre Reco Nor Bala
in the opposite manner (“mirror image”) as ases ded mal nce
liabilities and owner’s equity are recorded. by
The equation also explains why liabilities and Account Debit Credi Debi Cred
owner’s equity follow the same rules of debit t t it
and credit.
Assets X X
Debits and Credits – the double-entry liabilitie X X
bookkeeping system s
Owner’s
Accounting is based on a double –
equity
entry bookkeeping system which means that
the dual effects of a business transaction is Owner’s X X
recorded. A debit side entry must have a capital
corresponding credit side entry. For every Withdra X X
transaction, there must be one or more wals
accounts debited and one or more accounts
credited. Each transaction affects at least two Income X X
accounts. The total debits for a transaction expense X X
must always equal the total credits. s

An account is debited when an Accounting Events and Transactions

amount is entered on the left side of the An accounting event is an economic
account and credited when an amount is occurrence that causes changes in an
entered on the right side. The abbreviations enterprise’s assets, liabilities, and/or equity.
for debit and credit are DR. and CR Events may be internal actions, such as the
respectively. use of equipment for the production of goods
 or services. It can also be an external event, 6. Increase in Liabilities = Decrease in Owner’s
such as the purchase of raw materials from a equity (EC)
supplier. A transaction is a particular kind of 7. Increase in Owner’s equity = decrease in
event that involves the transfer of something Liabilities (EC)
of value between two entities. Examples of 8. Increase in one Liability = Decrease in
transactions include acquiring assets from another liabilities (EC)
owner, borrowing funds from creditors, and 9. Increase in one Owner’s equity = Decrease in
purchasing or selling goods and services. another Owner’s equity (EC)

Types and Effects of Transactions Statement of Financial Position

It will be beneficial in the long-term
to be able to understand a classification ASSETS
approach that emphasizes the effects of Assets are should be classified only
accounting events rather the recording into two: current assets and non-current
procedures involved. This approach is quite assets. Per revised Philippine Standards
pioneering. Although business entities (PAS) no. 1, an entity shall classify assets as
engage in numerous transactions, all current when:
transactions can be classified into one of four a. It expects to realize the asset, or intends to
types, namely: sell or consume it, in its normal operating
1. Source of Assets (SA). An asset account cycle;
increases and a corresponding claims b. It holds the asset primarily for the purpose
(liabilities or owner’s equity) accounts of trading;
increases. Examples: (1) Purchase of supplies
c. It expects to realize the asset within twelve
on account; (2) sold goods on cash on delivery
months after the reporting period; or
basis.
d. The asset is cash or a cash-equivalents (as
2. Exchange of Assets (EA). One asset
defined in PAS no. 7) unless the asset is
account increases and another asset account
restricted from being exchanged or used to
decreases. Example: acquired equipment for
settle a liability for at least twelve months
cash.
after the reporting period.
3. Use of assets (UA). An asset account
decreases and a corresponding claims
All other assets should classified as non-
(liabilities or equity) account decreases.
current assets. Operating cycle is the time
Example: (1) Settled accounts payable; (2)
between the acquisition of assets for
paid salaries of employees.
processing and their realization in cash or
4. Exchange of claims (EC). One claims cash equivalents. When the entity’s normal
(liabilities or owner’s equity) account operating cycle is not clearly identifiable, it is
increases and another claims (liabilities or assumed to be twelve months.
owner’s equity) account decreases. Example:
received utilities bill but did not pay.
Current assets
1. Cash. Cash is any medium of exchange
Every accountable event has a dual but
that a bank will accept for deposit at face
self-balancing effect on the accounting
value it includes coins, currency, checks,
equation. Recognizing these events will not in
any manner affect the equality of the basic money orders, bank deposits and drafts.
accounting model. The four types of
transactions above may be further expanded 2. Cash equivalents. Per PAS no.7, these
into nine types of effects as follows: are short –term, highly liquid
1. Increase in Assets = Increase in Liabilities investments that are readily convertible
(SA) to known amounts of cash and which are
2. Increase in Assets = Increase in Owner’s subject to an insignificant risk of changes
equity (SA) in value.
3. Increase in in one = Decrease in another Asset
(EA) 3. Notes receivable. A note receivable is
4. Decrease in Assets = Decrease in Liabilities a written pledge that the customer will
(UA) pay the business a fixed amount of
5. Decrease in Assets = Decrease in Owner’s money on a certain date.
Equity (UA)
4. Accounts receivable. These are Liabilities
claims against customers arising from Per revised Philippine Accounting Standards
sale of services or goods on credit. This (PAS) no. 1, an entity shall classify a liability
type of receivable offers less security as current when:
than a promissory note. a. it expects to settle the liability in its normal
operating cycle;
5. Inventories. Per PAS no. 2, these are b. it holds the liability primarily for the
assets which are (a) held for sale in the purpose of trading;
ordinary course of business; (b) in the c. the liability is due to be settled within twelve
process of production for such sale; or (c) months after the reporting period; or
in the form of materials or supplies to be d. the entity does not have an unconditional
consumed in the production process or right to defer settlement of the liability for at
in the rendering of services. least twelve months after the reporting
period.
6. Prepaid expenses. These are expenses
paid for by the business in advance. It is All other liabilities should be classified as non-
an asset because the business avoids current liabilities.
having to pay cash in the future for a
specific expense. These include Current Liabilities
insurance and rent. These prepaid items 1. Accounts payable. This account
represent future economic benefits- represents the reverse relationship of the
assets – until the time these start to accounts receivable. By accepting the
goods or services, the buyer agrees to pay
contribute to the earning process; these,
for them in the near future.
then, become expenses.
2. Notes payable. A note payable is like a
Non –current assets
note receivable but in a reverse sense. In
1. Property, Plant, and Equipment. the case of a note payable, the business
Per PAS no. 16, these are tangible assets entry is the maker of the note; that is, the
that are held by an enterprise for use in business entity is the party who promises
the production or supply of goods or to pay the other party a specified amount
services, or for rental to others, or for of money on a specified future date.
administrative purposes and which are
expected to be used during more than 1
3. Accrued Liabilities. Amounts owed to
period. Included are such items as land,
others for unpaid expenses. This account
building, machinery and equipment,
includes salaries payable, utilities
furniture and fixtures, motor vehicles and
payable, interest payable and taxes
equipment.
payable.
2. Accumulated depreciation. It is a
4. Unearned Revenues. When the
contra assets account that contains the
business entity receives payment before
sum of the periodic depreciation charges.
providing its customers with goods or
The balance in this account is deducted
services, the amounts received are
from the cost of the related assets-
recorded in the unearned revenue
equipment or buildings – to obtain book
account (liability method). When the
value.
goods or services are provided to the
customer, the unearned revenue is
3. Intangible Assets. Per PAS no. 38.
reduced and income is recognized.
These are identifiable, nonmonetary
assets without physical substance held for
5. Current portion of long-term debt.
use in the production or supply of goods
These are portions of mortgage notes,
or services, for rentals to others, or for
bonds and other long-term indebtedness
administrative purposes. These include
which are to be paid within one year from
goodwill, patents, copyrights, licenses,
the balance sheet date.
franchises, trademarks, brand names,
secret processes, subscription list, and
non-competition agreements.
 Non –current liabilities building materials by a construction
1. Mortgage Payable. This account supplies firm.
records long-term debt of the business
entity for which the business entity has Expenses
pledged certain assets as security to the 1. Cost of sales. The cost incurred to
creditor. In the event that the debt purchase or to produce the products sold
payments are not made, the creditor can to customers during the period; also
foreclose or cause the mortgaged asset to called cost of goods sold.
be sold to enable the entity to settle the
claim. 2. Salaries or wages expense. Includes
all payments as a result of an employer-
2. Bonds Payable. Business organization employee relationship such as salaries or
often obtain substantial sums of money wages, 13th month pay, cost of living
from lenders to finance the acquisition of allowances and other related benefits.
equipment and other needed assets. They
obtain these funds by issuing bonds. The 3. Telecommunications, electricity,
bond is a contract between the issuer and fuel and water expenses. Expenses
the lender specifying the terms of related to use of telecommunications
repayment and the interest to be charged. facilities, consumption of electricity, fuel
and water.
Owner’s Equity
1. Capital (from the Latin capitalis, 4. Rent expense. Expense for space,
meaning “property”). This account is equipment or other asset rentals.
used to record the original and additional
investments of the owner of the business 5. Supplies expense. Expense of using
entity. It is increased by the amount of supplies (e.g. office supplies) in the
profit earned during the year or is conduct of daily business.
decreased by a loss. Cash or other assets
that the owner may withdraw from the 6. Insurance expense. Portion of
business ultimately reduce it. This premiums paid on insurance coverage
account title bears the name of the owner. (e.g. on motor vehicle, health, life, fire,
typhoon or flood) which has expired.
2. Withdrawals. When the owner of a
business entity withdraws cash or other 7. Depreciation expense. The portion of
assets, such are recorded in the drawing the cost of a tangible asset ( e.g. buildings
or withdrawal account rather than and equipment) allocated or charged as
directly reducing the owner’s equity expense during an accounting period.
account.
8. Uncollectible account expense. The
3. Income Summary. It is a temporary amount of receivables estimated to be
account used at the end of the accounting doubtful of collection and charged as
period to close income and expenses. expense during an accounting period.
This account shows the profit or loss for
the period before closing to the capital 9. Interest expense. An expense related
accounts. to use of borrowed funds.
INCOME STATEMENT Accounting for Business Transactions
Accountants observe many events
Income that they identify and measure in financial
1. Service Income. Revenues earned by terms. A business transaction is the
performing services for a customer or occurrence of an event or a condition that
client; for example, accounting services affects financial position and can be reliably
by a CPA firm, laundry shop. recorded.

2. Sales. Revenues earned as a result of

sale of merchandise; for example, sale of
 Financial Transaction Worksheet Step 2: Transactions are recorded in
Every financial transaction can be the Journal
analyzed or expressed in terms of its effects Aim: To record the economic impact of
on the accounting equation. The financial transactions on the firm in a journal, which is
transactions will be analyzed by means of a a form that facilitates transfer to the accounts.
financial transaction worksheet which is a
form used to analyze increases and decreases Step 3: Journal Entries are posted to
in the assets, liabilities or owner’s equity of a the ledger
business entity. Aim: To transfer the information from the
journal to the ledger for classification.
Chapter 2:
Recording Business Transactions Step 4: Preparation of the trial balance
Aim: To provide a listing to verify the equality
Transaction Analysis (Step 1) of debits and credits in the ledger.
The analysis of transactions should follow
these four basic steps: Step 5: Preparation of the worksheet
1. Identify the transaction from source including adjusting entries
documents. Aim: To aid in the preparation of financial
2. Indicate the accounts – either assets, statements.
liabilities, equity, income or expenses –
affected by the transaction. Step 6: Preparation of financial
3. Ascertain whether each account is increased statements
or decreased by the transaction. Aim: To provide useful information to
4. Using the rules of debit and credit, determine decision –makers.
whether to debit or credit the account to
record its increase or decrease. Step 7: Adjusting journal entries are
journalized and posted
Source Documents Aim: To record the accruals, expiration of
Transactions and events are the deferrals, estimations and other events from
starting points in the accounting cycle. By the worksheet.
relying on source documents, transaction s
and events can be analyzed as to how they will Step 8: Closing Journal entries are
affect performance and financial position. journalized and posted
Source documents identify and describe Aim: To close temporary accounts and
transactions and events entering the transfer profit to owner’s equity.
accounting process. These original written
evidences contain information about the Step 9: Preparation of a post-closing
nature and the amounts of the transactions. trial balance
These are the bases for the journal entries; Aim: To check the equality of debits and after
some of the more common source documents
the closing entries.
are sales invoices, cash register tapes, official
receipts, bank deposit slips, bank statements,
Step 10: Reversing journal entries are
checks, purchase orders, time cards and
statements of account. journalized and posted
Aim: To simplify the recording of certain
Accounting Cycle regular transactions in the next accounting
The accounting cycle refers to a series period.
of sequential steps or procedures performed
to accomplish the accounting process. The This cycle is repeated each accounting
steps in the cycle and their aims follow: period. The first three steps in the accounting
cycle are accomplished during the period. The
Step 1: Identification of Events to be fourth to the ninth steps generally occur at the
recorded end of the period. The last step is optional and
occurs at the beginning of the next period.
Aim: To gather information about
transactions or events generally through the
source documents.
 The Journal To understand the nature of the
The journal is a chronological record affected accounts, the letter A (for asset), L
of the entity’s transactions. A journal entry (liability) or OE (owner’s Equity) is inserted
shows all the effects of a business transaction after each entry. In addition, owner’s equity
in terms of debits and credits. Each is further classified into OE: I (income) and
transaction is initially recorded in a journal OE: E (expenses)
rather than directly in the ledger. A journal is
called the book of original entry. The nature Note that the rule of double – entry system are
and volume of transactions of the business observed in each transaction:
determine the number and type of journals 1. Two or more accounts are affected by each
needed. The general journal is the simplest transaction.
journal. 2. The sum of the debits for every transaction
equals the sum of the credits.
Format 3. The equality of the accounting equation is
The standard contents of the general journal always maintained.
are as follows:
1. Date. The year and month are not rewritten The Ledger
for every entry unless the year or month A grouping of the entity’s accounts is
changes or a new page is needed. referred to as ledger. Although some firms
2. Account titles and explanation. The may use various ledgers to accumulate
account to be debited is entered at the certain detailed information, all firms have a
extreme left of the first line while the account general ledger. A general ledger is the
to be credited is entered slightly indented on “reference book” of the accounting system
the next line. A brief description of the and is used to classify and summarize
transaction is usually made on the line below transactions, and to prepare data for basic
the credit. Generally, skip a line after each
financial statements
entry.
3. P. R. (posting reference). This will be
The accounts in the general ledger are
used when the entries are posted, that is, until
classified into two general groups:
the amounts are transferred to the related
ledger accounts. The posting process will be 1. Balance sheet or permanent accounts (assets,
described later. liabilities and owner’s equity).
4. Debit. The debit amount for each account is 2. Income statement or temporary accounts
entered in this column. (income and expenses). Temporary or
nominal accounts are used to gather
5. Credit. The credit amount for each account
information for a particular accounting
is entered in this column.
period. At the end of the period, the balances
of these accounts are transferred to a
Simple and Compound Entry
permanent owner’s equity account.
In a simple entry, only two accounts
are affected – one account is debited and the
Each account has its own record in
other account credited. An example of this is
the ledger. Every account in the ledger
the entry to record the initial investment of
maintains the basic format of the T-account
PerezManalo. However, some transactions
but offers more information (e.g., the account
require the use of more than two accounts.
number at the upper right corner and the
When three or more accounts are required in
journal reference column). Compared to a
a journal entry, the entry is referred to as a
journal, a ledger organizes information by
compound entry.
account.
Transactions are journalized (Step 2)
Chart of Accounts
After the transaction or event has
A listing of all the accounts and their
been identified and measured, it is recorded
account numbers in the ledger is known as
in the journal. The process of recording a the chart of accounts. The chart is arranged
transaction is called journalizing. The in the financial statement order, that is,
following are the transactions for Wedding assets first, followed by liabilities, owner’s
“R” Us during the month of May. The double equity, income and expenses. The accounts
– entry system will be used.
 should be numbered in a flexible manner to The procedures in the preparation of a trial
permit indexing and cross-referencing. balance follow:
1. List the account titles in numerical order.
When analyzing transactions, the 2. Obtain the account balance of each account
accountant refers to the chart of accounts to from the ledger and enter the debit balances
identify the pertinent accounts to be increased in the debit column and the credit balances in
or decreased. If an appropriate account title the credit column.
is not listed in the chart, an additional account 3. Add the debit and credit columns.
may be added. Presented below is the chart of 4. Compare the totals.
accounts for the illustration.
The trial balance is a control device
Posting (Step 3) that helps minimize accounting errors. When
Posting means transferring the amounts the totals are equal, the trial balance is in
from the journal to the appropriate accounts balance. This equality provides an interim
in the ledger. Debits in the journal are posted proof of the accuracy of the records but it does
as debits in the ledger, and credits in the not signify the absence of errors. For example,
journal as credits in the ledger. The steps are if the bookkeeper failed to record payment of
illustrated as follows: rent, the trial balance columns are equal but
in reality, the accounts are incorrect since rent
1. Transfer the date of the transaction from the expense is understated and cash overstated.
journal to the ledger.
2. Transfer the page number from the journal to Locating Errors
the journal reference (J.R.) column of the An inequality in the totals of the debits
ledger. and credits would automatically signal the
3. Post the debit figure from the journal as a presence of an error. These errors include:
debit figure in the ledger and the credit figure 1. Error in posting a transaction to the ledger:
from the journal as a credit figure in the a. An erroneous amount was posted to
ledger. the account.
4. Enter the account number in the posting b. A debit entry was posted as a credit or
reference column of the journal once the vice versa.
figure has been posted to the ledger. c. A debit or credit posting was omitted.
2. Error in determining the account balances:
Ledger accounts after posting a. A balance was incorrectly computed
At the end of an accounting period, the b. A balance was entered in the wrong
debit or credit balance of each account must balance column.
be determined to enable us to come up with a 3. Error in preparing the trial balance:
trial balance. a. One of the columns of the trial
• Each account balance is determined balance was incorrectly added.
by footing (adding) all the debits and b. The amount of an account balance
credits. was incorrectly recorded on the trial
• If the sum of an account’s debits is balance.
greater than the sum of its credits, c. A debit balance was recorded on the
that account has a debit balance. trial balance as a credit or vice versa,
• If the sum of its credits is greater, that or a balance was omitted entirely.
account has a credit balance.
What is the most efficient approach in
Trial Balance (Step 4) locating an error? The following procedures
The trial balance is a list of all when done in sequence may save considerable
accounts with their respective debit or credit time and effort in locating errors:
balances. It is prepared to verify the equality 1. Prove the addition of the trial balance
of debits and credits in the ledger at the end of columns by adding these columns in the
each accounting period or at any time the opposite direction.
posting are updated. 2. If the error does not lie in addition,
determine the exact amount by which the
trial balance is out of balance. The amount
of the discrepancy is often a clue to the
 source of the error. If the discrepancy is liquidation. This, however, is not a practical
divisible by 9, this suggests either a way of measuring business performance.
transposition (reversing the order of
numbers) error or a slide (moving of the Accounting information is valued
decimal point). when it is communicated early enough to be
3. Compare the accounts and amounts in the used for economic decision-making. To
trial balance with that in the ledger. Be provide timely information, accountants have
certain that no account is omitted. divided the economic life of a business into
4. Recompute the balance of each ledger artificial time periods. This assumption is
account. referred to as the periodicity concept.
5. Trace all posting from the journal to the
ledger accounts. As this is done, place a Accounting periods are generally a
check mark in the journal and in the ledger month, a quarter or a year. The most basic
after each figure is verified. When the accounting period is one year. Entities differ
operation is completed, look through the in their choice of the accounting year- fiscal,
journal and the ledger for unchecked calendar or natural. A fiscal year is a period of
amounts. In tracing postings, be alert not any twelve consecutive months. A calendar
only for errors in amount but also for debits year is an annual period ended December 31.
entered as credits, or vice versa. A natural business year is a twelve-month
period that ends when business activities are
Note that even when a trial balance is in at their lowest level of the annual cycle. A
balance, the accounting records may still period of less than a year is an interim period.
contain errors. A balanced trial balance Some even adopt an annual reporting period
simply proves that, as recorded, debits equal of 52 weeks.
credits. The following errors are not detected
by a trial balance. Businesses need periodic reports to
1. Failure to record or post a transaction. assess their financial condition and
2. Recording the same transaction more than performance. The periodicity concept
once. ensures that accounting information is
3. Recording an entry but with the same reported at regular intervals. It interacts with
erroneous debit and credit amounts. the recognition and derecognition principles
4. Posting a part of a transaction correctly as to underlie the use of accruals.
debit or credit but to the wrong account. To measure profit in a fair manner, entities
update the income and expense-accounts
Chapter 3 immediately before the end of the period.
Adjusting the Accounts
Recognition and Derecognition
Accrual Basis The initial recognition of assets or
The financial statements, except for liabilities arising from transactions or other
events may result in the simultaneous
the cash flow statement, are prepared on the
accrual basis of accounting in order to meet recognition of both income and related
expenses. For example, the sale of goods for
their objectives. Under the accrual basis, the
effects of transactions and other events are cash results in the recognition of both income
(from the recognition of one asset- the cash)
recognized when they occur and not as cash is
and an expense (from the derecognition of
received or paid. This means that the
another asset- the goods sold). The
accountant records revenues as they are
earned and expenses as they are incurred. simultaneous recognition of income and
related expenses is sometimes referred to as
The timing of cash flows is relatively
the matching of costs with income.
immaterial for determining when to recognize
revenues and expenses.
Recognition is appropriate if it results
in both relevant information about assets,
Periodicity Concept
liabilities, equity income and expenses and a
The only way to know how
faithful representation of those items, because
successfully a business has operated is to close
the aim is to provide information that is useful
its doors, sell all its assets, pay the liabilities
to investors, lenders and other creditors.
and return any excess cash to the owners.
This process of going out of business is called
 Derecognition is the removal of all or part of a Deferral is the postponement of the
recognized asset or liability from an entity’s recognition of “an expense already paid but
statement of financial position. not yet incurred, “or of “revenue already
Derecognition normally occurs when that collected but not yet earned”. This
item no longer meets the definition of an asset adjustment deals with an amount already
or a liability. recorded in a balance sheet account; the entry,
in effect, decreases the balance sheet account
a. For an asset, derecognition normally occurs and increases an income statement account.
when the entity losses control of all or part of Deferrals would be needed in two cases:
the recognized asset; and 1. Allocating assets to expense to reflect
b. For a liability, derecognition normally occurs expenses incurred during the accounting
when the entity no longer has a present period (e.g., prepaid insurance, supplies
obligation for all or part of the recognized and depreciation).
liability. 2. Allocating revenues received in advance to
revenue to reflect revenues earned during
The need for Adjustment the accounting period (e.g., subscriptions).
Accountants make adjusting entries
to reflect in the accounts information on Accrual is the recognition of “an expense
economic activities that have occurred but already incurred but unpaid”, or “revenue
have not yet been recorded. Adjusting entries earned but uncollected”. This adjustment
assign revenues to the period in which they deals with an amount unrecorded in any
are earned, and expenses to the period in account; the entry, in effect, increase both a
which they are incurred. These entries are balance sheet and an income statement
needed to measure properly the profit for the account. Accruals would be required in two
period, and to bring related asset and liability cases:
accounts to correct balances for the financial 1. Accruing expenses to reflect expenses
statements. incurred during the accounting period that
are unpaid and unrecorded.
In short, adjustments are needed to 2. Accruing revenues to reflect revenues earned
ensure that the recognition and derecognition during the accounting period that are
principles are followed thus resulting to uncollected and unrecorded.
financial statements reporting the effects of
all transactions at the end of the period. The weddings “R” Us case is
continued to illustrate the adjustment
Adjusting entries involve charging process. The letters A, L, OE, OE:I and OE:E
account balances at the end of the period from are still used to ensure a better understanding
what is the current balance of the account to of the nature of the accounts affected.
what is the correct balance for proper
financial reporting. Without adjusting Adjustments for Deferrals (Step 5)
entries, financial statements may not fairly Allocating Assets to Expenses
show the solvency of the entity in the balance Entities often make expenditures that
sheet and the profitability in the income benefit more than one period. These
statement. expenditures are generally debited to an asset
account. At the end of each accounting
Deferrals and Accruals period, the estimated amount that has expired
Accountants use adjusting entries to during the period or that has benefited the
apply accrual accounting to transactions that period is transferred from the asset account to
cover more than one accounting period. an expense account. Two of the more
There are two general types of adjustments important kinds of adjustments are prepaid
made at the end of the accounting period – expenses, and depreciation of property and
deferrals and accruals. equipment.

