FABM Module

FUNDAMENTALS OF ACCOUNTANCY
AND BUSINESS MANAGMENT
MODULE
In a single day, a company engages in hundreds and thousands of business transactions. Some of
these include cash and credit sales, purchases of inventories, payment of expenses, acquisition of
equipment, and many more. A company should be able to collect and process this financial information in
order to summarize them at year-end and to be able to prepare its annual financial statements for its
internal and external users.
To keep track of its transactions more efficiently, companies keep and maintain a set of books and/or
records called books of accounts. Books of accounts are the finance records, ledgers, and journals that
compose the company’s accounts. These serve as a company’s financial memory and comprise of every
single business transactions and financial information of a company. Aside from decision-making and
analysis of a business’ performance, books of accounts are also crucial in ensuring regulatory compliance
as they also serve as proof of the business transactions reflected in the financial statements.
There are two major books of accounts – the journals and ledgers. A company usually has two kinds
of journals. First is the general journal wherein all business transactions are recorded in chronological
order and special journals which are used by large companies for recurring transactions such as sales on
account and purchases of merchandise on account. Ledgers, on the other hand, also have two types.
The general ledger is a grouping of all accounts (assets, liabilities, and equity) with their balances and
the subsidiary ledgers which are also used as an expansion of the general ledger. The subsidiary ledger
provides more detailed individual balances of accounts such as accounts receivable and accounts payable.
What is a journal? When does a company record a transaction in the journal?

A journal is a chronological record of the entity’s transactions listed by date. It is often referred to
as the book of original entry. This is because we first record the business transaction in this book. Each
transaction is initially recorded in a journal rather than directly in the ledger. A journal entry shows all the
effects of a business transactions in terms of debits and credits. The nature and volume of transactions of
the business determine the number and type of journals needed. The recording of financial information
into the journal is known as the process of journalizing.
In journalizing, transactions and events are recorded as the events happened chronologically. The
date when the event happened is the primary factor that determines what transaction should be recorded
first. The journal entry is primarily based on the source document. The journalizing process implies that
business activities, regardless of their nature, are recorded in accordance with the time of occurrence. The
journal, therefore, is a mixture of several types of accounts.
Illustration: Assume that on February 14, 2021, Mr. Nilo Co invested ₱1,200,000 to open his business,
Nilo Co Moving On Shipping. The journal entry follows:
Date Account Titles and Explanation P.R. Debit Credit
2021
Feb. 14 Cash ₱1,200,000
Co, Capital ₱1,200,000
To record the initial investment of Mr.
Nilo Co.
SIMPLE ENTRY
A journal entry with only one debit and one credit entry. In other words, only two account titles are
affected by the transaction.
2021
January 2 Cash ₱10,000
Accounts Receivable ₱10,000
To record collection.
COMPOUND ENTRY
A journal entry that has multiple debits or credits. It arises when some transactions require the use
of more than two accounts. A compound entry may have the following combinations:
1. There is only one debit and two or more credits.
2. There are two or more debits and one credit.
3. There are two or more debits and credits.
2021
January 2 Cash ₱10,000
Service Income ₱15,000
To record service income.
THE GENERAL JOURNAL