Each adjusting entry affects a balance Prepaid Expenses

sheet account (an asset or a liability account) Some expenses are customarily paid
and an income statement account (income or in advance. These expenditures (e.g.,
expense account). supplies, rent and insurance) are called
prepaid expenses. Prepaid expenses are
assets, not expenses. At the end of an expenses. Three factors are involved in
accounting period, a portion or all of these computing depreciation expense.
prepayments may have expire. The portion of 1. Asset cost is the amount an entity paid to
an asset that has expired becomes an expense. acquire the depreciable asset.
Prepaid expenses expire either with the 2. Estimated salvage value is the amount that
passage of time or through use and the asset can probably be sold for at the end of
consumption. The flow of costs from the its estimated useful life.
balance sheet to the income statement is 3. Estimated useful life is the estimated number
illustrated below: of periods that an entity can make use of the
asset. Useful life is an estimate, not an exact
If adjustment for prepaid expenses measurement.
are not made at the end of the period, both the
balance sheet and the income statement will Accountants estimate periodic
be misstated. First, the assets of the entity will depreciation. They have developed a number
be overstated; second, the expenses of the of methods for estimating depreciation. The
company will be understated. For this reason, simplest procedure is called the straight-line
owner’s equity in the balance sheet and profit method.
in the income statement will both be
overstated. Besides prepaid rent, Wedding The asset account is not directly
“R” Us has prepaid expenses for supplies and reduced when recording depreciation
insurance, both accounts need adjusting expense. Instead, the reduction is recorded in
entries. a contract account called accumulated
depreciation. A contra account is used to
Prepaid Rent (adjustment a). On May 1, record reductions in a related account and its
Weddings “R” Us paid P8,000 for two normal balance is opposite that of the related
months’ rent in advance. This expenditure account. Use of the contra account –
resulted to an asset consisting of the right to accumulated depreciation – allows the
occupy the office for two months. A portion of disclosure of the original cost of the related
the asset expires and becomes an expense asset in the balance sheet. The balance of the
each day. contra account is deducted from the cost to
obtain the book value of the property and
Supplies (adjustment c). On May 8, equipment.
Weddings “R” Us purchased supplies,
P18,000. During the month, the entity used Allocating revenues Received in
supplies in the process of performing services Advance to Revenues
for clients. There is no need to account for There are times when an entity
these supplies every day since the financial receives cash for services or goods even before
statements will not be prepared until the end service is rendered or goods are delivered.
of the month. At the end of the accounting When such is received in advance, the entity
period, Perez-Manalo makes a careful has an Obligation to perform services or
physical inventory of the supplies deliver goods. The liability referred to is
unearned revenues.
Depreciation of Property and
Equipment Adjustment for Accruals (Step 5)
When an entity acquires long-lived assets Accrued Expenses
such as buildings, service vehicles, An entity often incurs expenses
computers or office furnitures, it is basically before paying for them. Cash payments are
buying or preparing for the usefulness of that usually made at regular intervals of time such
asset. These assets help generate income for as weekly, monthly, quarterly or annually. If
the entity. Therefore, a portion of the cost of the accounting period ends on a date that
the assets should be reported as expense in does not coincide with the schedule cash
each accounting period. Proper accounting payment date, an adjusting entry is needed to
requires the allocation of the cost of the asset reflect the expense incurred since the last
over its estimated useful life. The estimated payment. This adjustment helps the entity
amount allocated to any one accounting avoid the impractical preparation of hourly or
period is called depreciation or depreciation daily journal entries just to accrue expenses.
Salaries, interest, utilities (e.g., electricity,
telecommunications and water) and taxes are PREPARING THE WORKSHEET (step
examples of expenses that are incurred before 5)
payment is made.
The steps in the preparation of a worksheet
Accrued Salaries (adj. g). will be illustrated using the Wedding “R” Us
Entities pay their employees at case:
regular intervals. It can be weekly, semi- 1. Enter the account balances in the
monthly or monthly. Weekly payrolls are unadjusted trial balance columns and
usually made on Fridays (for a five-day total the amounts. The numbers, titles
workweek) or Saturdays (for a six-day and balances of the accounts as at May 31
workweek). Weddings “R” Us pays salaries are lifted directly from the ledger before
every two Saturdays. the adjusting entries are prepared. The
accounts are listed in the worksheet in the
Accrued Interest (adj. h). order they appear in the ledger. Total
Interest is a charge for the use of money over debits must equal total credits, as shown
time. Interest expense is matched to a in Exhibit 4-1. Accounts with zero
particular period during which the benefit – balances (e.g., salaries payable, interest
the use borrowed money – is received. The payable, etc.) are also presented. Listing
interest is a fixed obligation and accrues all the accounts with their balances helps
regardless of the result of the entity’s identify the accounts that need
operations. adjustments. This practice will help
ensure the achievement of completeness
Accrued Revenues and accuracy in the adjustment process.
An entity may provide services during the
period that are neither paid for by clients nor 2. Enter the adjusting entries in the
billed at the end of the period. The value of adjustment columns and total the
amounts. When a worksheet is used, all
these services represents revenue earned by
adjustments are first entered in the
the entity. Any revenue that has been earned
worksheet. The required adjustments for
but not recorded during the accounting period
Weddings “R” Us were explained in the
calls for an adjusting entry that debits as asset
previous chapter. The same adjustments
account and credits an income account.
are entered in the adjustments columns of
the worksheet in Exhibit 4-2. As each
Chapter 4 adjustment is entered, a letter is used to
The Worksheet identify the debit entry and the
Accountants often use a worksheet to help corresponding credit entry. Note that the
transfer data from the unadjusted trial adjustments are not journalized until
balance to the financial statements. This after the worksheet is completed and the
multi-column document provides an efficient financial statements prepared.
way to summarize the data for financial
statements. The accountant generally 3. Compute each account’s adjusted balance
prepares a worksheet when it is time to adjust by combining the unadjusted trial balance
the accounts and prepare financial and the adjustment figures. Enter the
statements. Note, however, that it is possible adjusted amounts in the adjusted trial
to prepare financial statements directly from balance columns. Exhibit 4-3 exhibited
the adjusted trial balance at the end of the the adjusted trial balance prepared by
accounting period if the business has combining horizontally, line by line, the
relatively few accounts. amount of each account in the unadjusted
trial balance columns with the
The worksheet simplifies the adjusting and corresponding amounts in the
closing process. It can also reveals errors. adjustment columns. This procedure is
The work sheet is not part of the ledger or the called crossfooting. To illustrate, the first
journal, nor is it a financial statement. It is a line showed cash with a debit amount of
summary device used by the accountant for P22,200 in the unadjusted trial balance.
his convenience. There is no adjustment to the cash
account so that the P22,200 is entered in
the debit column of the adjusted trial
 balance. On the second line is accounts capital balance; this is done when the
receivable with a P12,000 balance in the statement of changes in equity is prepared.
unadjusted trial balance; a debit of
P5,300 is entered in the adjustments ESSENCE OF FINANCIAL
columns. The resulting balance is a STATEMENTS
P17,300 debit in the adjusted trial There are questions that the owner of
balance. a business periodically asks – how much did
the business entity earn? What is the financial
4. Extend the asset, liability and owner’s condition of the business? How much is the
equity amounts from the adjusted trial owner’s interest in the entity today? What
balance columns to the balance sheet happened to the cash receipts? Where did
columns. Extend the income and expense cash go? Investors, creditors, taxing
amounts to the income statement authorities and other users have their own
columns. Total the statement columns. questions about the business which need to be
answered.
Every account is either a balance
sheet account or an income statement The financial statements are the
account. Asset, liability, capital and means by which the information accumulated
withdrawal accounts are extended to the and processed in financial accounting is
balance sheet columns. Income and periodically communicated to the users.
expense accounts are moved to the Without accounting information embodied in
income statement columns. Debits in the the financial statements, users may not be
adjusted trial balance remain as debits in able to arrive at sound economic decisions.
the statement columns while credits as
credits. Each accounts adjusted balance Per March 2018 Conceptual
should appear in only one statement framework for Financial Reporting (2018
column as shown in exhibit 4-4. At this conceptual framework), the objective of
stage, the initial totals of the income financial statements is to provide financial
statement and balance sheet columns are information about the reporting entity’s
not equal. assets, liabilities, equity, income and expenses
that is useful to users of financial statements
5. Compute profit or loss as the difference in assessing the prospects for future net cash
between total revenues and total expenses inflows to the reporting entity and in
in the income statement. Enter profit or assessing management’s stewardship of the
loss as a balancing amount in the income entity’s economic resources.
statement and in the balance sheet, and
compute the final column totals. COMPLETE SET OF FINANCIAL
STATEMENTS
The profit or loss should always be the
amount by which the debit and credit columns
Per revised PAS no. 1, a complete set of
for income statement, and the debit and credit
financial statements comprises:
columns for balance sheet differ. The profit
figure of P35,000 is entered in the debit 1. A statement of financial position as at
column of the income statement and the the end of the period;
credit column of the balance sheet. After 2. A statement of financial performance
completion, total debits and total credits in for the period;
the income statement and balance sheet 3. A statement of changes in equity for
columns must equal. the period;
4. A statement of cash flows for the
The profit figure is extended to the credit period;
column of the balance sheet because profit 5. Notes, comprising a summary of
increases owner’s equity are recorded as significant accounting policies and
credits. Observe that the capital account other explanatory information; and
amount of P250,000 shown in the worksheet 6. A statement of financial position as at
reflects the beginning rather than the ending the beginning of the earliest
balance. Profit must be added and comparative period when an entity
withdrawals subtracted to arrive at the ending applies an accounting policy
retrospectively or makes a
 retrospective restatement of items in performance comprises a single statement or
its financial statements or when it two statements.
reclassifies items in its financial
statements. The income statement is a statement
showing the performance of the enterprise for
In a nutshell, the statement of financial a given period of time. It summarizes the
position (or balance sheet) lists all the assets, revenues earned and expenses incurred for
liabilities and equity of an entity as at a that period of time. The income statement for
specific date. The statement of financial Weddings “R” Us (refer to exhibit 4-5) is
performance (or income statement) presents prepared directly from the income statement
a summary of the revenues and expenses of an columns of the worksheet in exhibit 4-4.
entity for a specific period. The statement of
changes in equity presents a summary of the Information about the performance
changes in capital such as investments, profit of an enterprise, in particular its profitability,
or loss, and withdrawals during a specific is required in order to assess potential
period. The statement of cash flows reports changes in the economic resources that it is
the amount of cash received and disbursed likely to control in the future. It is also useful
during the period. Accounting policies are the in predicting the capacity of the enterprise to
specific principles, bases, conventions, rules generate cash flows from its existing resource
and practices adopted by an enterprise in base.
preparing and presenting financial
statements. Notes to financial statements Statement of Changes in Equity
provide narrative description or The statement of changes in equity
disaggregation of items presented in the summarizes the changes that occurred in
statements and information about items that owner’s equity. This statement is now a
do not qualify for recognition in the required statement (per revised Philippine
statements. Accounting Standards (PAS) no.1). Changes
in an enterprise’s equity between two balance
PREPARING THE FINANCIAL sheet dates reflect the increase or decrease in
(step 6) its net assets during the period.