Most businesses, especially large companies, may adopt different kinds of journal but all business
organizations use the most basic and simplest type of journal which is the general journal. The general
journal typically displays the transaction’s date, account titles and explanations, posting reference, and
respective amounts of corresponding accounts.
2021
January 1 Cash 101 ₱200,000
Shayne, Capital 301 ₱200,000
Owner’s investment of cash in the
business
2 Property, Plant and Equipment 140 ₱50,000
Shayne, Capital 301 ₱50,000
Owner’s investment of equipment in the
business.
3 Inventory 121 ₱20,500
Cash 101 ₱20,500
Purchase of inventories from supplier
through cash
4 Accounts Receivable 111 ₱50,000
Sales 400 ₱50,000
Sales of inventories to customer on
account.
Cost of Goods Sold 500 ₱15,000
Inventory 121 ₱15,000
Sale of inventories to customer
8 Inventory 121 ₱40,000
Accounts Payable 201 ₱40,000
Purchase of inventories from supplier
on account.
12 Cash 101 ₱60,000
Sale 400 ₱60,000
Sale of inventories to customer
14 Cash 101 ₱24,000
Accounts Receivable 111 ₱24,000
Collection of customer’s accounts
receivable.
15 Sales Return 401 ₱5,000
Accounts Receivable 111 ₱5,000
Return of merchandise from customer.
Inventory 121 ₱1,500
Cost of Goods Sold 500 ₱1,500
Return of merchandise from customer.
25 Accounts Payable 201 ₱10,000
Cash 101 ₱10,000
Payment of accounts payable to
supplier.
30 Shayne, Drawing 302 ₱2,000
Cash 101 ₱2,000
Withdrawal of cash from the business
for her personal use.
31 Salaries Expense 505 ₱5,000
Cash 101 ₱5,000
Paid salaries to employees for the
month.
With the forgoing illustration, we can see the significance of the journal in the accounting
process. First, it shows a chronological record of the company’s transactions. Through the journal,
companies can easily detect if there are missing or unrecorded transactions. Like a person’s diary, the
journal narrates the different business dealings of the company by date of occurrence. Next, it discloses
the full effect of each of the transactions per entry. Like in the first journal entry of the given illustration,
we can easily identify the transaction has an effect on the company’s assets (cash) and equity (Shayne,
Capital). Lastly, the journal serves as a check-and-balance tool of the company. It provides the
transaction’s corresponding debits and credits. We know from the preceding chapters that the debits
should always equal the credits of each entry. As such, each entry in the journal helps prevent and locate
errors as the debits and credits can be easily compared.
Illustration: In the year 2021, the following transactions were made in the first quarter.
February 14 Acquired vehicle for ₱950,000.
March 1 Purchased office equipment for ₱150,000; paying ₱80,000 in cash and the balance next
month.
Date Account Titles and Explanation P.R Debit Credit

.
2021
February 14 Service Vehicle ₱950,000
Cash ₱950,000
To record the acquisition of service
vehicle.
March 1 Office Equipment ₱150,000
Cash ₱80,000
Accounts Payable ₱70,000
The purchase of office equipment on
cash and on account.
What are the essential parts of a general journal?

DATE ACCOUNT TITLES AND EXPLANATION
 Shows the date of the occurrence of the  Shows the account debited and credited as
transaction. The year and the month are not well as a brief explanation of the transaction.
rewritten for every entry unless the year and The account to be debited is entered at the
month have changed, or a new page is needed. extreme left of the first line while the account
POSTING REFERENCE (P.R.) to be credited is entered slightly indented on
 This will be used when the entries are posted, the next line. A brief description of the
that is, until the amounts are transferred to the transaction is usually made on the line below
related ledger accounts. The posting process will the credit.
be described later.
DEBIT CREDIT
 Corresponding amount of the account debited is  Corresponding amount of the account
entered in this column. credited is entered in this column
THE SPECIAL JOURNAL