Once the worksheet is completed, it is In the case of sole proprietorships,

easy to prepare the financial statements for increases in owner’s equity arise from
the account balances have been extended to additional investments by the owner and
the appropriate income statement and profit during the period. Decreases result
balance sheet columns. Most of the from withdrawals by the owner and from loss
information needed to prepare the income for the period. The beginning balance and
statement, statement of changes in equity and additional investments are taken from the
balance sheet are available from the owner’s capital account in the general ledger.
worksheet. The statements presented are The profit or loss figure comes directly from
those of Weddings “R” Us. Note that financial the income statement while the withdrawals
statements shall be presented at least from the balance sheet columns in the
annually (per revised PAS no. 1) worksheet

Statement of Financial Performance Statement of Financial Position

An entity can present all items of The statement of financial position is
income and expense recognized in a period: a statement that shows the financial position
in a single statement of comprehensive or condition of an entity by listing the assets,
income, or in two statements: a statement liabilities and owner’s equity as at a specific
displaying components of profit or loss date. The information needed for this
(separate income statement) and a second statement are the net balances at the end of
statement beginning with profit or loss and the period, rather than the total for the period
displaying components of other as in the income statement. This statement is
comprehensive income. However, the 2018 also called the balance sheet.
conceptual framework does not specify
whether the statement of financial Users of financial statements analyze
the balance sheet to evaluate an entity’s
liquidity, its financial flexibility, and its ability When presentation based on liquidity
to generate profits, and its solvency. Liquidity provides accounting information that is
refers to the availability of cash in the near reliable and more relevant to decision-makers
future after taking account of the financial then an entity shall present all assets and
commitments over this period. Financial liabilities in order of liquidity. For example,
flexibility is the ability to take effective actions • Assets are classified and presented in
to alter the amounts and timings of cash flows decreasing order of liquidity. Cash is
so that it can respond to expected needs and the most liquid. Assets that are least
opportunities. This includes the ability to likely to be converted to cash are
raise new capital or tap into unused lines of listed last.
credit. Solvency refers to the availability of • Liabilities are generally classified and
cash over the longer term to meet financial presented based on time of maturity
commitments as they fall due. such that obligations which are
currently due are listed first.
In preparing the balance sheet, it may
not be necessary to make any further analysis Statement of Cash Flows
of the data. The needed data – that is, the The statement of cash flows provides
balances of the asset, liability, and owner’s information about the cash receipts and cash
equity accounts- are already available from payments of an entity during a period. It is a
the balance sheet columns of the worksheet. formal statement that classifies cash receipts
However, the interim balance for owner’s (inflows) and cash payments (outflows) into
equity must be revised to include profit or loss operating, investing and financing activities.
and owner’s withdrawals for the accounting This statement shows the net increase or
period. The adjusted amount for ending decrease in cash during the period and the
owner’s equity is shown in the statement of cash balance at the end of the period; it also
changes in equity. helps project the future net cash flows of the
entity. The discussion below gives an
Format overview of some important concepts
The balance sheet can be presented in involved in the preparation of the cash flow
either the report format or the account statement.
format. The report format simply lists the
assets, followed by the liabilities then by the Cash Flows from Operating Activities
owner’s equity in vertical sequence. The Operating activities generally involve
account format lists the assets on the left and providing services, and producing and
the liabilities and owner’s equity on the right. delivering goods. Cash flows from operating
Either balance sheet format is acceptable. activities are generally the cash effects of
transactions and other events that enter into
Classification the determination of profit or loss. This cash
The revised PAS no. 1 does not flow can be presented using either the direct
prescribe the order or format in which an or the indirect method.
entity presents items in the statement of
financial position; what is required is the Using the direct method, the entity’s net
current and non-current distinction for assets cash provided by (used in) operating activities
and liabilities. Assets can be presented is obtained by adding the individual operating
current then non-current, or vise versa. cash inflows and then subtracting the
Liabilities and equity can be presented individual operating cash outflows.
current liabilities then non-current liabilities
then equity, or vice versa. The indirect method derives the net cash
provided by (used in) operating activities by
It is proper to present a classified adjusting profit for income and expense items
balance sheet; that is, the assets and liabilities not resulting from cash transactions. The
are separated into various categories. Assets adjustment begins with profit followed by the
are sub-classified as current assets and non- addition of expenses and charges (e.g.,
current assets; while liabilities as current depreciation) that did not entail cash
liabilities and non-current liabilities. payments. Then, increases in current assets
Classifying a balance sheet aids in the analysis and decreases in current liabilities involved in
of financial statement data. the determination of profit but which did not
actually increase or decrease cash, are and obtaining and selling or property and
subtracted from profit. Finally, decreases in equipment and other productive assets.
current assets and increases in current
liabilities are added to profit to obtain net Cash Inflows
cash provided by (used in) operating • Receipts from sale of property and
activities. equipment
• Receipts from sale of investments in
For example, increases in accounts debt or equity securities
receivable from sale of services or goods • Receipts from collections on notes
represented an increase in profit without the receivable
corresponding increase in cash – for it is still
a receivable. Since these revenues are already Cash Outflows
included in the computation of profit, the • Payments to acquire property and
increase in accounts receivable should be equipment
deducted from the profit figure. To illustrate
• Payments to acquire debt or equity
further, assume that salaries payable
securities
increased. Increases in salaries payable
meant that the entity did not pay the full • Payments to make loans to others
amount of salaries expense for the period. generally in the form of notes
receivable
The expense in the income statement,
for cash flow purposes, is overstated by the Cash Flows from Financing Activities
amount of unpaid salaries. If expense is Financing activities include obtaining
overstated, then profit is understated by the resources from owners and creditors.
same amount; hence, the increase in current
liability is added to profit. Cash Inflows
• Receipts from investment by owners
Per Philippine Accounting Standards • Receipts from issuance of notes
(PAS) no. 7, enterprises are encouraged to payable
report cash flows from operating activities the
direct method but the indirect method is Cash Outflows
acceptable. Only the direct method is • Payments to owners in the form of
illustrated here. The following are the major withdrawals
classes of operating cash flows using the direct • Payments to settle notes payable
method.

Cash Inflows Cash Flows from Operating Activities:

• Receipts from sale of goods and Cash received from clients
performance of services Payments to suppliers
• Receipts from royalties, fees, Payments to employees
commissions and other revenues Payments for office rent
Payments for insurance
Cash Outflows Payments for utilities
• Payments to suppliers of goods and Net cash provided by (used) operating activities
services
• Payments to employees Cash Flows from Investing Activities:
• Payments for taxes Payments to acquire service vehicle
• Payments for interest expense Payments to acquire office equipment
• Payments for other operating Net cash provided by (used in) investing activities
expenses
Cash Flows from Financing Activities:
Cash Flows from Investing Activities
Cash received as investments by owner
Investing activities include making
Cash received from borrowings
and collecting loans; acquiring and disposing
of investments in debt or equity securities; Payments for withdrawals by owner
Net cash provided by (used in) financing activities
 Net increase (decrease) in Cash income, expense, and withdrawal P 22,200
Cash balance at the beginning of the period transactions. This phase of the cycle is called-
Cash balance at the end of the period the closing procedure. ------------------

Relationships among the financial A temporary account is said to be closed

statements when an entry is made such that its balance
The financial statements are based on the becomes zero. Closing simply transfer the
same underlying data are fundamentally balance of one account to another account. In
related. The following shows the basic this case, the balances of the temporary
interrelationships among the financial accounts are transferred to the capital
statements: account. A summary account-Income
Summary is used to close the income and
1. The income statement reports all income and expense accounts. The steps in closing the
expenses during the period. The profit or loss accounts of an entity will be illustrated using
is the final figure in this statement. the Weddings “R” Us case.
2. The statement of changes in equity considers
the profit or loss figure from the income 1. Close the income accounts
statement as one of the determining factors Income accounts have credit
that explains the change in owner’s equity. balances before the closing entries are
3. The statement of financial position reports posted. For this reason, an entity debiting
the ending owner’s equity, taken directly from each revenue account in the amount of its
the statement of changes in equity. balance is needed to close the account. The
4. The statement of cash flows reports the net credit is made to the income summary
increase or decrease in cash during the period account.
and ends with the cash balance reported in the The dual effect of the entry is to
balance sheet. This statement is prepared make the balances of the income accounts
based on information from the income equal to zero, and to transfer the balances in
statement and the balance sheet. total to the credit side of the income
summary account. Note that the data for
ADJUSTMENTS ARE JOURNALIZED closing the income accounts can be found in
AND POSTED (step 7) the credit side of the income statement
The adjustment process is a key columns of the worksheet in exhibit 4-4.
element of accrual basis accounting. The
worksheet helps in the identification of the 2. Close the expense accounts
accounts that need adjustments. The Expense accounts have debit
adjusting entries are directly entered in the balances before the closing entries are
worksheet. Most accountants prepare the posted. For this reason, a compound entry is
financial statements immediately after needed crediting each expense account for its
completing the worksheet. The adjustments balance and debiting the income summary
are journalized and posted as the closing
for the total. These data can be found in the
entries are made. This step in the accounting
debit side of the income statement columns
cycle brings the ledger into agreement with
of the worksheet.
the data reported in the financial statements.
The effect of posting the closing
CLOSING ENTRIES ARE
entry is to reduce the expense account
JOURNALIZED AND POSTED (step 8)
balances to zero and to transfer the total of
Income, expense and withdrawal
the account balances to the debit side of the
accounts are temporary accounts that
income summary account.
accumulate information related to a specific
accounting period. These temporary
accounts facilitate income statement 3. Close the income summary account
After posting the closing entries
preparation. At the end of each year, the
involving the income and expense accounts,
balances of these temporary accounts are
the balance of the income summary account
transferred to the capital account. Thus, the
will be equal to the profit or loss for the
balance of the owner’s capital account
period. A profit is indicated by a credit
represents the cumulative net result of
 balance and a loss by a debit balance. The It should be emphasized that
income summary account, regardless of the reversing entries are optional. Also, the act of
nature of its balance, must be closed to the reversing a previously recorded adjusting
capital account. entry should not lead us to the conclusion that
the entries reversed are unnecessary or
The effect of posting this closing inaccurate.
entry is to close the income summary
account balance and to transfer the balance Even when an entity follows the
to Perez-Manalo’s capital account for the policy of making reversing entries, not all
profit. adjusting entries should be reversed.
Generally, a reversing entry should be made
for any adjusting entry that increased an asset
4. Close the withdrawals account
or a liability account. Therefore, all accruals
The withdrawals account shows the
are reversed but only deferrals initially
amount by which capital is reduced during recorded in income statement –income or
the period by withdrawals of cash or other expense – accounts are reversed
assets of the business by the owner for
personal use. Using the summary of adjusting
entries in chapter 4, the veracity of the general
The effect of posting this closing rule stated in the previous paragraph can be
entry is to close the withdrawal account and proven. For example, in the case of a prepaid
to transfer the balance to the capital account. expense initially recorded in an expense
account, the adjusting entry debited an asset
PREPARATION OF A POST-CLOSING – prepaid expense. An asset increased; hence,
TRIAL BALANCE (step 9) applying the general rule, this adjustment can
It is possible to commit an error in be reversed.
posting the adjustments and closing entries to
the ledger accounts; thus, it is necessary to After analyzing the rest of the
test the equality of the accounts by preparing adjusting entries, the adjustments that can be
a new trial balance. This final trial balance is reversed are as follows: prepaid expenses
called a post-closing trial balance. (expense method), unearned revenues
• The post-closing trial balance verifies (income method), accrued expenses and
that all the debits equal the credits in accrued revenues.
the trial balance.
• The trial balance contains only Chapter 6
balance sheet items such as assets, Merchandising Operations
liabilities, and ending capital because
all income and expense accounts, as COMPARISON OF INCOME
well as the withdrawals account, have STATEMENTS
zero balances. Service entities perform services for a
Notice that only the balance sheet accounts fee. In ascertaining profit, a basic income
have balances because at this point, all the statement is all that is needed. In figure 6-1,
income statement accounts have been closed. profit is measured as the difference between
revenues from services and expenses. In
Preparing the post-closing trial contrast, merchandising entities earn profit
balance may not be the last step in the by buying and selling goods. These entities
accounting cycle. Some entities elect to use the same basic accounting methods as
reverse certain end-of-period adjustments on service entities, but the process of buying and
the first day of the new period. A reversing selling merchandise requires some additional
entry is a journal entry which is the exact accounts and concepts. This process results in
opposite of a related adjusting entry made at a more complex income statement. To
the end of the period. It is basically a provide a better measure of performance, the
bookkeeping technique made to simply the income statement of a merchandising
recording of regular transactions in the next business is presented with additional items:
accounting period.
 Figure 6-1 Components of Income conditions and terms of delivery such as
Statements for Service and freight terms, time, place, and the person
Merchandising Entities named to receive the goods.
3. The statement of account is a formal
In a merchandising business, net notice to the debtor detailing the accounts
sales arise from sale of goods while cost of already due.
sales or cost of goods sold represents the cost 4. The official receipt evidences the
of inventory the entity has sold to customers. receipt of cash by the seller or the
The difference between net sales and cost of authorized representative. It notes the
sales is called gross profit. Then, other invoices paid and other details of
operating income is added and operating payment.
expenses (like distribution costs, 5. Deposits slips are printed forms with
administrative expenses and other operating depositor’s name, account number and
expenses) are deducted from gross profit to space for details of the deposit. A
arrive at operating profit. Investment validated deposit slip indicates that cash
revenues, other gains and losses, and finance and checks with the supplied details were
costs (e.g. interest expense) are considered to actually deposited or credited to the
arrive at profit before tax then income tax account holder.
expense is deducted to have profit from 6. A check is a written order to a bank by a
continuing operations. Finally, profit from depositor to pay the amount specified in
discontinued operations (net of tax) is taken the check from his checking account to
to account to get profit for the period. the person named in the check. The entity
issuing the check is the payor while the
OPERATING CYCLE OF A receiver is the payee.
MERCHANDISING BUSINESS 7. The purchase requisition is a written
The merchandising entity purchases request to the purchaser of an entity from
inventory, sells the inventory and uses the an employee or user department of the
cash to purchase more inventory –and the same entity that goods be purchased.
cycle continues. For cash sales, the cycle is 8. The purchase order is an authorization
from cash to inventory and back to cash. For made by the buyer to the seller to deliver
sales on account, the cycle is from cash to the merchandise as detailed in the form.
inventory to accounts receivable and back to 9. Receiving report is a document
cash. In any industry, the manager strives to containing information about goods
shorten the cycle. The faster the sale of received from a vendor. It formally
inventory and the collection of cash, the records the quantities and description of
higher the profits the goods delivered.
10. A credit memorandum is a form used by
SOURCE DOCUMENTS the seller to notify the buyer that his
account is being decreased due to errors
Merchandising businesses use various
or other factors requiring adjustments.
business forms and documents to help
identify the transactions that should be
recorded in the books. These source STEPS IN A PURCHASE
documents contain vital information about TRANSACTION
the nature and amount of the transactions. Whenever a purchase or sale of
merchandise occurs, the buyer and the seller
1. Sales invoice is prepared by the seller of should agree on the price of the merchandise,
goods and sent to the buyer. This the payment terms and the party to shoulder
document contains the name and address the transportation costs. Owners of small
of the buyer, the date of sale and merchandising firms may settle these terms
information quantity, description and informally by phone or by discussion with the
price – about the goods sold. It also vendor’s representative. Most large
specifies the amount of sales, and the businesses, however, follow certain
transportation and payment terms. procedures when purchasing merchandise.
2. The bill of lading is a document issued
by the carrier-a trucking, shipping or The procedures are as follows:
airline – that specifies contractual 1. When certain items are needed, the user
department fills in a purchase requisition
 form and sends it to the purchasing invoice is due ten days after the end of the
department. month, it may be marked “n/10 eom”.
2. The purchasing department then prepares a
purchase order after checking with the price Cash Discounts
lists, quotations, or catalogs of approved Some businesses gives discounts for
vendors. The purchase order, addressed to prompt payment called cash discounts. If a
the selected vendor, indicates the quantity, trade discount is also offered, cash discount is
description, and price of the merchandise computed on the net amount after the trade
ordered. It also indicates expected payment discount. This practice improves the seller’s
terms and transportation arrangements. cash position by reducing the amount of
3. After receiving the purchase order, the seller money in accounts receivable. Cash discount
forwards an invoice to the purchaser upon is designated by such notation as “2/10”
shipment of the merchandise. The invoice – which means the buyer may avail of a two
called a sales invoice by the seller and a percent discount if the invoice is paid within
purchase invoice by the buyer-defines the ten days from the invoice date. The period
terms of the transaction. covered by the discount, in this case –ten
4. Upon receiving the shipment of merchandise, days, is called the discount period.
the purchaser’s receiving department sees to
it that the terms in the purchase order are Cash discounts are called purchase
complied with, and prepares a receiving discounts from the buyer’s viewpoint and
report. sales discounts from the seller’s point of view.
5. Before approving the invoice for payment, the
accounts payable department compares It is usually worthwhile for the buyer
copies of the purchase requisition, purchase to take a discount if offered although it may be
order, receiving report and invoice to ensure necessary to borrow the money to make the
that quantities, descriptions, and prices agree. payment.

All of the above forms – purchase Trade Discounts

requisition, purchase order, invoice and Suppliers furnish smaller wholesalers
receiving report – are source documents. or retailers with price lists and catalogs
When the goods are received or when title has showing suggested retail prices for their
passed, the entity should record purchases products. These firms, however, also include
and a liability (or a cash disbursement). a schedule of trade discounts from the listed
Generally, the seller recognizes the sales prices to enable the customer to determine
transaction in the records when the goods the invoice price to be paid. Trade
have been shipped. discounts encourage the buyers to purchase
products because of markdowns from the list
TERMS OF TRANSACTIONS price. Trade discounts should not be confused
Merchandise may be purchased and with cash discounts. This type of discount
sold either on credit terms or for cash on enables the suppliers to vary prices
delivery. When goods are sold on account, a periodically without the inconvenience of
period of time called the credit period is revising price lists and catalogs.
allowed for payment. The length of the credit
period varies across industries and may even There is no trade discount account
vary within an entity, depending on the and there is no special accounting entry for
product. this discount. Instead, all accounting entries
are based on the invoice price which is
When goods are sold on credit, both obtained by subtracting the trade discount
parties should have an understanding as to from the list price.
the amount and time of payment. These
terms are usually printed on the sales invoice Transportation Costs
and constitute part of the sales agreement. If When merchandise is shipped by a
the credit period is 30 days, then payment is common carrier – a trucking entity or an
expected within 30 days from the invoice date. airline –the carrier prepares a freight bill in
The credit period is usually described as the accordance with the instructions of the party
net credit period or net terms. The credit making the shipping arrangements. The
period of 30 days is noted as “n/30”. If the freight bill designates which party shoulders
the costs, and whether the shipment is freight account which is also called delivery expense,
prepaid or freight collect. is an operating expense in the income
statement.
Freight bills usually show whether the
shipping terms are FOB shipping point or INVENTORY SYSTEMS
FOB destination. FOB is an abbreviation for Merchandise inventory is the key
“free on board”. When the freight terms are factor in determining cost of sales. Because
FOB shipping point, the buyer shoulders the merchandise inventory represents goods
shipping costs; ownership over the goods available for sale, there must be a method of
passes from seller to the buyer when the determining both the quantity and the cost of
inventory leaves the seller’s place of business- these goods. There are two systems available
the shipping point. The buyer already owns to merchandising entities to record events
the goods while still in transit and therefore, related to merchandise inventory: the
shoulders the transportation costs. perpetual inventory system and the periodic
inventory system.
If the terms are FOB destination, the
seller bears the shipping costs. Title passes Perpetual Inventory System
only when the goods are received by the buyer The perpetual inventory system is an
at the point of destination; while in transit, the alternative to the periodic inventory system.
seller is still the owner of the goods so the Under the perpetual inventory system, the
seller shoulders the transportation costs. inventory account is continuously updated.
Perpetually updating the inventory account
In freight prepaid, the seller pays the requires that at the time of purchase,
transportation costs before shipping the merchandise acquisitions be recorded as
goods sold; while in freight collect, the freight debits to the inventory account. At the time of
entity collects from the buyer. Payment by sale, the cost of sales is determined and
either party will not dictate who should recorded by a debit to the cost of sales account
ultimately shoulder the costs. and a credit to the inventory account. With a
perpetual inventory system, both the
Normally, the party bearing the inventory and cost of sales accounts receive
freight cost pays the carrier. Thus, goods are entries throughout the accounting period.
typically shipped freight collect when the
terms are FOB shipping point; and freight Many merchandising entities are now
prepaid when the terms are FOB destination. using the perpetual inventory system with
point of sale equipment. Computers have
Sometimes, as a matter of decreased in prices. These powerful machines
convenience, the firm not bearing the freight have dramatically reduced the time required
costs pays the carrier. When this situation to manage inventory. Supermarket and
occurs, the seller and buyer simply adjust the department stores use point-of-sale scanners
amount of the payment for the merchandise. built into checkout counters to collect
transactional data for the cash register and to
Figure 6-3 treatment of transportation update their perpetual inventory system. In
costs the absence of point of sales scanners, the
The shipping costs borne by the buyer perpetual inventory system is more advisable
using the periodic inventory system are for firms that sell low-volume, high-priced
debited to transportation in account. In goods such as motor vehicles, jewelry and
accounting, the cost of an asset – the furniture.
merchandise inventory – includes all costs
(e.g. shipping costs) incurred to bring the When an entity uses the perpetual
asset to its intended use. In the cost of sales inventory system, the ending inventory
section of the income statement, the balance should reconcile with the actual physical
in this account is added to purchases in count at the end of the period assuming that
computing for the net cost of purchases for the no theft, spoilage, or error has occurred. Even
period. if there is a little chance for or suspicion of
inventory discrepancy, most entities make a
Shipping costs borne by the seller are physical count. At that time, the account is
debited to transportation out account. This adjusted for any inaccuracies discovered. The
count provides an independent check on the Alternatively, the seller may just
amount of inventory that should be reported grant an allowance or deduction from the
at the end of the period. selling price. A high sales returns and
allowances figure is not commendable
Periodic Inventory System because it may signal poor quality of goods
The periodic inventory system is and thus may result to dissatisfied customers.
primarily used by businesses that sell
relatively inexpensive goods and that are not Transportation Out
yet using computerized scanning systems to When the freight term FOB
analyze goods sold. A characteristic of the destination, the seller shoulders the
periodic inventory system is that no entities transportation costs; when the term is FOB
are made to the inventory account as the shipping point, the buyer bears the shipping
merchandise is bought and sold. When goods costs.
are purchased, a separate set of accounts –
purchases, purchases discounts, purchases COST OF SALES
returns and allowances, and transportation in Cost of sales or cost of goods sold is
–is used to accumulate information on the net the largest single expense of the
cost of the purchases. Only at the end of the merchandising business. It is the cost of
period, when the inventory is counted, will inventory that the entity has sold to
entries be made to the inventory account to customers. Every merchandising business
establish it’s proper balance. The periodic has goods available for sale to customers. The
inventory system will be used in the goods available for sale during the year is the
succeeding discussions sum of two factors – merchandise inventory
at the beginning of the year and net cost of
Gross Sales purchases during the period.
Under accrual accounting, revenues
from the sale of merchandise are considered If an entity is able to sell all the goods
to be earned in the accounting period in which available for sale during a given accounting
the tittle of goods passes-usually at the point period, the cost of sales would then equal
of delivery –from the seller to the buyer. goods that had been available for sale. In
Gross sales consist of total sales for cash and most cases, however, the business will have
on credit during an accounting period. goods still unsold at the end of the year. To
Although cash for the sale is uncollected, the find the actual cost of sales, the merchandise
revenue is recognized as earned at the time of inventory at the end of the period is
the sale. For this reason, there is likely to be a subtracted from the goods available for sale.
difference between net sales and cash
collected from those sales in a given period. Merchandise Inventory
The inventory of a merchandising
As an income account, the sales entity consists of goods purchased for resale.
account is credited whenever sales on account For a grocery store, inventory would be made
or cash sales are made. Only sales of up of meats, vegetables, canned goods, and
merchandise held for resale are recorded in other items. For a lumber and hardware, it
the sales account. If a merchandising firm would be plywood, nails, paints, iron sheets,
sold one of its delivery trucks, the credit would cement, tools and other items.
be made to the delivery equipment account, Merchandising entities purchase their
not to sales account. inventories from manufacturers, wholesalers
and other suppliers.
Sales Returns and Allowances
Buyers may be dissatisfied with the The merchandise inventory at the
merchandise received either because the beginning of the accounting period is called
goods are damaged or defective, of inferior the beginning inventory. Conversely, the
quality or not in accordance with their merchandise inventory at the end of the
specifications. In such a cases, the buyer may accounting period is called the ending
return the goods to the seller for credit if the inventory. As presented in exhibit 6-3,
sale was made on account or for cash refund if beginning and ending inventory are used in
the sale was for cash. calculating cost of sales in the income
statement. The ending inventory shown in
the income statement will be the merchandise Like purchases returns and
inventory to be reported in the balance sheet. allowances, purchases discounts is a contra
Effectively, the ending inventory of the account that is deducted from purchases on
current period will be the beginning inventory the income statement. If the entity makes a
of the next period. partial payment on an invoice, most creditors
will allow the entity to take the discount
Net Cost of Purchases applicable to the partial payment. The
Under the periodic inventory discount does not apply to transportation or
method, net cost of purchases consist of gross other charges that might appear on the
purchases minus purchases discounts and invoice.
purchases returns and allowances equals net
purchases; plus transportation costs. VALUE ADDED TAX ENTRIES
The foregoing entries for sales and
Purchases purchases did not incorporate the effect of
When the periodic inventory method value –added taxes on the transactions to
is used, all purchases of merchandise are simplify the illustrations.
debited to the purchases account.
Input tax increased the amount to be
The purchases account, a temporary paid but has no effect on the cost of the
account, is used only for merchandise purchases. Output tax also increased the
purchased for resale. Its sole purpose is to amount collected but not necessarily, the sales
accumulate the total cost of merchandise figure. The value of goods or properties sold
purchased during an accounting period. and subsequently returned or for which
Purchases of other assets such as equipment allowances were granted by a VAT-registered
should be recorded in the appropriate assets person may be deducted from the gross sales
accounts. Recording merchandise purchases or receipts for the quarter in which the refund
at invoice price is known as the gross price is made or a credit memorandum is issued.
method of recording purchases. Sales discounts granted or indicated in the
invoice at the time of sale may be excluded
Purchases Returns and Allowances from the gross sales within the same quarter
Sales returns and allowances in the it was given.
seller’s books are recorded as purchases
returns and allowances in the books of the OPERATING EXPENSES
buyer. Operating expenses make up the
Purchases returns and allowances is a third major part of the income statement for a
contra account and is accordingly deducted merchandising entity. These are expenses,
from purchases in the income statement. It is other than the cost of sales, which are
important that a separate account be used to incurred to generate profit from the entity’s
record purchases returns and allowances major line of business- merchandising. It is
because management needs the information customary to group operating expenses into
for decision making. useful categories. Distribution costs,
administrative expenses and other operating
It may be very costly to return expenses are the categories.
merchandise. There are costs that cannot be
recovered such as ordering costs, accounting Distribution costs or selling expenses
costs, transportation costs, and interest on the are those expenses related directly to the
money invested in the goods. There may also entity’s efforts to generate sales. These
be lost sales resulting from poor ordering or include sales salaries and commissions, and
unsaleable goods. Frequent returns may call the related employer payroll expenses;
for new purchasing procedures or suppliers. advertising and store displays; traveling
expenses; store supplies used; depreciation of
Purchases Discounts store property and equipment; and
Merchandise purchases are usually transportation out.
made on credit and commonly involve
purchases discounts for early payment. Administrative expenses are those
expenses related to the general
administration of the business. These include
officers and office salaries, and the related depreciation of building and office equipment
employer payroll expenses; office supplies (adjs. d & e); accrual of interest expense (adj.
used; depreciation of office property and f); no adjustment entry is made for
equipment; business taxes; professional merchandise inventory because the closing
services; uncollectible accounts expense and entry method was used. After the adjusting
other general office expenses. entries are entered in the worksheet, the trial
balance columns and adjustment columns are
Other operating expenses are those totaled to prove the equality of the debits and
expenses that are not related to the central credits.
operations of the business. These are
expenses and losses from peripheral or Omission of Adjusted Trial Balance
incidental transactions of the enterprise; for Columns. These two columns are used when
example, loss on sale of investments or loss on there are many adjusting entries to be
sale of property and equipment. considered. When only a few adjusting
entries are required, as in this case, these
CHAPTER 7 columns are not necessary and may be
Completing the Cycle for a omitted.
Merchandising Business
Income Statement and Balance Sheet
NEED FOR A PHYSICAL COUNT Columns. After the trial balance columns
In the periodic inventory system, have been totaled, the adjustments entered,
purchases of merchandise are accumulated in and the equality of the columns proved, the
the purchases account. During the accounting balances are extended to the statement
period, no entry is made to the merchandise columns. Each account balance is entered in
inventory account such that its balance at the the proper column of the income statement or
end of the period, before adjusting and closing balance sheet.
entries, is the same as the beginning
inventory. With no perpetual record of the PREPARING THE FINANCIAL
cost of sales during the period, the only way to STATEMENTS
obtain the cost of the ending inventory to
make a physical count. Income statement
The discussion on the major parts of
PREPARING THE WORKSHEET the income statement for a merchandising
The worksheet of a merchandising entity has been made in the previous chapter.
business is the same as that of a service The statement may be prepared by referring
business except that it has to deal with the to the income statement columns of the
new accounts related to merchandising worksheet. Per revised PAS no. 1, an
transactions. These accounts include sales, enterprise should present an analysis of
sales returns and allowances, sales discounts, expenses using a classification based on either
purchases, purchases returns and allowances, the nature of expenses or their function within
purchase discounts, transportation in, the entity, whichever provides information
merchandise inventory and transportation that is reliable and more relevant. Entities are
out. encouraged to present the analysis of
expenses on the face of the income statement.
Trial Balance Columns. The first step in
the preparation of the worksheet is to enter Nature of Expense Method
the balances from the ledger accounts into the Expenses are aggregated or combined
trial balance columns. in the income statement according to their
nature and are not reallocated among various
Adjustment Columns. Under the closing functions within the entity. This method is
entry method of handling merchandise simple to apply in many smaller enterprises
inventory, the adjusting entries for G. Detoya because no allocation of operating expenses
Traders are entered in the adjustments between functional classifications is
columns in the same way that they were for necessary. Examples include raw materials
service entities. These involve insurance and consumables used, employee benefits
expired during the period (adjustment a); expense, depreciation and amortization
store and office supplies used (adjs. b & c);
expense, transportation costs, advertising Classified Balance Sheet
costs and other operating expenses. ADJUSTING AND CLOSING ENTRIES
The adjusting entries are journalized
Function of Expense Method and posted to the ledger as they would be in a
This method, also referred to as the service entity.
“cost of sales” method, classifies expenses
according to their function as part of cost of POST CLOSING TRIAL BALANCE
sales, distribution/selling, administrative and A final trial balance is prepared to test
other operating activities. This presentation the equality of the accounts after posting the
often provides information that is more adjusting and closing entries. This trial
relevant to users than nature of expense balance is similar to the one discussed in the
method but the allocation of costs to functions service business except for the addition of the
can be arbitrary and involves considerable merchandise inventory account.
judgment. This method provides multiple
classifications and intermediate differences to CHAPTER 8
highlight significant relationships. Manufacturing Operations

In a merchandising business, net ACCOUNTING FOR MANUFACTURING

sales arise from the sale of goods while cost of ACTIVITIES
sales or cost of goods sold represents the cost Two accounting systems may be used
of inventory the entity has sold to customers. in accounting for manufacturing activities –
The difference between net sales and cost of cost and non-cost. The cost system keeps
sales is called gross profit. perpetual records of the costs of raw material,
work in process and finished goods
Then, other operating income is inventories. This system provides more
added and operating expenses (like timely information about those inventories
distribution costs, administrative expenses and changes in their levels. It also produces
and other operating expenses) are deducted timely information about manufacturing
for gross profit to arrive at operating profit. costs per unit of product which managers use
in their efforts to control costs. Accounting
Investment revenue, other gains and for manufacturing activities using cost
losses, and finance costs (e.g., interest systems is the subject of course in higher
expense) are considered to arrive at profit accounting.
before tax then income tax expense is
deducted to arrive at profit from continuing The non-cost system produces a
operations. Finally, profit from discontinued manufacturing accounting system based on
operations (net of tax) is taken to account to the periodic inventory system. The costs of
get profit for the period. raw materials, work in process and finished
goods inventories are based on physical
The difference between the two counts of the quantities on hand at the end of
methods lies in the items above operating each period. This information is then used to
profit. The standard does not prescribe any compute the amounts consumed, finished and
format. The choice between the two methods sold during the period. This system does not
depends on historical and industry factors provide for a detailed flow of costs in the
and the nature of the entity. manufacturing process. In the discussion to
follow, the non-cost system will be used. it is
Statement of Changes in Equity also assumed that the entity uses the voucher
system.
Balance Sheet
The balance sheet dated “December In order for a manufacturer to summarize
31, 2019” is implicitly understood to mean “at all the transactions that affect the
the close of business on December 31, 2019” computation of the cost of goods
manufactured, a manufacturing summary
account is maintained. It is credited for the
results of the physical count of raw materials
inventory and work in process inventory at
the end of the accounting period. The contra-
purchases accounts are also credited to this extended to the debit column of the income
account. This account is debited for the statement. Beginning finished goods
beginning balances of raw materials and work inventory being a component in the
in process inventory, and the manufacturing computation of cost of goods sold is extended
accounts with debit balances. to the debit side of the income statement
columns while the ending finished goods
Total manufacturing costs should not be inventory to the credit column.
confused with the cost of goods
manufactured. Total manufacturing costs are CHAPTER 9
the costs of direct materials used, direct labor Accounting for Payroll
and manufacturing overhead incurred and
charged to production during an accounting ACCOUNTING FOR PAYROLL
period. The cost of goods manufactured Definition of Terms
consists of the total manufacturing costs 1. Employee refers to any individual who is
related to the products completed during an a recipient of salaries or wages. It
accounting period. This statement is also includes an officer, employee or elected
called the manufacturing statement. official of the Government of the
Philippines or any political subdivision,
STATEMENT OF COST OF GOODS agency or instrumentality thereof. The
SOLD term also includes an officer of a
The difference in the income corporation.
statement of a merchandising and a
manufacturing entity lies in the cost of goods 2. Employer means a person for whom an
sold section. As illustrated, observe that the individual performs or performed any
merchandiser used the term merchandise service, of whatever nature, as the
inventory while the manufacturer used the employee of such person.
term finished goods inventory. A
merchandiser’s entire inventory is finished 3. Payroll refers to the total amount paid to
goods; a merchandiser has no materials employees for services provided during a
inventory and work in process inventory. period.

A manufacturer produces its own 4. Payroll period means a period for

finished goods inventory. Cost of goods which an employer ordinarily makes
manufactured is the manufacturer’s payment of salaries or wages to the
counterpart to the merchandiser’s bought for employees.
resale during the period. Cost of goods
manufactured is the manufacturing cost of the Gross Pay
goods completed during a production period. Salaries or wages means all
remuneration paid for services performed by
WORKSHEET FOR MANUFACTURING an employee for his employer, including the
ENTITY cash value of all remuneration paid in any
The worksheet for a manufacturing medium other than cash. The term salary is
entity is basically the same as that for a usually applied to managerial, supervisory
merchandising entity except that it includes a and administrative services. The rate of salary
pair of columns for cost of goods is expressed in terms of a month or a year.
manufactured. All the accounts that comprise Remuneration for skilled or unskilled labor is
the statement of cost of goods manufactured ordinarily referred to as wages; the rates are
are extended to these columns. Beginning stated on an hourly or piecemeal basis.
raw materials inventory and work in process Commissions, bonuses, cost of living
are debited in the manufacturing columns allowance and fringe benefits may increase
while the related ending inventories are the basic salary or wage of an employee. The
credited. total earnings of an employee for a payroll
period before taxes and other deductions are
The other manufacturing accounts taken out, is called gross pay.
are either debited or credited as necessary.
The difference between the total debits and Salary and wage rates are
total credits of these two columns is then determined, in general, by agreement
between the employer and the employee investments in privatized government owned
subject to the Minimum Wages Law and the and controlled corporations.
Labor Code of the Philippines. Regular
working hours shall not be more than eight Recently, the SSS has required
hours in any one day nor more than 40 hours employers to serve as guarantors of their
in any one week. Employees who worked for employees applying for salary loans and cut
more than 8 hours a day should be paid an down its repayment period from two years to
additional compensation generally equivalent one year. The employer would be liable to pay
to regular pay plus at least 25%. the balance should the borrower resign or
transfer to another company.
Every employee shall be paid a night
shift differential of not less than 10% of his Self- employed and voluntary
regular pay for each hour of work performed members, who have no employer’s would
between ten o’clock in the evening and six need another member of good standing to
o’clock in the morning. Work on Sundays serve as co-maker of their loan application.
calls for overtime pay at a premium of 30% The co-maker would be liable If the self-
while work on holidays requires a 100% employed or voluntary member reneged on
premium. For purposes of computing the loan.
overtime and other additional remuneration,
the regular pay shall include only cash The Employees’ Compensation (EC)
payments. Program aims to assist workers who suffer
work-related sickness or injury resulting in
Employee Benefits disability or death. The benefits under the EC
Private employees, whether program may be enjoyed simultaneously with
permanent, temporary or provisional, who is benefits under the social security program.
not over 60 years old, is subject to compulsory All SSS –registered employers and their
coverage under the Social Security System employees are compulsorily covered under
(SSS) and the National Health Insurance this program. The benefits under the EC
Program (NHIP) and the Pag-IBIG fund. program are as follow: medical services and
Employers who avail of the services of another supplies, rehabilitation services and income
person in business, trade, industry or any cash benefit for temporary total disability or
undertaking must also be registered with the sickness, permanent total or partial disability,
SSS, NHIP and Pag-IBIG fund. and death.

Covered employees are entitled to a The National Health Insurance

package of benefits under the Social Security Program (NHIP), formerly known as the
and Employee’s Compensation in case of Medicare, is a health insurance program for
death, disability, sickness, maternity and old SSS members and their dependents whereby
age. The SSS administers the two programs, the healthy subsidize the sick who may find
namely: the Social Security Program and the themselves in need of financial assistance
Employee’s Compensation Program. when they get hospitalized.

The Social Security System provides for a The program aims to provide medical
replacement of income lost on account of the care residents of the country in an
aforementioned contingencies. The benefits evolutionary way within our economic means
under the program are as follows: sickness, and capability as a nation. It also aims to
maternity, disability, retirement and death provide our people with a viable means of
benefits. helping themselves pay for adequate medical
care. The Philippine health Insurance
Although the SSS was mandated primarily to Corporation of Philhealth is the mandated
give social security protection, it has also administrator of the Medicare program under
provided its members with loan programs the National Health Insurance Act of 1995.
from which the members can borrow for The benefits under the NHIP for a single
personal purposes. These loans may be used period of confinement are as follows: room
for the member’s or his dependents’ and board, medical expenses (drugs and
education; or for the purchase of stock medicines, laboratory charges), operating
room fees for surgical procedures, medical
and dental practitioners’ fee, surgeon’s fee, earnings for the month. The contribution
anesthesiologist’s fees and fees for surgical schedule for employed members can be found
family planning procedures. during the discussion of the payroll register.