Large companies often engage in hundreds of transactions each day. In order to expedite the
journalizing process, a company usually utilizes special journals in addition to the general journal.
Special journals are used to record typical and similar types of transactions. The number of special
journals managed by a company is dependent on the types of transactions that occur frequently.
A. Sales Journal – Used in journalizing all sales of merchandise on account.
SALES JOURNAL
Date Account Debited Invoice Number Reference Dr. Accounts Receivable
Cr. Sales
B. Purchases Journal - Used to record purchases of inventory made on account.
PURCHASES JOURNAL
Date Account Credited Terms Reference Dr. Inventory
Cr. Accounts Pable
C. Cash Receipts Journal – Used to record all cash that had been received.
CASH RECEIPTS JOURNAL
Date Account Reference Dr. Cash Cr. Accounts Cr. Sales Cr. Other
Credited Receivable Accounts
D. Cash Payments Journal – Used to record transactions involving cash payments. It is also known as
cash disbursement journal.
CASH PAYMENTS JOURNAL
Date Check Account Reference Dr. Accounts Dr. Other Cr. Cash
Number Debited Payable Accounts
In cases where a company has other recurring transactions not mentioned in the foregoing, the
company may opt to add further special journals. Consequently, the company records the rest of the
transactions that cannot be entered in the special journals on the general journal. In addition, correcting,
adjusting, and closing entries are recorded in the general journal
After journalizing the business transactions in the general journal and special journals, the
company will now proceed to the process of posting. Posting involves the process of transferring of the
same information found in the journal to the ledger accounts to bring together the effect of the
transactions to the individual accounts of the company.
The journal does not reflect information like outstanding balance of the account or the total
balance of an account. It is, rather, a chronological listing of transactions, where the value received and
value parted with are given importance.
Posting, basically, is a sorting process. It groups similar transactions according to their nature and
type. Another distinct difference between journalizing and posting is that journalizing is undertaken daily;
while posting is usually done at the end of the month.
The grouping of the transactions follows the accounting elements – assets, liabilities, equity,
income, and expenses. The grouping of transactions is done in the ledger. Hence, information found in the
general journal are transferred to the ledger.
In the process of transferring the information from the journal to the ledger, the following
guidelines may be observed:
1. No alterations should be made.
2. Debit entries in the journal shall be transferred to the debit side of the ledger.
3. Credit entries in the journal shall be transferred to the credit side of the ledger.
The terms “debit entries” and “credit entries” include the date, debit or credit account, and debit or
credit amount.
THE LEDGER
Ledger is a grouping of the entity’s accounts showing its respective outstanding balances. It is also
called the book of final entry of accounting transactions. It presents the changes in specific account
balances. All account balances presented in the financial reports of the company are derived from the
ledger. The two kinds of ledgers are the general ledger and the subsidiary ledgers.
GENERAL LEDGER
A general ledger is the reference book of the accounting system and is used to classify and
summarize transactions, and to prepare data for basic financial statements. It contains all the asset,
liability, and owner’s equity accounts of the company. The ledgers are usually grouped according to their
chart of accounts and arranged according to the order on how they appear on the financial statements.
Each account is numbered based on the chart of accounts for easier and faster reference. The general
ledger shows the amount outstanding on each of the company’s accounts as of a certain date.
The accounts in the general ledger are classified into two general groups:
1. Balance Sheet or Permanent Accounts (assets, liabilities and owner’s equity).
2. Income Statement or Temporary Accounts (income expenses). Temporary or nominal accounts
are used to gather information for a particular accounting period. At the end of the period, the
balances of these accounts are transferred to a permanent owner’s equity account.
CHART OF ACCOUNTS
The chart of accounts is a list of accounts and their account numbers adopted by a business to
organize the recording process and segregate accounting values into assets, liabilities, equity, income, and
expenses. The listing usually follows the order or arrangement of the accounts that appear in the ledger.
The selection of accounts is normally defined by the business in accordance with its recording and
reporting system.
Usually, there are codes, which can be numerical, alphabetical, or alpha-numeric, assigned to the
different accounting values to easily identify the major classification. For example, the business may
assign numeric code to assets starting at 100, and liabilities starting at 200. The accounts should be
numbered in a flexible manner to permit indexing and cross-referencing.
When analyzing transactions, the accountant refers to the chart of accounts to identify the pertinent
accounts to be increased or decreased. If an appropriate account title is not listed in the chart, an
additional account may be added.
SHAYNE
Chart of Accounts
Balance Sheet Accounts Income Statement Accounts
Assets Income
101 Cash 400 Sales
111 Accounts Receivable 401 Sales Return
121 Inventory
140 Property, Plant and Equipment Expenses
500 Cost of Goods Sold
Liabilities 505 Salaries Expense
201 Accounts Payable
Owner’s Equity
301 Shayne, Capital
302 Shayne, Drawing
PARTS OF LEDGER
1. Account Title – The general ledger contains all of the company’s accounts and its balances.
2. Ledger Account Reference Number – With the reference to the company’s chart of accounts, each
of the account titles corresponds to a reference number.
3. Date – The date of the transaction is also entered in reference to the journal.
4. Explanation – A brief description of the business transaction is defined. This is sometimes omitted
since the entries on the journal already provide an explanation of the transaction.
5. Journal Reference (J.R.) – This column displays the journal page number from which the
transaction was posted.
6. Debit – Amounts debited to the account are inputted.
7. Credit – Amounts credited to the account are entered.
8. Balance – What distinguished a ledger from the journal is the running outstanding balances provided
by the ledger. After every transaction, the balances of each of the accounts are known. On year-end,
these balances will be the basis of the amounts presented in the financial statements of the company.
Account: Cash Account No. 101

Date Explanation J.R Debit Credit Balance
.
2021
January 1 Investment of capital by owner. J1 ₱200,000 ₱200,000
3 Purchase of inventories from supplier. J1 ₱20,50 179,500
0
12 Sales of inventories to customers. J1 60,000 239,500
14 Collection of customer’s accounts receivable. J1 24,000 263,500
25 Payment of accounts payable to supplier. J1 10,000 253,500
30 Withdrawal of cash from the business. J1 2,000 251,500
31 Paid salaries to employees for the month. J1 5,000 246,500
31 Balance ₱246,500
Account: Accounts Receivable Account No. 111

.
2021
January 4 Sale of inventories to customer on account. J1 ₱50,000 ₱50,000
14 Collection of customer’s accounts receivable. J1 ₱24,00 26,000
0
15 Return of merchandise from customer. J1 5,000 21,000
31 Balance ₱21,000
Account: Inventory Account No. 121

.
2021
January 3 Purchase of inventories from supplier J1 ₱20,500 ₱20,500
through cash.
4 Sale of inventories to customer. J1 ₱15,00 5,500
0
8 Purchase of inventories from supplier on J1 40,000 45,500
account.
12 Sale of inventories to customer. J1 18,000 27,500
15 Return of merchandise from customer J1 1,500 29,000
31 Balance ₱29,000
Account: Property, Plant and Equipment Account No. 140

.
2021
January 2 Owner’s investment of equipment. J1 ₱50,000 ₱50,000
31 Balance ₱50,000
Account: Accounts Payable Account No. 201

.
2021
January 8 Purchase of inventories from supplier on J1 ₱40,00 ₱40,000
account. 0
25 Payment of accounts payable to supplier. J1 ₱10,000 30,000
31 Balance ₱30,000
Account: Shayne, Capital Account No. 301

.
2021
January 1 Investment of capital by owner. J1 ₱200,000 ₱200,00
0
2 Owner’s investment of equipment J1 50,000 50,000
31 Balance ₱250,00
0
Account: Shayne, Drawing Account No. 302

.
2021
January 30 Withdrawal of cash from the business. J1 ₱2,000 ₱2,000
31 Balance ₱2,000
Account: Sales Account No. 400

.
2021
January 4 Sale of inventories to customer on account. J1 ₱50,000 ₱50,000
31 Balance ₱110,000
Account: Sales Return Account No. 401

.
2021
January 15 Return of merchandise from customer. J1 ₱5,000 ₱5,000
31 Balance ₱5,000
Account: Cost of Goods Sold Account No. 500

.
2021
January 4 Sale of inventories to customer. J1 ₱15,000 ₱15,000
15 Return of merchandise from customer. J1 ₱1,500 31,500
31 Balance ₱31,500
Account: Salaries Expense Account No. 405