Effective July 1, 1999, Medicare Pag-IBIG Fund Contributions

collection and membership functions being • Employees earning not more than
performed by the SSS for the private sector P1,500 per month – 1%, or
members shall now be assumed by Philhealth. Employees earning more
than P1,500 per month – 2%
The Pag-IBIG Fund promotes home • Employers – 2% of the monthly
ownership through the establishment of an compensation of the contributing
affordable and adequate housing credit employee.
system for its members. It also provides small
and short-term loans. The members upon Monthly compensation shall mean basic
termination of membership will also receive salary plus cost-of-living allowance (COLA).
the accumulated dividend benefit. The Pag- Note that the maximum monthly
IBIG Fund promotes the benefits of home compensation to be used in computing
ownerships and savings. Membership in the employee and employer contribution shall not
fund is mandatory upon all employees be more than P5,000; the effect will be a
covered by the Social Security System and the maximum contribution of only P100. A
Government Services Insurance System, and member may be allowed to contribute more
their respective employers. However, the than what is required. The employer,
coverage of employees whose monthly however, shall only be mandated to
compensation is less than P4,000 shall be contribute what is required unless the
voluntary. employer agrees to match the employee’s
increased contribution.
Employees’ Payroll Deductions and
Employer’s Payroll Expenses 2. Withholding Taxes
Every employer making payment of
1. Contributions. The monthly contribution wages shall deduct and withhold upon such
are based on the compensation-basic wages a tax determined in accordance with
monthly salary plus cost of living the rules and regulations prescribed by the
allowance – of the member and payable Secretary of the department of Finance, upon
under the three programs, as follows: recommendation of the Commissioner of the
• Social Security Benefits -8.4% of Bureau of Internal Revenue.
average monthly compensation not
exceeding P12,000 and payable by Withholding taxes are applied on gross
both employer (5.04%) and pay after deducting the mandatory employee
employee(3.36%) contributions and other non-taxable
• Philhealth Benefits-2.75% computed benefits. According to Section 32(B) (7) (f)
straight based on the monthly basic of the tax Reform Act of 1997, GSIS or SSS,
salary, with a salary floor of P10,000 Medicare (now Philhealth) and Pag-IBIG
and a ceiling of P40,000, to be contributions and union dues of individuals
equally shared by the employee and are excluded from gross income effective
their employer (updated per January 1, 1998.
Philhealth Circular 2017-0024).
• Employee’s Compensation Benefits – Withholding tax tables are available for
1% of average monthly compensation various periods, such as daily, weekly
not exceeding P1,000 and payable semimonthly and monthly. The revised
only by the employer withholding tax table under the TRAIN LAW
(effective Jan. 1, 2018 to Dec. 31, 2022) is
To simplify, a contribution schedule is given for illustrative purposes.
provided to help determine the monthly
contributions of a member based on his Net Pay
monthly salary credit. the monthly salary Gross pay for a payroll period less the
credit is the compensation base for payroll deductions – SSS, Philhealth, and
contribution and benefits related to the total
Pag-IBIG contributions of the employee; The net pay section lists each employee’s take-
withholding taxes; union dues and other home pay and if payroll is paid through
deductions- equals net pay. Net pay or take- checks, the number of the check issued to the
home pay is the amount to be paid to the employee.
employee.
Employee Earnings Record
The Payroll System Each employer must keep a detailed
Expenditures for labor costs and related record of earnings and withholdings for each
payroll expenses are usually significant for employee in an employee earnings record.
most business entities for several reasons: This form is designed to help the employer
• Employees are sensitive to payroll meet various reporting requirements. The
errors or irregularities, and sections of this record are the same as that of
maintaining good employee morale a payroll register; however, the record
requires that payroll be paid on a maintains a cumulative gross pay column and
timely and accurate basis. additional data on employment specifics like
• Payroll is subject to various SSS number, Philhealth identification
regulations. number, taxpayer’s identification number,
• Payroll and other related expenses pay rate, date of employment and tax status.
have a significant effect on the net
income of most entities. Pay Slip, Check or ATM
To make payroll accounting accurate and If payments of salaries or wages are
timely, accountants have developed the made in cash, payroll slips should be prepared
payroll system. The components of the for every payroll period. A pay slip is prepared
payroll system follow: for each employee; each slip contains the
pertinent payroll figures found in the payroll
Time Cards register. The employee upon receipt of cash
A payroll system should include an signs this slip and a duplicate copy is given to
accurate and reliable record of the employees’ him.
work hours during a particular payroll period.
Employee time records are usually Most employers with a large number
maintained in time cards. of employees use a special bank account to
disburse paychecks to employees. Other
Time cards may be filled in either employers do away with writing numerous
manually or through time clocks. Both checks and instead pay their employees
systems record the daily arrival and departure through their automated teller machine
times of each employee. A typical time card (ATM) accounts. The bank is simply notified
has three sections to keep track of employees’ of the amounts to be credited to the account of
in and out time in the morning, afternoon and each employee.
overtime; and another section to summarize
the hours worked – regular and overtime. Payroll Entries
The following summarizes the
Payroll Register employer’s entries to record the semi-
Each pay period, the entity organizes monthly payroll of P116,500 for the period
the payroll data in a special journal called the Oct.16 to 31, 2018. The amounts used in the
payroll register. This register lists each first entry are lifted directly from the payroll
employee and the related payroll amounts. register. The second entry recorded the cash
This journal also serves as the basis for payment to the employees. The third entry
preparing the payroll journal entries. presented the employer’s payroll expenses.
Note that the contributions are based on a
The register can have major sections semi-monthly payroll as explained in the
for employees’ names, tax status, total hours notes to the payroll register (to be found at the
worked, gross pay, total deductions and net end of the chapter.) Entries for the
pay. The gross pay section may have columns remittances will entail debits to payables and
for regular, overtime pay and total earnings credits to cash in bank on specific dates.
for each employee. Deductions include the
SSS, Philhealth , Pag-IBIG, withholding taxes,
advances and other authorized deduction.
Remittances Chapter 10:
The employer shall collect Partnerships: Basic Considerations
contributions of members through payroll and Formation
deductions. At certain dates, the employer is
required to remit the employees’ DEFINITION
contributions along with his counterpart In a contract of partnership, two or more
contributions. persons bind themselves to contribute money,
property, or industry to a common fund, with
The SSS, Phil-health and Ec the intention of dividing the profit among
contribution should be remitted by the themselves. Two or more person may also
employer on or before the 10th day of the form a partnership for the exercise of a
month following the applicable month if the profession (civil code of the Philippines,
payment is to be done through the electronic article 1767).
data interchange (EDI). If the payment is to
be made over the counter, the remittance An association of two or more persons to
should be made on or before the last day of the carry on, as co-owners, a business for profit
applicable month. The SSS has phased out the (uniform partnership act, section 6)
acceptance of over-the-counter payments at
the SSS main office. The partnership has a juridical
personality separate and distinct from that of
When sending remittances through each of the partners (civil code of the
the bank, it is important to secure the Philippines, article 1768). Thus, for example,
duplicate copy of the special bank receipt where Vincent Fabella and Wilhelmina Neis
(SBR) and the original copy of the SSS form established a partnership, three persons are
R5 (monthly contributions payment return) involved, namely: the partnership and the
issued by the bank for these would serve as the partners, Fabella and Neis.
official receipt. At the end of the quarter, the
three form R5s and SBRs collected for past Partnership reaemble sole
three months will be submitted along with proprietorships, except that there are two or
SSS form R3 (quarterly collection list). more owners of the business. Each owner is
called a partner. Partnerships are often
In the case of Pag-IBIG contributions, formed to bring together various talents and
the employer shall remit to the fund the knowledge. Partnerships provide a means of
contributions as well as those of the covered obtaining more equity capital than a single
employees on specific days of the month individual can obtain and allow the sharing of
based on the initial letter of the employer’s risks for rapidly growing businesses.
business name. employers with names
starting with letters A to D will have payment A profession is an occupation that
due dates on the 10th to the 14th day of the involves a higher education or its equivalent,
month; E to L 15th to the 19th ; M to Q 20th to and mental rather than manual labor. Strictly
the 24th ; and R to Z 25th to the end of the speaking, the exercise of a profession is not a
month. business or an enterprise for profit but the law
allows two or more persons to act as partners
Taxes deducted and withheld by the in the practice of their profession.
employer on salaries or wages of employees Partnerships are generally associated with the
shall be covered by a return and paid on or practice of law, public accounting, medicine
before the 10th day of the month following the and other professions. Partnerships of this
month in which withholding was made. For nature are called general professional
taxes withheld on compensation for the partnerships. On the other hand, service
month of December, not later than January 15 industries, retail trade, whole sale and
of the following year. manufacturing enterprises may also be
organized as partnership.
 CHARACTERISTICS OF A Partners’ Equity Accounts. Accounting
PARTNERSHIP for partnerships are much like accounting
for sole proprietorships. The difference
The characteristics of partnership are lies in the number of partners’ equity
different from the sole proprietorships accounts. Each partner has a capital
already studied in basic accounting. Some of account and a withdrawal account that
the more important characteristics are as serves similar functions as the related
follows: accounts for sole proprietorships.

1. Mutual Contribution. There cannot be Advantages and Disadvantages of a

a partnership without contribution of partnership
money, property or industry (i.e. work of A partnership offers certain
services which may either be personal advantages over a sole proprietorship and
manual efforts or intellectual) to a a corporation. It also has a number of
common fund. disadvantages. They are as follows:

2. Division of Profits or Losses. The Advantages versus Proprietorships

essence of partnership is that each 1. Brings greater financial capability to
partner must share in the profits or losses the business.
of the venture. 2. Combines special skills, expertise and
experience of the partners.
3. Co-Ownership of Contributed 3. Offers relative freedom and flexibility
Assets. All assets contributed into the of action in decision-making.
partnership are owned by the partnership
by virtue of its separate and distinct Advantages versus Corporations
juridical personality. If one partner 1. Easier and less expensive to organize.
contributes an asset to the business, all 2. More personal and informal
partners jointly own it in a special sense.
Disadvantages
4. Mutual Agency. Any partner can bind
the other partners to a contract if he is 1. Easily dissolved and thus unstable
acting within his express or implied compared to a corporation.
authority. 2. Mutual agency and unlimited liability
may create personal obligations to
5. Limited Life. A partnership has a partners.
limited life. It may be dissolved by the 3. Less effective than a corporation in
admission, death, insolvency, incapacity, raising large amounts of capital.
withdrawal of a partner or expiration of
the term specified in the partnership Partnership distinguished from
agreement. corporation
1. Manner of Creation. A partnership is
6. Unlimited Liability. All partners created by mere agreement of the
(except limited partners), including partners while a corporation is created by
industrial partners, are personally liable operation of law.
for all debts incurred by the partnership.
If the partnership cannot settle its 2. Number of Persons. Two or more
obligations, creditors’ claims will be persons may form a partnership; in a
satisfied from the personal assets of the corporation, at least five (5) persons, not
partners without prejudice to the rights of exceeding fifteen (15).
the separate creditors of the partners.
3. Commencement of Juridical
7. Income Taxes. Partnership, except Personally. In a partnership, juridical
general professional partnerships, are personality issuance of certificate of
subject to tax at the rate of 30% (per R.A incorporation by the Securities and
no. 9337) of taxable income. Exchange Commission.
 4. Management. In a partnership, every personal contributions. In a limited
partner is an agent of the partnership if partnership, the law states that there
the partners did not appoint a managing shall be at least one general partner.
partner; in a corporation, management is
vested on the Board of Directors. 3. According to duration:
A. Partnership with a fixed term or for a
5. Extent of Liability. In a partnership, particular undertaking.
each of the partners except a limited B. Partnership at will. One in which no
partner is liable to the extent of his term is specified and is not formed for
personal assets; in a corporation, any particular undertaking.
stockholders are liable only to the extent
of their interest or investment in the 4. According to purpose:
corporation. A. Commercial or trading partnership.
One formed for the transaction of
6. Right of Succession. In a partnership, business.
there is no right of succession; in a B. Professional or non-trading
corporation, there is right of succession. partnership. One formed for the
A corporation has the capacity of exercise of profession.
continued existence regardless of the
death, withdrawals, insolvency or 5. According to legality of existence:
incapacity of its directors or A. De jure partnership. One which has
stockholders. complied with all the legal
requirements for its establishment.
7. Terms of Existence. In a partnership, B. De facto partnership. One which has
for any period of time stipulated by the failed to comply with all the legal
partners; as a corporation, not to exceed requirements for its establishment.
fifty (50) years but subject to extension.
KINDS OF PARTNERS
CLASSIFICATIONS OF
1. General partner. One who is liable to the
PARTNERSHIPS extent of his separate property after all the
assets of the partnership are exhausted.
1. According to object: 2. Limited partner. One who is liable only to
A. Universal partnership of all present the extent of his capital contribution. He is
property. All contributions become not allowed to contribute industry or services
part of the partnership fund. only.
B. Universal partnership of profits. All 3. Capitalist partner. One who contributes
that the partners may acquire by their money or property to the common fund of the
industry or work during the existence partnership.
of the partnership and the use of 4. Industrial partner. One who contributes
whatever the partners contributed at his knowledge or personal service to the
the time of the institution of the partnership.
contract belong to the partnership. If 5. Managing partner. One whom the
the articles of universal partnership partners has appointed as manager of the
did not specify its nature, it will partnership.
considered a universal partnership of
6. Liquidating partner. One who is
profits.
designated to wind up or settle the affairs of
C. Particular partnership. The object of the partnership after dissolution.
the partnership is determinate – its
7. Dormant partner. One who does not take
use or fruit, specific undertaking, or
active part in the business of the partnership
the exercise of a profession or
and is not known as a partner.
vocation.
8. Silent partner. One who does not take
active part in the business of the partnership
2. According to liability: though may be known as a partner.
A. General. All partners are liable to the 9. Secret partner. One who takes active part
extent of their separate properties. in the business but is not known to be a
B. Limited. The limited partners are partner by outside parties.
liable only to the extent of their
10. Nominal partner or partner by accountancy (The Philippine Accountancy act
estoppel. One who is actually not a partner of 2004, sec. 28).
but who represents himself as one.
The purpose of the registration is to
ARTICLES OF PARTNERSHIP set “a condition for the issuance of the licenses
to engage in business or trade. In this way, the
A partnership may be constituted orally or in tax liabilities of big partnerships cannot be
writing. In the latter case, partnership evaded, and the public can also determine
agreements are embodied in the Articles of more accurately their membership and capital
Partnership. The following essential before dealing with them. “
provisions may be contained in the
agreement. To register a partnership with the SEC, here
are the basic steps to follow:
1. The partnership name, nature, purpose, and • Have your proposed business name
location; verified in the verification unit of SEC
2. The names, citizenship and residences of the
partners; The partnership name shall bear the
3. The date of formation and the duration of the word “Company” or “Co.” and if it’s a
partnership; limited partnership, the word
4. The capital contribution of each partner, the “Limited “ or “Ltd.” A professional
procedure for valuing non-cash investments, partnership may bear the word
treatment of excess contribution (as capital or “Company,” “ Associates” or
as loan) and the penalties for a partner’s “Partners” or other similar
failure to invest and maintain the agreed descriptions. (SEC memorandum
capital; circular 5, series 2008).
5. The rights and duties of each partner.
6. The accounting period to be adopted, the • Submit the following documents:
nature of accounting records, financial 1. Articles of Partnership
statements and audits by independent public 2. Verification slip for the Business
accountants; Name
7. The method of sharing profit or loss, 3. Written undertaking to change
frequency of income measurement and business name if required
distribution, including any provisions for the 4. Tax identification number
recognition of differences in contributions. of each partner and/or that
8. The drawings or salaries to be allowed to of the partnership
partners; Registration data sheet for
9. The provision for arbitration of disputes, partnership duly
dissolution, and liquidation. accomplished in six copies