.
2021
January 31 Paid salaries to employees for the month J1 ₱5,000 ₱5,000
31 Balance ₱5,000
With the illustration, it will be easier for the company to determine the balances of each of its accounts.
These are as follows:
ASSETS
 Cash ₱246,500
 Accounts Receivable 21,000
 Inventory 29,000
 Property, Plant and Equipment 50,000
LIABILITIES
 Accounts Payable ₱ 30,000
EQUITY
 Shayne, Capital ₱250,000
 Shayne, Drawing 2,000
 Sales 110,000
 Sales Return 5,000
 Cost of Goods Sold 31,500
 Salaries Expense 5,000
The general ledger aids in knowing the balances of each of the accounts at any given time. Unlike
the journal, the general ledger classifies the transactions into accounts and provides the outstanding
balances of each. Additionally, the general ledger, together with the subsidiary ledgers, serves as a control
account to check for errors and misstatements in posting. At month-end or year-end, the company
reconciles the balances of its general ledger and subsidiary ledgers.
SUBSIDIARY LEDGERS
Large companies have thousands of transactions from their hundreds of customers who buy goods
and merchandise on credit. If the company only utilizes a general ledger, imagine the time it will take to
determine the outstanding balances of each of its individual customers. The same is also true when it
comes to the company’s individual creditors.
To ease their burden, large companies use subsidiary ledgers. A subsidiary ledger is a group of
accounts with a similar characteristic. It is an additional record to the general ledger utilized by the
company to track the per-individual accounts of the company’s customers, creditors, and the like.
The two most common types of subsidiary ledgers are the accounts receivable ledger and the
accounts payable ledger.
Accounts Receivable Ledger – Used in tracking individual accounts receivable balances of

company’s customers.
Ianbabes & Co.

Date J.R. Debit Credit Balance
2021
March 5 J1 ₱40,000 ₱40,000
10 J1 60,000 100,000
31 J1 ₱20,000 80,000
Jowsie & Co.

2021
March 1 J1 ₱33,000 ₱33,000
4 J1 47,000 80,000
29 J1 24,000 104,000
31 J1 ₱85,000 19,000
Ryanbear & Co.

2021
March 9 J1 ₱80,000 ₱80,000
17 J1 ₱30,000 50,000
31 J1 50,000 0
The format of an accounts receivable subsidiary ledger is the same as that of the general ledger. The
only difference is that the accounts receivable subsidiary ledger provides a running balance of each of the
company’s customer on credit. In the illustrations, it is recognized without effort that the balances of
Ianbabes & Co., Jowsie & Co., and Ryanbear & Co. as of March 31 are ₱80,000, ₱19,000, and ₱0
respectively.
Accounts Payable Ledger – Used in tracking individual accounts payable balances of company’s
creditors.
TedSchmosby Inc.
Date J.R Debit Credit Balance
.
2021
March 1 J1 ₱20,000 ₱20,000
16 J1 30,000 50,000
27 J1 ₱15,000 35,000
31 J1 10,000 25,000
Scherbatsky Ltd.
2021
March 5 J1 ₱10,000 ₱10,000
6 J1 25,000 35,000
7 J1 30,000 65,000
19 J1 50,000 115,000
Barney WaitForlt Stinson & Co.

2021
March 6 J1 ₱5,000 ₱5,000
21 J1 ₱3,000 2,000
22 J1 2,000 0
23 J1 20,000 20,000
Like the accounts receivable subsidiary ledger, the format of an accounts payable subsidiary
ledger is the same as that of the general ledger. The accounts payable subsidiary ledger provides a
running balance of each of the company’s suppliers or creditors. From the foregoing illustrations, the
balances of TedSchmosby Inc., Scherbatsky Ltd., and Barney WaitForlt Stinson & Co. are determined
easily – ₱25,000, ₱115,000, and ₱20,000 respectively.
Subsidiary ledgers are valuable especially in large companies with thousands of transactions from
numerous customers and creditors. This provides an up-to-date information on the different individual
account balances. In addition, the subsidiary ledgers help in detecting errors and misstatements in posting
of entries in the ledger. At year-end or month-end, the company can easily reconcile the balance of the
general ledger account to the total of the individual subsidiary ledgers to determine whether there are
transactions not posted. Finally, like the special journal, the subsidiary ledger allows greater division of
labor for the company. As the two kinds of ledgers are being utilized, different employees can post in the
general ledger and in the subsidiary ledgers simultaneously.
THE ACCOUNTING CYCLE