A contract of partnership is void whenever • Other documents that may

immovable property or real rights are be required:
contributed and a signed inventory of the said
property is not made and attached to a public 1. Endorsement from other government
instrument. agencies if the proposed partnership
will engage in an industry regulated
SEC REGISTRATION by the government.
When the partnership capital is
P3,000 or more, in money or property, the For partnership with foreign partners:
public instrument must be recorded with the SEC form F-105, bank certificate on the
Security and Exchange Commission (SEC). capital contribution of partners, proof of
Even if it not registered, the partnership remittance of contribution of foreign
having a capital of P3,000 or more is still valid partners;
and therefore has legal personality. • Pay the registration/filling and
The SEC shall not registered any corporation miscellaneous fees: filling fee
organized for the practice of public equivalent to 1/5 of 1% of the
partnership capital but not less than
 P1,000 and legal research fee which is Typically, partners do not wait until
1% of the filling fee; the end of the year to determine how much
• Forward documents to the SEC of the profits they wish to withdraw from the
Commissioner for signature partnership. To meet personal living
expenses, partners customarily withdraw
Accreditation to practice public money on a periodic basis throughout the
accountancy year. A partner’s drawing account is debited
Certified public accountants (CPAs), to reflect assets temporarily withdrawn by
firms and partnerships of CPAs, engaged in him from the partnership. At the end of each
the practice of public accountancy, including accounting period, the balances in the
the partners and staff members thereof, shall drawing accounts are closed to the related
register with the Professional Regulation capital accounts.
Commission and the Professional regulatory
board of Accountancy. The registration shall Permanent withdrawals are made
be renewed every three years (the Philippines with the intention of permanently decreasing
accountancy act of 2004, sec.31). the rules the partner’s capital while temporary
and regulations covering the accreditation for withdrawals are regular advances made by the
the practice of public accountancy are partners in anticipation of their share in
specified in annex B of the rules and profit.
regulation implanting republic act 9298
otherwise known as the Philippine The use of drawing accounts for
accountancy act of 2004. temporary withdrawals provides a record of
each partner’s drawings during an accounting
ACCOUNTING FOR PARTNERSHIPS period. Hence, drawings in excess of the
Owners’ Equity Accounts allowed amounts as stated in the partnership
agreement may be controlled.
In the earlier chapters of this book,
generally accepted accounting principles were Notice that profit (or loss) is credited
discussed in the context of a sole (or debited) either to the drawing account to
proprietorship. These accounting principles the capital account. The choice of the account
also apply to a partnership. Thus, the to credit or debit depends on the intention of
recording of assets, liabilities, income and the partners. If they wish to maintain their
expenses is consistent for both capital accounts for investments and
proprietorships and partnerships. permanent withdrawals, then profit or loss
Comparing two businesses of the same should be entered in the drawing account.
nature, one organized as a sole proprietorship
and another as a partnership, there will be no On the other hand, if the purpose of
marked difference in their operations. the partners is to make profit or loss part of
their capital, then the capital account should
However, differences arise between be used. in either case, the resulting partners’
the two forms of business concerning owners’ ending capital balance will be the same.
equity. For a proprietorship, there is only a
single owner. Therefore, there is only one Loans Receivable from or Payable to
capital account and one drawing account. On Partners
the other hand, since a partnership has two or If a partner withdraws a substantial
more owners, separate capital and drawing amount of money with the intention of
accounts are established for each partner. repaying it, the debit should be to loans
receivable-partner account instead of to
A partner’s capital account is credited partner’s drawing account. This account
for his initial and additional net investments should be classified separately from the other
(assets contributed less liabilities assumed by receivables of the partnership.
the partnership), and credit balance of the
drawing account at the end of the period. It is A partner may lend amounts to the
debited for his permanent withdrawals and partnership in excess of his intended
debit balance of the drawing account at the permanent investment. These advances
end of the period. should be credited to loans payable-partner
account and not to partner’s capital account capital account would instead be debited or
classified among the liabilities but separate credited. This is so because the business has
from liabilities to outsiders. This distinction ceased to be a going concern. A business is not
is important in case of liquidation. Loans viewed as a going concern if liquidation
payable to partners must be paid after the appears imminent. For example, two sole
claims of outside creditors have been paid in proprietorships will cease operations because
full. These loans have priority over partners’ of their agreement to enter into a partnership.
equity. Both proprietorships have ceased to be a
going concerns.
PARTNERSHIP FORMATION
Valuation of Investments by Partners Opening Entries of a Partnership Upon
The books of the partnership are Formation
opened with entries reflecting the net A partnership may be formed in any of the
contributions of the partners to the firm. following ways:
Asset accounts are debited for assets 1. Individuals with no existing business form a
contributed to the partnership, liability partnership.
accounts are credited for any liabilities 2. Conversion of a sole proprietorship to a
assumed by the partnership and separate partnership.
capital accounts are credited for the amount a. A sole proprietor and an individual
of each partner’s net investment (asset less without an existing business form a
liabilities). partnership.
b. Two or more sole proprietors form a
Partners may invest cash or non-cash partnership.
assets in the partnership. When a partner
3. Admission or retirement of a partner (to be
invests noncash assets, they are to be
covered in another accounting subject).
recorded at values agreed upon by the
partners. In the absence of any agreement,
Individuals with no Existing Business Form a
the contributions will be recognized at their
Partnership
fair market values at the date of transfer to the
The opening entry to recognize the
partnership.
contributions of each partner into the
partnership is simply to debit the assets
The fair market value of an asset is the
contributed, and to credit the liabilities
estimated amount that a willing seller would
assumed and the capital account of each
receive from a financially capable buyer for
partner.
the sale of the asset in a free market. Per
international financial reporting standards
A Sole Proprietor and Another
(IFRS) no. 3, fair value is the price at which an
Individual Form a Partnership
asset or liability could be exchanged in a
current transaction between knowledgeable, A sole proprietor may consider
unrelated willing parties. forming a partnership with an individual who
has no existing business. Under this type of
formation, the assets and the liabilities of the
Adjustment of Accounts Prior to
proprietor will be transferred to the newly
Formation
formed partnership at values agreed upon by
In cases when the prospective all the partners or at their current fair prices.
partners have existing businesses, their
respective books will have to be adjusted to
CHAPTER 11
reflect the fair market values of their assets or
PARTNERSHIPS: Operations and
to correct misstatements in the accounts. If
Financial Reporting
the adjustments will not be made, the initial
capital balances of the partners may be
inequitable. Partners equity in assets contrasted
with share in profit or losses
The adjustments of the assets and The basis on which profits or losses
liabilities prior to formation will be similar to are shared is a matter of agreement among the
the adjustments that we are already familiar partners and may not necessarily be the same
with. However, when the adjustment involves as their capital contribution ratio. The equity
a debit or credit to a nominal account, the of a partner in the net assets of the
 partnership should be distinguished from a Examples of the use of performance criteria
partner’s share profits or losses. are:
1. Chargeable hours. These are the total number
Factors to consider in arriving at a of hours that a partner incurred on client
plan for dividing related assignments. Weight may be given to
Money, Property or Industry hours in excess of a standard.
2. Total billings. The total amount billed to
Partnership profits are realized as a clients for work performed and supervised by
result of putting together the contribution – a partner constitutes total billings. Weight
money, property or industry-of the partners. may be given to billings in excess of norm.
The amount of capital invested by each 3. Write-offs. Consist of uncollectible billings.
partner, the amount of time each partner Weight may be given to a write-off percentage
devotes to the business and other below a norm.
contributions are the factors being considered 4. Promotional and civic activities. Time
in the formulation of an equitable profit and devoted to developing future business and
loss ratio. enhancing the partnership name in the
community is considered promotional and
There are profit-sharing plans which civic activity. Weight may be given to time
emphasize either the value of personal spent in excess of a norm or to specific
services rendered by individual partners or accomplishments resulting in new clients.
the amounts of capital invested by each 5. Profits in excess of specified levels. Designed
partner. Some agreements consider the partners commonly receive a certain
importance of both the amount and quality of percentage of profits in excess of a specified
managerial services rendered, and the level of earnings.
amount of capital invested by the partners for
the success or failure of a partnership. In this Rules for the distribution of profit or
case, allowances may be provided for salaries losses
to partners and interest on their respective The profits or losses shall be
capital balances as a preliminary step in the distributed in conformity with the agreement.
division of profits or losses; the balance may If only the share of each partner in the profits
then be divided in a specified ratio. Among has been agreed upon, the share of each in the
the other factors which may be considered are losses shall be in the same proportion.
as follows:
In the absence of stipulation, the
1. A partner has considerable personal financial share of each partner in profits or losses shall
resources, thus giving the partnership a be in proportion to what he may have
strong credit rating. In general, partners have contributed (according to the ratio of original
unlimited liability. A very solvent partner will capital investments or in its absence, the ratio
make the partnership attractive to creditors. of capital balances at the beginning of the
2. A partner who is well known in a profession or year), but the industrial partner may not be
an industry may contribute immensely to the liable for the losses.
success of the partnership although he may
not participate actively in the operations of As for the profits, the industrial partner
the partnership. shall receive such share as may be just and
equitable under the circumstances. If aside
These two factors may be incorporated in the from his services he has contributed capital,
plan to arrive at a ratio by which any he shall also receive a share in the profits in
remaining profits or losses are to be divided. proportion to his capital (civil code of the
Philippines, article 1797). A stipulation which
Performance Methods excludes one or more partners from any share
Many partnerships use profit and loss in the profits or losses is void. (article 1799).
sharing arrangements that give some weight The partnership must exist for the common
to the specific performance of each partner to benefit or interest of the partners. A summary
provide incentives to perform well. This of the above legal provisions is prepared as
allocation of profits to a partner on the basis follows:
of performance is frequently referred to as a
bonus.
1. Profits exercise of due care should serve to minimize
a. The profits will be divided according to the number of financial reporting errors that
partners’ agreement. occur; however, these safeguards cannot be
expected to completely eliminate errors in the
b. If there is no agreement: financial statements.

• as to capitalist partners, the profits Per International Accounting

shall be divided according to their Standard (IAS) no.8 Accounting Policies,
capital contributions (according to Changes in Accounting Estimates and Errors,
the ratio of original capital prior period errors are omissions from and
investments or in its absence, the other misstatements of the entity’s financial
ratio of capital balances at the statements for one or more prior periods that
beginning of the year). are discovered in the current period. Errors
• as to industrial partners (if any), such ,ay occur as a result of mathematical mistakes,
share as may be just and equitable mistakes in applying accounting policies,
under the circumstances, provided, misinterpretation of facts, fraud or oversights.
that the industrial partner shall Examples include errors in the estimation of
receive such share before the depreciation, errors in inventory valuation,
capitalist partners shall divide the and omission of accruals of revenue and
profits expenses.

2. Losses Material prior periods must be

restated to report financial position and
a. The losses will be divided according
results of operations as they would have been
to partners’ agreement.
presented had the error never taken place.
b. If there is no agreement as to
The amount of the correction of a prior period
distribution of losses but there is an
error that relates to prior periods should be
agreement as to profits, the losses
reported by adjusting the opening balances of
shall be distributed according to the
partners’ equity and affected assets and
profit sharing ratio. liabilities. The correction of a prior period
c. In the absence of any agreement. error is excluded from profit or loss for the
• as to capitalist partners, the losses period in which the error is discovered.
shall be divided according to their
capital contributions (according to If an error resulted an
the ratio of original capital understatement of profit in previous periods,
investments or in its absence, the a correcting entry would be needed to increase
ration of capital balances at the capital. If an error overstated profit in prior
beginning of the year). periods, then capital would have to be
• as to purely industrial partners (if decreased. The effect of the error correction
there’s any), shall not be liable for any will be divided based on the applicable profit
losses. and loss ratio.

The industrial partner is not liable for DISTRIBUTION OF PROFITS OR

losses because he cannot withdraw the work LOSSES BASED ON PARTNERS’
or labor already done by him, unlike the AGREEMENT
capitalist partners who can withdraw their In general, profits or losses shall be
capital. In addition, if the partnership failed
divided in accordance with the agreement of
to realize any profits, then he has labored in
the partners. The ratio in which profits or
vain and in a real sense, he has already
losses from partnership operations are
contributed his share in the loss.
distributed is recognized as the profit and
loss ratio.
CORRECTION OF PRIOR PERIOD
ERRORS
Any business entity will from time to The partners may agree on any of the
time discover errors made in the following scheme in distributing profits or
measurement of profit in prior accounting losses:
periods. Good internal control and the 1. Equally or in other agreed ratio.
2. Based on partners’ capital contributions:
 a. ratio of original capital investments Ratio of Average Capital Balances.
b. ratio of capital balances at the Division of profits or losses on the basis of the
beginning of the year three preceding capital concepts –original
c. ratio of capital balances at the end of capital investments; capital balances at the
the year beginning of the year; or capital balances at
the end of the year – may prove inequitable if
d. ratio of average capital balances there are material changes in the capital
3. By allowing interest on partners’ capital and accounts during the year.
the balance in an agreed ratio
4. By allowing salaries to partners and the When beginning capital balances are
balance in an agreed ratio used in allocating profits, additional
5. By allowing bonus to the managing partner investments during the year are discouraged
based on profit and the balance in an agreed because the partners making such
ratio investments are not compensated in the
6. By allowing salaries, interest on partners’ division of profits until the next year.
capital bonus to the managing partner and the
balance in an agreed ratio (combination of 3 If ending capital balances are used,
to 5) year-end investments are encouraged, but
there is no incentive for a partner to make any
Note that the partners can agree on investments before year end. In addition,
not using a residual sharing ratio (“the amounts earlier withdrawn may be reinvested
balance in an agreed ratio”) if profits do not before year-end. These considerations
exceed the total salary and interest suggest that using average balances as a basis
allowances. In such a case, the partners must for distributing profits or losses is preferable
agree on the priority of the various profit or because it reflects the capital actually
loss distribution schemes. available for use by the partnership during the
year.
Based on Partners’ Capital
Contributions The agreement should also state the
Division of partnership profits in amount of drawings each partner may make.
proportion to the capital invested by each These drawings are considered temporary
partner is most likely to be found in and are recorded as debits to the partner’s
partnerships in which substantial drawing account. Drawings within the
investments is the principal ingredient for allowable amount will not affect the
success. It is essential that the partnership computation of the average capital balance.
contract be specific with respect to the On the contrary, drawings in excess of the
concept of capital. Capital may refer to either allowable amount are considered permanent
of the following: reductions in capital; hence, the computation
of the average capital balance is affected.
Ratio of Original Capital Investments.
Assume that the partnership agreement In the preceding section, the plan for
provides for the division of profits in the ratio dividing the total profits in the ratio of
of original capital investments. partners’ capital balances was based on the
assumption that capital investments were the
Ration of Capital Balances at the controlling fator in the success of the
Beginning of the year. Assume that the partnership. However, it is not always the
partnership agreement provided for the case. Consequently, partnerships may choose
division of profits in the ratio of capital to allocate a portion of the total profits in the
balances at the beginning of the year. capital ratio and the balance equally or in
other agreed ratio after due consideration of
Ratio of Capital Balances at the End of the partners’ other contributions.
the Year. Assume that the profit is divided
in the ratio of capital balances at the end of the To allow interest on partners’ capital
year before drawings and the distribution of account balances is almost similar to dividing
profit. part of profits in the ratio of partners’ capital
balances. If the partners agree to allow
interest on capital as a first step in the division
of profit, they should specify the interest rate The partnership agreement should be
to be used. it should also state whether clear on the treatment of salary allowances
interest is to be computed on capital balances when losses are incurred. In the absence of an
on specific dates or on average capital agreement to govern this situation, salary
balances during the year. allowances will be provided even when
operations yielded losses. This allowance
Partners invested in a partnership for should not be confused with salaries expense
profits, not for interest. The interest on or with the partner’s drawing account which is
partners’ capital, along with the other profit debited for periodic salary allowances. The
sharing plans to be discussed in the remainder cash withdrawals will in no way affect the
of the chapter, are to be considered as mere division of profits; the division of profits is
techniques to share partnerships profits of governed by the sharing agreement.
losses equitably and not as expenses of the Partners are the partnership’s owners; they
partnership. On the other hand, the interest are not employees of the business. If partners
on loans from partners is recognized as devote their time and services to the affairs of
expense and a factor in the measurement of the partnership, they are understood to do so
profit or loss of the partnership. Similarly, for profit, not for salary. Therefore, when the
interest earned on loans to partners partners calculate the profit of the
recognized as partnership income. This partnership, salaries to the partners are not
treatment is consistent with the discussion in deducted as expenses in the statement of
the previous chapter that loans receivable recognized income and expense.
from or payable to partners are assets and
liabilities, respectively, of the partnership. By Allowing Bonus to the Managing
Partner Based on Profit and the Balance in
Comparison of distribution based an Agreed Ratio
solely on capital ratios as against
distribution with interest on capital A partnership contract may provide
balances. There will be a significant for a special compensation in the form of
difference between the two distribution plans bonus to the managing partner when the
if the partnership is operating at a loss. Under results of operations of the partnerships are
the capital ratio plan, the partner who favorable. This allowance is given in order to
invested more capital will ultimately shoulder encourage the partner to maximize the profit
a bigger share of the loss. This result may be potentials of the partnership. Bonus is not
considered inequitable because the being considered in the computation of profit,
investment of capital presumably is not the rather it is a mere technique to distribute
cause of the loss. profits.

Under the interest plan, the partner The service contributions and capital
who invested more capital is credited contributions of the partners are often not
(increased) for an interest on his capital and equal. If the service contributions are not
is ultimately debited (decreased) with a lesser equal, salary allowances can compensate for
share of the loss; in some cases, the result may the differences. Or, when capital
even be a net credit (increase). contributions are not equal, interest
allowances can make up for the unequal
By Allowing Salaries to Partners and investments. When both service and capital
the Balance in an Agreed Ratio contributions are unequal, the allocation of
profits or losses may include salary
The sharing agreement may provide allowances, interest on their capital balances,
for variations in compensating the personal bonus to the managing partner, and the
services contributed by partners. Even among balance to be divided in an agreed ratio.
partners who devote equal service time, one
partner’s superior experience and knowledge Note that the provisions for salaries
may command a greater share of the profit. and interest in the partnership agreement are
To acknowledge the harder working or more called allowances. These allowances are not
valuable partner, the profit-sharing plan may reported in the statement of recognized
provide for salary allowances. income and expense as salaries and interest
expense; they are merely means of allocating Offsetting.
profit to the partners. An entity shall not offset assets and
liabilities, income and expenses unless
FINANCIAL REPORTING required or permitted by an IFRS.
Purpose of Financial Statements
Financial statements are a structured Frequency of Reporting and
representation with the objective of providing Comparative Information.
information about the financial position, At least annually, an entity shall
financial performance and cash flows of an present with equal prominence each financial
entity that is useful to a wide range of users in statement in a complete set of financial
making economic decisions. Financial statements including comparative
statements also show the results of the information in respect of the previous period
management’s stewardship of the resources for all amounts reported in the current
entrusted to it. To meet the objective, period’s financial statements.
financial statements provide information
about an entity’s assets, liabilities, equity, Consistency of Presentation.
income and expenses, other changes in equity An entity shall retain the presentation
and cash flows. and classification of items in the financial
statements in successive periods unless an
Overall Considerations alternative would be more appropriate or an
Fair Presentation and Compliance IFRS requires a change in presentation.
with International Financial Reporting
Standards (IFRSs). The financial statements Identification of the Financial
shall present fairly the financial position, Statements.
financial performance and cash flows of the An entity shall clearly identify the
entity. Fair presentation requires the faithful financial statements and distinguish them
representation of the effects of transactions, from other information in the same published
other events and conditions in accordance document. International financial Reporting
with the definitions and recognition criteria Standard (IFRSs) apply only to the financial
for assets, liabilities, income and expenses set statements and not necessarily to other
out in the IASB’s new Conceptual Framework. information presented in an annual report, a
Under IAS no. 1 (revised 2007), entities are regulatory filing or another document.
required to make an explicit and unreserved
statement of compliance with IFRS in the An entity shall clearly identify each
notes. financial statement and the notes. An entity
shall display the following information
Going Concern. prominently:
Financial statements should be • Name of the reporting entity.
prepared on a going concern basis unless • Whether the financial statements are
management intends to liquidate the entity or of the individual entity or a group of
cease trading or has no realistic option but to entities;
do so. • The date of the end of the reporting
period or the period covered by the
Accrual Basis of Accounting. set of financial statements or notes;
An entity shall prepare its financial • The presentation currency;
statements, except for cash flow information, • And the level of rounding used in
using the accrual basis of accounting. presenting amounts in the financial
statements.
Materiality and Aggregation.
An entity shall present separately Complete Set of Financial Statements
each material class of similar items. Material Per revised International Accounting
items that are dissimilar in nature or function Standards (IAS) no. 1, Presentation of
should be separately disclosed. Financial Statements, a complete set of
financial statements comprises:
a. statement of financial position as at the
end of the period;
 b. a statement of financial performance for j. Total financial performance.
the period;
c. a statement of changes in equity for the Statement of Changes in Equity
period; An entity shall present a statement of
d. a statement of cash flows for the period; changes in equity, showing in the statement:
e. notes, comprising a summary significant a. total financial performance for the period
accounting policies and other showing separately the total amounts
explanatory information; and attributable to owners of the parent and to
f. a statement of financial position as at the minority interests;
beginning of the earliest comparative b. for each component of equity, the effects of
period when an entity applies an retrospective restatement recognized in
accounting policy retrospectively or accordance with IAS no. 8 accounting
makes a retrospective restatement of policies, changes in accounting estimates
items in its financial statements, or when and errors;
it reclassifies items in its financial c. the amounts of transactions with owners
statements. in their capacity as owners, showing
separately contributions by and
Statement of Financial Performance distributions to owners; and
The form and content of the income d. for each component of equity, a
statement of the partnership resemble those reconciliation between the carrying
of the sole proprietorship with the exception amount at the beginning and the end of the
of the presentation of the division of profits or period, separately disclosing each change.
losses at the lower portion of the statement.
The components of equity referred to
The component of profits or loss may above include for example, each class of
be presented either as part of a single contributed equity, the accumulated balance
statement of comprehensive income or in an of each class of other comprehensive income
income statement, as permitted by paragraph and retained earnings (these are applicable to
81 of IAS no. 1 (revised 2007). When an corporations). The amount of dividends
income statement is presented, it is part of a recognized as distributions to owners during
complete set of financial statements and shall the period, and the related amount per share,
be displayed immediately before the shall be presented either in the statement of
statement of comprehensive income. changes in equity or in the notes.
As a minimum, the statement of financial
performance shall include line items that In the case of Aguilar and Porras, as
present the following amounts for the period: contrasted with a sole proprietorship, the
a. Revenue; number of capital and drawing accounts has
b. Finance costs; made the preparation of this statement all the
c. Share of profit or loss of associates and joint more useful. Changes in an entity’s equity
ventures accounted for using the equity between the beginning and the end of the
method; reporting period reflect the increase or
d. Tax expense; decrease in its net assets during the period.
e. A single amount comprising the total of:
f. The post-tax profit or loss of discontinued Statement of Financial Position
operations; and ii. The post-tax gain or loss After all the components of the
recognized on the measurement to fair value statement of financial performance along with
less costs to sell on the disposal of the assets the changes in partners’ equity for the period
or disposal group(s) constituting the have been properly presented, the
discontinued operations; preparation of the statement of financial
g. Profit or loss; position will present no major difficulty.
h. Each component of other financial
performance classified by nature (excluding Though some of the items are not as
amounts in (h) below); familiar yet, per revised international
i. Share of the other financial performance of accounting standards (IAS) no. 1 presentation
associates and joint ventures accounted for of financial statements, as a minimum, the
using the equity method; and face of the statement of financial position
 shall include line items that present the An entity shall classified as asset as current
following amounts: when it satisfies any of the following criteria:
• it expects to realize the assets, intends
a. Property, plant and equipment; to sell or consume it, in its normal
b. Investment property; operating cycle; or
c. Intangible assets; • it holds the asset primarily for the
d. Financial assets (excluding amounts shown purpose of trading; or
under e, h and i); • it expects to realize the asset within 12
e. Investment accounted for using equity months after the end of the reporting
method. period; or
f. Biological assets; • the asset is cash or a cash equivalent
g. Inventories; as defined in IAS no.7
h. Trade and other receivables;
i. Cash and cash equivalents; All other assets are non-current. Operating
j. The total of assets classified as held for sale cycle is the time between the acquisition of
and assets included in disposal groups assets for processing and their realization in
classified as held for sale in accordance with cash or cash equivalents.
IFRS 5;
k. Trade and other payables; A liability should be classified as a current
l. Provisions; liability when it:
m. Financial liabilities (excluding amounts • is expected to be settled in the normal
shown under k and l); operating cycle; or
n. Liabilities and assets for current tax, as • is held primarily for the purpose of
defined in IAS 12; trading; or
o. Deferred tax liabilities and deferred tax • is due to be settled within 12 months
assets, as defined in IAS12; after the end of the reporting period;
p. Liabilities in disposal groups classified as held or
for sale in accordance with IFRS 5; • does not have an unconditional right
q. Minority interest, presented within equity; to defer settlement of the liability for
and at least 12 months after the reporting
r. Issued capital and reserves attributable to period.
equity holders of the parent.
All other liabilities should be classified as non-
IAS no.1 (revised 2007) does not current liabilities.
prescribe the order or format in which an
entity presents items. The above enumeration The statement of cash flows has been
(from Paragraph 54 of IAS no.1 revised 2007) discussed in an earlier chapter.
simply provides a list of items that are
sufficiently different in nature or function to Chapter 12
warrant a separate presentation in the Corporations: Basic Considerations
statement of financial position.
DEFINITION
Note that an entity makes the judgment about A corporation is an artificial being
whether to present additional items created by operation of law, having the right
separately on the basis of an assessment of: of succession and the powers, attributes and
a. the nature and liquidity of assets; properties expressly authorized by law or
b. the function of assets within the entity; and incident to its existence (The Corporation
c. the amounts, nature and timing of liabilities. Code of the Philippines, sec. 2)

Current and noncurrent assets and ATTRUBUTES OF A CORPORATION

liabilities should be separately classified on 1. A corporation is an artificial being with a
the face of the statement of financial position personally separate and apart from its
except when a presentation based on liquidity individual shareholders or members.
provides more reliable and relevant 2. It is created by operation of law. It cannot
information. come into existence by mere agreement of the
parties as in the case of business partnership.
 Corporations require special authority or shares dividends or allotments of the surplus
grant from the State, either by a special profits on the basis of the shares held.
incorporation law that directly creates the 2. Non-stock corporation. A non-stock
corporation or by means of a general corporation is one where no part of its income
corporation law (i.e.., the corporation code of is distributable as dividends to its members,
the Philippines). trustees or officers. Any profit that a nonstock
3. It enjoy the right of succession. A corporation corporation may obtain as an incident to its
has the capacity of continued existence operation shall, whenever necessary or
subject to the period stated in the Articles of proper, be used for the furtherance of the
Incorporation. The death, withdrawal, purpose or purposes for which the
insolvency or incapacity of the individual corporation was organized ( the Corporation
shareholders or members will not dissolve the Code of the Philippines, Sec. 87).
corporation. The transfer of ownership of
shares of stock does not dissolve the Non-stock corporations may be
corporation. formed or organized for charitable, religious,
4. It has the powers, attributes and properties educational, professional, cultural,
expressly authorized by law or incident to its recreational, fraternal, literary, scientific,
existence. social, civic service, or similar purposes (sec.
88).
ADVANTAGES OF A CORPORATION
1. The corporation has the legal capacity to acts OTHER CLASSIFICATIONS OF
as a legal entity. CORPORATIONS
2. Shareholders have limited liability. 1. According to number of persons:
3. It has continuing of existence. A. Corporation aggregate. A
4. Shares of stock can be transferred without the corporation consisting of more than
consent of the other shareholders. one corporator.
5. Its management is centralized in the board of B. Corporation sole or a special form of
directors. corporation usually associated with
6. Shareholders are not general agents of the the clergy. It is a corporation which
business. consists of only one member or
7. Greater ability to acquire funds. corporator and his successors such as
a bishop.
DISADVANTAGES OF A 2. According to nationality:
CORPORATION A. Domestic corporation. A corporation
1. A corporation is relatively complicated in organized under Philippine laws.
formation and management. B. Foreign corporation. A corporation
2. There is a greater degree of government organized under foreign laws.
control and supervision. 3. According to whether for public or private
3. It requires a relatively high cost of formation purpose:
and operation. A. Public corporation. A corporation
4. It is subject to heavier taxation than other formed or organized for the
forms of business organizations. government of a portion of the state
5. Minority shareholders are subservient to the (e.g., provinces, cities, municipalities
wishes of the majority. and barangays).
6. In large corporations, management and B. Private corporation. A corporation
control have been separated from ownership. created for private aim, benefit or
7. Transferability of shares permits the uniting purpose.
of incompatible and conflicting elements in 4. According to whether for charitable purpose
one venture. or not:
A. Ecclesiastical corporation. Those
CLASSES OF CORPORATIONS organized for religious purposes.
Section 3 of the Corporation Code classified B. Eleemosynary corporation. Those
private corporations into: established for public charity.
1. Stock corporation. Corporations which C. Civil corporation. Those established
have share capital divided into shares and are for business or profit.
authorized to distribute to the holders of such
5. According to their legal right to corporate (SEC) that the proposed corporate
existence. name is not the same or similar to an
A. De jure corporation. A corporation existing corporation. The corporate
existing in fact and in law. It is name shall contain the word
organized in strict conformity with “Corporation” or “Incorporated”, or the
the law. abbreviations “Corp.” or “Inc.,”
B. De facto corporation. A corporation respectively. The corporate name of a
existing in fact but not in law. foundation shall use the word
6. According to degree of public participation “foundation”. A term that describes the
with regard to share ownership. business of a corporation in its name
should refer to its primary purpose
A. Close corporation. A corporation (SEC Memorandum Circular 5, Series
whose share ownership is limited to
of 2008).
selected persons or members of a
family not exceeding 20 persons. b. Drafting and execution of the articles of
incorporation (AI) by the
B. Open corporation. A corporation incorporators. The person elected as
where the share is available for
temporary treasurer should execute an
subscription or purchase by any
affidavit regarding the share capital
person.
subscribed and paid up. The treasurer
C. Publicly –held corporation. A should also submit a sworn statement
corporation with a class of equity of assets and liabilities of the
securities listed on an exchange or corporation.
with assets in excess of P50,000,000
c. Deposit by the treasurer of the cash
and having 200 or more holders, at
paid for the shares subscribed in the
least 200 of which are holding at least
bank in the name of the treasurer in
100 shares of a class of its equity
trust for and to the credit of the
securities (SRC rule 3-1.M, amended
corporation. The bank is required to
IRR of the Securities Regulations
issue a certificate of deposit.
code (RA 8799).
7. According to their relation to another d. Filling of the articles of incorporation
with the SEC together with treasurer’s
corporation:
affidavit, statement of financial
A. Parent or holding corporation. A position, certificate of bank deposit,
corporation that is related to another and certificate as to the name of the
corporation that it has the power to corporation;
either directly or indirectly elect the
majority of the directors of a
e. Payment of the filling fees: for the AI,
equivalent to 1/5 of 1% of the
subsidiary corporation.
authorized capital stock of the
B. Subsidiary corporation. A proposed corporation but not less than
corporation controlled by another P1,000 for the by laws, P510; for SEC
corporation known as a parent form F-100, P2,000; and a legal
corporation. research fee which is 1% of the filling
fee for the AI;
STEPS IN THE CREATION OF A
f. Endorsement from other government
CORPORATION agencies if the proposed corporation
There are three steps in the creation and will engage in an industry regulated by
organization of a corporation, namely: the government, other requirements
1. Promotion. It is the process of bringing for corporations with foreign equity
together the incorporators or the persons and additional requirements based on
interested in the business, of procuring the kind of payment of subscriptions;
subscriptions or capital for the and
corporation and of setting in motion the g. Issuance by the SEC of the certificate of
machinery that leads to the incorporation.
incorporation of the corporation itself.
2. Incorporation. This step includes the
3. Formal organization and
following:
commencement of business
a. Verification from the records of the operations. Formal organization
Securities and Exchange Commission requires the adoption of by-laws and the
 election of the board of directors and of •names, nationalities and residences
the administrative officers. It also of the original subscribers.
includes the taking of such other steps as • the amount subscribed and paid by
are necessary to enable the corporation each subscriber on his subscription.
to transact the legitimate business or d. In case of no par value, the articles need only
accomplish the purpose for which was state such fact, and the number of shares
created. into which said share capital is divided.

Section 22 of the Corporation Code states 9. If it be a non-stock corporation, the amount of

that if a corporation does not formally its capital, the names, nationalities and
organize and commence the transaction of its residences of the contributors and the amount
business within two (2) years from the date of contributed.
its incorporation, its corporate powers shall
cease and the corporation shall be deemed BY LAWS
dissolved. These are the rules of action adopted by
the corporation for its internal government
However, if a corporation has and for the government of its officers,
commenced business but subsequently shareholders or members. The by-laws shall
becomes continuously inoperative for a be adopted within one month from the
period of at least five (5) years, the same shall issuance of the certificate of incorporation by
be a ground for the suspension or revocation the SEC. failure to file a code of by-laws shall
of its certificate of incorporation. render the corporation liable for the
revocation of its registration. A private
ARTICLES OF INCORPORATION corporation may provide in its by-laws for:
In the Philippines, the general law which 1. The time, place and manner of calling and
governs the creation of private corporations is conducting regular or special meetings of the
the Corporation Code of the Philippines. directors;
Section 14 provides that all corporations 2. The time and manner of calling and
organized under this code shall file with the conducting regular or special meetings of the
SEC articles of incorporation in any of the shareholders or members.
official languages duly signed and 3. The required quorum in meetings of
acknowledged by all of the incorporators, shareholders or members and the manner of
containing substantially the following matters voting there in;
except as otherwise prescribed by this Code or 4. The form for proxies of shareholders and
by special law:
members and manner of voting them;
1. The name of the corporation; 5. The qualifications, duties and compensation
2. The specific purpose or purposes for which of directors or trustees, officers and
the corporation is formed. employees.
3. The principal place of business which must be 6. The time for holding the annual election of
within the Philippines; directors or trustees and the mode or manner
4. The term of existence; of giving notice thereof;
5. The names, nationalities and residences of the 7. The manner of election or appointment and
incorporators; the term of office of all officers other than
6. The number of directors or trustees, which directors or trustees.
shall not be less than five (5) nor more than 8. The penalties for violation of the by-laws.
fifteen (15); 9. In the case of stock corporations, the manner
7. The names, nationalities and residences of the of issuing stock certificates; and
persons who shall act as directors or trustees 10. Such other matters as may be necessary for
until the first regular directors or trustees are the proper or convenient transaction of its
elected and qualified. corporate business and affairs.
8. If it be a stock corporation:
a. Amount of authorized share capital in pesos,
b. Number of shares into which it is divided,
c. In case the shares are par value shares:
• the par value of each share,
 RIGHTS OF A SHAREHOLDER 6. Promoters are persons who bring about or
The following are some of the rights of a cause to bring about the formation and
shareholder: organization of a corporation.
1. Right to be issued certificate of stock or other 7. Underwriters are usually investment
evidence of share ownership and to transfer bankers who have
such shares. • agreed, alone or with others, to buy at
2. Right to attend and vote in person or by proxy stated terms an entire or a substantial
at shareholders’ meeting. part of an issue of securities; or
3. Right to elect and remove directors. • guaranteed the sale of an issue by
4. Right to adopt, amend or repeal the by-laws. agreement to buy from the issuing
5. Right to purchase a portion of any new shares corporation any unsold portion at a
issued to maintain the same percentage of stated price; or
stock ownership. This right is known as the • agreed to use his best efforts to
pre-emptive right. However, this right is not market all or part of an issue; or
absolute and may be denied. • offered for sale shares he has
6. Right to receive dividends when declared. purchased from a controlling
7. Right to inspect corporate books and records, stockholder.
and to receive financial reports of the 8. Independent director is a person who
corporation’s operations. apart from his fees and shareholdings is
8. Right to participate in the distribution of independent of management and free from
corporate assets upon dissolution. any business or other relationship which
could, or could reasonably be perceived to,
COMPONENTS OF A CORPORATION materially interfere with his exercise of
1. Corporators are those who compose a independent judgment in carrying out the
corporation whether as shareholders or responsibilities of a director.
members, at anytime. This term includes
incorporators, shareholders or members (Sec. A publicly-held corporation, as
5). Note: A corporation or a partnership can earlier defined, shall have at least two
be a corporator, but cannot be an independent directors or at least 20% of the
incorporator. A partnership can be a member of the board, whichever is the lesser
corporator in a corporation but a corporation (section 38 of the SRC). This is being done to
cannot be a general partner in a partnership. protect the interest of the shareholders and
2. Incorporators are shareholders or investors. The election of the independent
members mentioned in the articles of directors is done during the annual
incorporation as originally forming and stockholders meeting by the stockholders
composing the corporation and are themselves.
signatories to said articles of Incorporation
(section 5). They must be natural persons (i.e. CLASSES OF SHARES IN GENERAL
human beings) as distinguished from artificial 1. Par value shares. One in which a specific
beings (e.g., a corporation or a partnership). amount is fixed in the articles of incorporation
An incorporator will always retain his status and appearing on the certificate of stock. The
as such though no longer having an interest in par value is the minimum issue price of the
the corporation. shares.
3. Shareholders or stockholders are
corporators in a stock corporation (section 5). Section 6 of the code states that
Shareholders may be natural or juridical preference (or preferred) shares of stock may
persons. be issued only as par value shares.
4. Members are corporators of a non-stock
corporation (section 5). 2. No-par value shares. One without any value
5. Subscribers are persons who have agreed to appearing on the face of the certificate of
take and pay for original, unissued shares of a stock. A no-par value share may have a stated
corporation formed or to be formed. Note: all value which may be fixed in the articles of
incorporators are subscribers but a subscriber incorporation or by the board of directors or
need not be an incorporator. the shareholders. Thus, the issue price may
vary from time to time as it is usually fixed
based on the book value of the corporation’s
shares.
3. However, the minimum stated value of a no- with. Observe that the new Corporation Code
par value share is five pesos (P5.00) per share used the term “total” subscription as the basis
(section 6). In addition, shares issued without for the application of the second 25%. It is not
par value are deemed fully paid. necessary that each and every subscriber shall
pay twenty-five percent of his subscription. It
Banks, trust companies, insurance is enough that 25% of the total subscription is
companies, public utilities, and building and paid.
loan associations are not permitted to issue
no-par value shares of stock. BASIC CORPORATE
ORGANIZATIONAL STRUCTURE
4. Voting shares. Those issued with the right to The ultimate control of the
vote. corporation rests with the shareholders.
5. Non-voting shares. Those issued without the They are the owners of the corporation. The
right to vote. shareholders elect the top governing body of
6. Ordinary shares. These shares entitle the the corporation, the members of the board
holder to an equal pro-rata division of profits directors. The board of directors is
without any preference. responsible for the formulation of the overall
7. Preference shares. These shares entitle the policies for the corporation and for the
holder to certain advantages or benefits over exercise of corporate powers. The board also
the holders of ordinary shares. elects a chairman of the board.
8. Promotion shares. Those issued to promoters
as compensation in promoting the welfare of The election of the professional
the corporation. management team or the administrative
9. Treasury shares. A stock that has been issued officers is entrusted to the board. This team
by the corporation as fully paid and later may include the president; executive vice-
reacquired but not retired. president; vice-presidents in charge of sales,
10. Convertible shares. A stock which is manufacturing, accounting, finance,
convertible or changeable from one class to administration and other key areas; secretary;
another class. and controller. These officers implement the
policies of the board of directors and actively
MINIMUM SUBSCRIPTION AND PAID manage the day-to-day affairs of the
– IN CAPITAL corporation. Annually, a corporation holds
At the time of incorporation, at least the shareholders’ meeting during which the
twenty – five (25%) percent of the authorized shareholders elect their directors and make
capital stock (or share capital) as stated in the other decisions.
articles of incorporation must be subscribed
and at least twenty – five (25%) percent of the Hierarchy of Corporate Structure
total subscription must be paid upon
subscription, the balance to be payable on a Shareholders
date or dates fixed in the contract of Elect the
subscription without need of a call, or in the Board of Directors
absence of a fixed date or dates, upon call for Elect the
payment by the board of directors. In no case Officers
shall the paid-in capital be less than five
Hire
thousand (P5,000) pesos. (the Corporation
Employees
Code of the Philippines, Sec. 13). In practice,
the SEC requires higher minimum capital
requirements for particular types of Sec. 25 of the Corporation Code of the
corporations. Philippines, states that the president of a
corporation must be a director of the
These requirements are mandatory. corporation, but he cannot act as president
The SEC shall not accept the articles of and secretary or as president and treasurer at
incorporation of any stock corporation unless the same time. The president is the only
accompanied by a sworn statement of the officer required by law to be a director.
treasurer elected by the subscribers showing
that the minimum subscription and paid-in The corporate secretary must be a resident
capital requirements have been complied and a citizen of the Philippines. He need not
 be a director unless required by the corporate 6. Subscribers’ ledger. It is a subsidiary ledger
by-laws. It is generally the duty of the for the subscriptions receivable account; it
secretary to make and keep its records and to reports the individual subscriptions of the
make proper entries of the votes, resolutions subscribers.
and proceedings of the shareholders and 7. Stock certificate book. It is a book of printed
directors in the management of the blank certificate of stock.
corporation. The corporate treasurer is the
proper officer entrusted with the authority to Chapter 13
receive and keep the money of the corporation CORPORATION: Share Capital,
and to disburse them as he may be authorized. Retained Earnings and Financial
The treasurer may or may not be a director. Reporting

There is no prohibition in the law against a OVERVIEW OF SHAREHOLDERS’

shareholder being a director or officer of two EQUITY
or more corporations. The Corporation Code Generally, the type of business
does not prohibit a corporate officer from organization-sole proprietorship, partnership
occupying the same position in another or corporation, does not affect the asset and
corporation organized for the same purpose. liability sections of the statement of financial
position. The only difference in the owners’
However, such situation may be prohibited equity sections. Sole proprietorships and
by special law, the articles of incorporation or partnerships use capital accounts and
the corporate by-laws. There is a particular ultimately combine the owners’ contributions
case involving a business tycoon who wanted and accumulated profits in accordance with
to become a San Miguel Corporation director some legal provisions
although he was already occupying the same
post in two corporations directly competing The owners’ equity section of a
with the food and beverage giant. At that corporation’s statement of financial position
time, San Miguel amended its by-laws to is called shareholders’ equity. Shareholders
provide for the disqualification of a equity has two major components – share
shareholder from being a director of the capital (contributed or paid –in capital) and
corporation if the former already occupies the retained earnings. Share capital reflects the
same position in a competing firm. The amount of resources received by a corporation
Supreme Court later upheld the decision of as a result of investment by shareholders,
San Miguel. Thus, a corporation is authorized donation or other share capital transactions.
to prescribe qualifications for its directors Retained earnings (or accumulated profits or
(Gokongwei vs. sec, 89 SCRA 336). losses) is the amount of capital accumulated
and retained through the profitable
CORPORATE BOOKS AND RECORDS operations of the business.
Every private corporation, stock or non-
stock, is required to keep books and records at SHARE CAPITAL
its principal office of the following. It is the shares to be subscribed and
1. Minutes book. It contains the minutes of the paid in or secured to be in by the shareholders,
meetings of the directors and shareholders. either in money, property or services, at the
2. Stock and transfer book. It is a record of the time of organization of the corporation or
names of shareholders, installments paid and afterwards, and upon which it is to conduct its
unpaid by shareholders and dates of payment, operations. The share, contributed or paid-in
any transfer of stock and dates thereof, by capital is further divided into the following:
whom and to whom made.
3. Books of accounts. These represent the Legal Capital.
record of all business transactions. The books Capital contributed by shareholders
of accounts normally include the journal and comes from the sale of shares of stock. The
the ledger. shares of stock issued are generally referred to
4. Subscription book. It is a book of printed as share capital. Legal capital is that portion
blank subscription. of the contributed capital or the minimum
5. Shareholders’ ledger. It is a ledger which amount of paid-in capital, which must remain
details the number of shares issued to each in the corporation for the protection of
shareholders.
corporate creditors. The amount of legal number of shares capital. Note that any
capital is determined as follows: increase or decrease in the authorized share
capital requires prior approval of the SEC and
In case of par value shares, legal formal amendment to the articles of
capital is the aggregate par value of all issued incorporation.
and subscribed shares.
Issued Share Capital.
In case of no-par value shares, legal These are shares which have been
capital is the total consideration received by sold and paid for in full. Issued share may
the corporation for the issuance of its shares include treasury shares. Share capital, either
to the shareholders including the excess of ordinary shares account or preference shares
issue price over the stated value (section 6, account, is credited for the total par value of
par. 3, Corporation Code of the Philippines). fully collected subscriptions or in the case of
no-par value shares, for the total
Share Premium. (or additional Paid-In consideration received in relation to the issue.
Capital). Share capital is debited only when the issued
It is the portion of the paid –in capital shares are retired, redeemed or cancelled by
representing amounts paid by shareholders in the corporation.
excess of par. It may also from transactions
involving treasury stocks, retirement of Subscribed Share Capital.
shares, donated capital, share dividends and It is the portion of the authorized
any other “gain” on the corporation’s own share capital that has been subscribed but not
stock transactions. fully paid. This shareholders’ equity account
is credited for the total par value of the shares
TWO BASIC TYPES OF SHARES subscribed and debited for the total par value
Share capital is divided into transferable of the collected subscriptions.
shares of stock. A share of stock represents
the interest or right of a shareholder in a Outstanding Share Capital.
corporation and is evidenced by a certificate These are issued shares, which are in
of stock. Share capital includes all types of the hands of the shareholders. The number of
ownership shares in a corporation. outstanding shares will equal the difference
Shareholders acquire either of the following the issued shares and the treasury shares.
basic types of share capital:
Treasury Stock.
1. Ordinary Share. This share These are issued shares acquired by
represents the basic ownership class the corporation but not retired and are
of the corporation. When only one therefore, waiting to be reissued at a later
class of share is issued, it must be date.
ordinary share. Ordinary shares are
the entity’s residual equity. ACCOUNTING FOR ISSUANCE OF
2. Preference Share. This share gives SHARE CAPITAL
its owners certain advantages over The entry to record the issuance of
ordinary shareholders. These special share capital depends on whether the stock is
benefits relate either to the receipt of with or without par value.
dividends when declared before the
ordinary shareholders (preferred as When shares with par value are sold,
to dividends) or to priority claims on the proceeds should be credited to the share
assets in the event of corporate capital account to the extent of the par value
liquidation (preferred as to assets). of the shares, with any excess being reflected
as share premium.
TERMS RELATED TO SHARE
CAPITAL When shares without par value are
Authorized Share Capital. sold, the proceeds should be credited to the
The number of authorized shares share capital account. If the no-par stock has
indicates the maximum number of shares the a stated value, the excess proceeds over stated
corporation can issue as specified in the value may alternatively be credited to share
article of incorporation. This maximum premium.
 Section 65 of the Corporation Code Without Par Value
prohibits the original issue of share capital (or When shares without par value are
capital stock) for a consideration less than the sold, the proceeds should be credited to the
par or stated value (i.e. issued at a discount). ordinary share account. Accounting for
issuance of preference shares is basically the
Corporation set the par value of their same as that of ordinary shares. Note,
ordinary shares at nominal amounts such as however, that Section 6 of the Corporation
P1 per share. The par value is no indication of Code prohibits the issue of no-par value
its market value; it merely indicates the preference shares.
amount per share to be entered in the share
capital account. SUBSCRIPTION OF SHARES
There are times when a corporation
CONSIDERATIONS FOR ISSUANCE sells its shares directly to investors on a
OF SHARES subscription basis. The subscription contract
Share capital may be issued in exchange is a legally binding contract which provides
for any of the following considerations: for the number of shares subscribed, the
1. Actual cash paid to the corporation. subscription price, the terms of payment and
2. Tangible or intangible properties other conditions of the transaction. A
actually received by the corporation. subscriber becomes a shareholder upon
3. Labor already performed for or subscription but the stock certificates
services actually rendered to the evidencing ownership over shares of stocks
corporation. are not issued until the full collection of the
4. Previously incurred indebtedness by subscription.
the corporation.
Subscriptions Receivable is a
In issuing its share capital, a corporation shareholders’ equity account. It is presented
may avail of the services of an investment in the statement of financial position as a
banker who is specialist in marketing shares deduction from the related subscribed
to investors. The investment banker may ordinary shares; however, when it is
underwrite a share issue which means that the collectible within one year, this may be shown
banker agrees to buy the shares of the as a current asset. It is debited for the total
corporation and to sell them to investors. The proceeds of the subscriptions to the ordinary
corporation considers the shares as sold shares and credited for the collections on the
because the underwriter will buy the shares subscriptions.
that he is not able to sell. The underwriter
bears this risk in return for gains from selling There are instances when a
the shares at a price higher than that paid to subscriber fails to settle the subscriptions in
the corporation. An investment banker who is full on the date specified in the subscription
not willing to underwrite may handle a share contract or in the “call” made by the board of
issue on a best efforts basis. In this case, the directors. In such case, the subscribed shares
banker undertakes to sell as many shares as are declared delinquent shares. The usual
possible at a set price but the corporation remedy is to dispose of these shares in a public
bears the risk on unsold shares. auction for the account of the delinquent
subscriber. These shares will be sold to the
Share issue costs can be quite substantial person who is willing to pay the “offer price”
given the work involved. The costs include which includes the full amount of the
costs associated with preparing, printing and subscription balance plus accrued interest,
filling the relevant documentation and cost of advertisement and expenses of auction
marketing the share issue. Various experts sale in exchange for the smallest number of
are consulted to ensure a successful issue. shares. This person is referred to as the
highest bidder.
Accounting for share issue costs is
covered in paragraph 37 of International If there is no bidder, the corporation
Accounting Standard (IAS) no. 32, Financial may bid for the delinquent shares and the
total amount due shall be credited as paid in
full in the books of the corporation. These
shares shall be considered as treasury shares.
 cash payment. If the treasury stock is
TREASURY STOCKS acquired for non-cash assets consideration,
Treasury stocks are shares of stock the cost is usually measured by the recorded
which have been issued and fully paid for, but amount of the non-cash assets surrendered or
subsequently reacquired by the issuing given in exchange.
corporation either by purchase, redemption,
donation or through other lawful means. The purchase of treasury shares does
Such shares may again be disposed of for a not decrease the number of shares issued;
reasonable price fixed by the board of only the outstanding shares decrease. The
directors. effect of the purchase is to decrease both total
assets and total shareholders’ equity.
Section 41 of Corporation Code Treasury stock transactions may affect cash
provides that a stock corporation has the flows but they have no effect on the profit of
power to purchase its own shares for a the corporation.
legitimate purpose it has unrestricted
retained earnings. Some of the reasons for the Retirement of Treasury Stock
purchase of treasury stock are as follows: (1) The shares purchased may be
to support employee stock compensation subsequently retired. The ordinary shares
plans; (2) to improve the stock market price account is reduced by its par value. The
by decreasing the supply of shares; (3) to number of shares issued is reduced by the
avoid takeover by an outside party. stock retired. The treasury stock account is
credited at cost. Retirement may result in a
Paragraph 33 of International “gain” or “loss” (note IAS 32, par. 33).
Accounting Standard (IAS) no.32, Financial
Instruments: presentation, states that, if an With Gain on Retirement.
entity reacquires its own equity instruments, Assume that Plantation EcoResort
these instruments (treasury shares) shall be purchased the treasury shares for P750 per
deducted from equity. No gain or loss shall be share. Observe that there is a “gain” on
recognized in profit or loss on the purchase, retirement if the cost of treasury shares is less
sale issue or cancellation of an entity’s own than par value.
equity instruments. Such treasury shares may
be acquired and held by the entity or by other With loss on Retirement.
members of the consolidated group. Assume that a total of 10,000 shares
Consideration paid or received shall be have been issued at P1,500 per share prior to
recognized directly in equity. the purchase of treasury shares.

Treasury stock is not an asset because OVERVIEW OF RETAINED EARNINGS

the corporation may not own shares itself. To Retained earnings represent the
reiterate, it is reported as a deduction from component of the shareholders’ equity arising
the total shareholders’ equity. There are two from the retention of assets generated from
methods of accounting for treasury stock the profit-directed activities of the
transactions, namely: (1) par or stated value corporation. At the end of an accounting
method and (2) cost method. In the first period, the income summary account of a
method, treasury stock is debited for an corporation is closed to the retained earnings
amount equal to the par or stated value of the account. The retained earnings account is
stock reacquired. The cost method is the credited with the corporation’s profit or
preferred method of accounting for treasury debited with the loss. The basic source of
stocks by the accounting standard council as retained earnings is profit. Distributions to
stated in SFAS no. 18, par. 6. Only the cost shareholders of cash, property or stocks from
method will be illustrated. unrestricted retained earnings on the basis of
all issued and fully paid shares, and all
Purchase of Treasury Stock subscribed par value shares except treasury
When the cost method is used, shares are called dividends. Dividend
treasury stock is recorded at cost regardless of declarations reduce retained earnings.
whether the share is acquired below or above
par or stated value. If treasury stock is Other less common situations that
purchased for cash, the cost is equal to the cause increases or decreases in retained
earnings are as follows: debits resulting from The declaration and payment of
reissuance of treasury stocks below cost and dividends involve three important dates and
loss on retirement of treasury stocks; and they are:
debits or credits for prior period errors. 1. Date of Declaration
On the date of declaration, the board
Prior period errors are errors of directors will adopt a resolution declaring
discovered in the current period that are of that a dividends is to be paid. The resolution
such significance that the financial statements will specify the amount, type and date of
of one or more prior periods can no longer be payment of this dividend. It will also set a
considered to have been reliable at the date of date of record. Cash dividends are declared
their issue. Note that credit entries increase solely by the board of directors while share
the retained earnings balance and debits dividends will necessitate the concurrence at
decrease it. least two-thirds of the outstanding
shareholders.
A debit balance in the Retained
Earnings may be restricted or appropriated, Legally, declared dividends are
and unrestricted or unappropriated. obligations of the firm. Dividends to be paid
Unrestricted retained earnings are free and in cash or property become a liability on this
can be declared as dividends. Retained dates. Shares distributable is also recognized.
earnings restrictions may be legal, contractual An entry is made debiting retained earnings
or voluntary. and crediting a dividend liability or shares
distributable account. Some corporations
DIVIDENDS in GENERAL debit a dividends declared account instead of
Retained earnings is not a cash fund the retained earnings account. This account is
waiting to be distributed as dividends. nevertheless closed to the retained earnings
Instead, it is an owners’ equity account account at the end of the year.
representing claim on all assets in general and
not on any asset in particular. In fact, the Paragraph 10 of IFRIC 17 provides
corporation may have a sizeable balance in that the liability to pay a dividend shall be
this account but may not have cash to pay a recognized when the dividend is appropriately
cash dividend. Shareholders are not authorized and is no longer at the discretion
guaranteed dividends and dividends do not of the entity, which is the date:
become a liability of the corporation until the a. when declaration of the dividend, e.g. by
board of directors has formally declared a management or the board of directors, is
dividend distribution. Section 43 of the approved by the relevant authority, e. g. the
Corporation Code states that dividends shareholders, if the jurisdiction requires
should only be declared out of the such approval, or
unrestricted retained earnings. Thus, b. when the dividend is declared, e.g. by
dividends cannot be declared out of the legal management or the board of directors, if the
capital of the corporation for the security of its jurisdiction does not require further
creditors. approval

Dividends may take the form of cash, IFRIC 17 Distributions of Non- cash assets to
property or additional shares of stock of the owners was developed by the International
corporation. As a general rule, any form of Financial Reporting Interpretation
dividend declaration should be based on the Committee and issued by the International
total subscription of a shareholder and not Standards Board in November 2008. Its
merely on the shares already paid. effectivity date is July 1 2009.
Subscribers are considered shareholders from
the time their subscriptions are accepted by 2. Date of Record
the corporation and not from the time they are A list of shareholders entitled to the
issued stock certificates. declared dividends is prepared at the date of
record. If an investor buys a share of stock
after this date, he will not receive the
dividend. The share is said to be traded ex-
dividend. No entry is required on this date.
3. Date of Payment different from cash or property dividends
The corporation settles its liability on because share dividends do not transfer assets
this date. An entry is made debiting the to the shareholders. This type of dividend
dividend liability or shares distributable affects only the accounts within the
account and crediting cash, property shareholders’ equity. Share dividends
distributed or share capital. increase the total share capital and decrease
the retained earnings account. Because both
CASH DIVIDENDS of these are components of shareholders’
Majority of dividends distributed by equity, total shareholders’ equity in
corporations is paid in cash. In declaring cash unchanged.
dividends, a corporation must have both an
appropriate amount of retained earnings and From the shareholders’ point of view,
the necessary amount of cash. Some investors a share dividend does not change their
view that a large retained earnings balance percentage interest in the corporation
automatically permits generous dividend although total outstanding shares have
distributions. increased. The accounting entries depend
upon the size of the share dividend.
A corporation, however, may
successfully accumulate earnings and at the Small Share Dividends
same time not be sufficiently liquid to pay Small share dividends are dividends
large dividends. Many corporations, in which the additional shares issued are less
especially new firms in growth industries, than 20% of the previously outstanding
finance their expansion from assets generated shares. These share dividends are recorded by
through earnings and pay out small cash transferring from retained earnings to share
dividends or non at all. capital (ordinary shares and share premium
accounts) the fair market value of the
Dividends on par value shares are additional shares to be issued. In cases when
stated as a certain percentage of the par value. the fair market value is lower than the par or
As to no par value shares, the dividends are stated value, the par or stated value will be the
stated at a certain amount per share. When basis for recording.
the board of directors declares a cash
dividend, an entry is made debiting retained Retained Earnings (or the temporary
earnings and crediting cash dividends account, share dividends declared) is debited
payable. for the fair market value of the share
dividends. Shares distributable is credited for
Cash dividends payable are reported the par value of the shares to be distributed
as current liabilities in the statement of and share premium for the balance. If a
financial position. Note that cash dividends statement of financial position is prepared
decrease total assets and total shareholders’ between the declaration date and the
equity. distribution date of a share dividend, the
shares distributable account will be shown in
It is worthwhile to reiterate that with the shareholders’ equity immediately after the
ordinary shares account.
the exception of treasury shares, all issued
and fully paid shares, and all subscribed par
value shares are entitled to dividends when When the share is distributed, only
declared. The subscribed shares must be par the components of the shareholders’ equity
value shares. No-par value shares are changes; retained earnings decreased by
considered as legally issued only when fully P220,000 (P650,000 minus P430,000) and
paid. Unissued shares, subscribed no-par total share capital increased by P220,000
value shares and treasury shares are not (P1,420,000 minus P1,200,000). The total
entitled to dividends. shareholders’ equity did not change.

SHARE DIVIDENDS Large Share Dividend

A corporation may distribute to If the share dividend is 20% or more
shareholders additional shares of the entity’s of the previously outstanding shares such that
own share as share dividends. Share the effect is to reduce materially the market
dividends or bonus issues are fundamentally value per share, then only the par or stated
value is credited to ordinary shares with a
corresponding debit to retained earnings.

The account titles used to record a

large share dividend are the same as those for
small share dividends. Note though that the
balance in the account – share premium
remained the same; this is because large share
dividends are recorded at par value.

STATEMENT OF RETAINED
EARNINGS
This statement is not required per revised
International Accounting Standard (IAS) no.
1. The required financial statements were
enumerated in an earlier chapter. A retained
earnings statement is normally divided into
two major sections:
• Appropriated. This section presents
the beginning balance of the retained
earnings appropriated account, any
additions or deductions during the
period, and ending balance.
• Unappropriated. This section shows
the beginning balance of the retained
earnings unappropriated account,
correction of prior period error, profit
or loss for the period, dividends,
transfers to and from the
appropriated and unappropriated
accounts, and the ending balance.

The statement concludes with the total retained earnings as of P 280,000

the end of the period.