Companies follow a standard schedule for recognizing financial transactions and the impact of those
transactions. The sequence of activities beginning with the occurrence of a transaction is known as
the accounting cycle. The accounting cycle involves several steps, which include identifying each
financial transaction, recording the financial transactions, analyzing and adjusting financial accounts,
creating financial statements and setting up each financial account to start the new period.
The accounting cycle for service companies and merchandising companies experiences some
similarities and differences.
THE ACCOUNTING CYCLE
STEP PROCESS ACTIVITY
1 Identification of Identifying involves the process of determining quantifiable transactions or
Events to be events based on available supporting documents. Supporting documents
Recorded serve as evidence of the existence of transactions to assure reliability and
verifiability of accounting records. The most common source documents,
among others, are invoices, official receipts, delivery receipts, receiving
reports, and check vouchers.
Aim: To gather information about transactions or events generally through
the source documents.
2 Transactions Journalizing involves the mechanical and routine process of writing business
are Recorded in transactions in the journal. A business entity may use general journal or
the Journal special journal to record the various business transactions for the first time.
Aim: To record economic impact of transactions on the firm in a journal,
which is a form that facilitates transfer to the accounts.
3 Journal Entries Posting refers to the transfer of information from the journal to the ledger.
are Posted to Posting involves the process of properly classifying business transactions
the Ledger according to their nature and type.
Aim: To transfer the information from the journal to the ledger for
classification.
4 Preparation of a Trial balance is a listing of accounts with open balances. It verifies the
Trial Balance equality of debits and credits in the ledger. The accounts in the trial balance
should be arranged in the following order: assets should be listed first,
followed by the liability accounts, capital accounts, income, and expenses
accounts.
Aim: To provide a listing to verify the equality of debits and credits in the
ledger.
5 Making Adjusting entries are intended to reflect the accruals, expiration of deferrals,
Adjusting estimation and other events that will update the account to its present
Journal Entries balance. This type of journal entry is usually made at the end of accounting
period.
Aim: To record the accruals, expiration of deferrals, estimations and other
events.
6 Preparing of The worksheet is a tool used by accountants to facilitate the preparation of
Worksheet adjusting entries and the financial statements. When the operation is simple
and only few accounts are involved, worksheet preparation can be omitted.
Aim: To aid in the preparation of financial statements.
7 Preparation of Financial statements are the final product of accounting. The operating
the Financial performance and financial condition of the business entity are communicated
Statements to various interested users through the financial statements.
Aim: To provide useful information to decision-makers.
8 Making Closing Nominal accounts, otherwise known as temporary accounts, are closed at the
Entries end of the accounting period. Nominal accounts are only used for a
particular period, and they are closed at the end of such period. The closing
of nominal accounts is done through the preparation of closing entries.
Aim: To close temporary accounts and transfer profit to owner’s equity.
9 Preparing of Post-closing trial balance is a statement of financial position in a trial
Post-Closing balance form. Post-closing trial balance is made to verify the equality of
Trial Balance debits and credits after closing the nominal accounts.
Aim: To check the equality of debits and credits after the closing entries.
10 Making Some adjusting entries are reversed on the first day of the next accounting
Reversing period to facilitate and simplify the recording process of the following
Entries period.
Aim: To simplify the recording of certain regular transactions in the next
accounting period.
This cycle is repeated each accounting period. The first three steps in the accounting cycle are
accomplished during the period. The fourth to ninth steps generally occur at the end of the period. The
last step is optional and occurs at the beginning of the next period.
What should you keep in mind in identifying transactions?

The analysis of transactions should follow these four basic steps:
1. Identify the transaction from source documents.
2. Indicate the accounts – either assets, liabilities, equity, income or expenses – affected by the
transaction.
3. Ascertain whether each account is increased or decreased by the transaction.
4. Using the rules of debit and credit, determine whether to debit or credit the account to record its
increase or decrease.
What are the common examples of source documents?

THE SOURCE DOCUMENTS
Transactions and events are the starting points in the accounting cycle. By relying on source
documents, transactions and events can be analyzed as to how they will affect performance and financial
position. Source documents identify and describe transactions and events entering the accounting process.
These original written evidences contain information about the nature and the amounts of the transactions.
These are the bases for the journal entries; some of the more common source documents are:
1. Purchase Order
A purchase order is an official business document issued by the buyer to the seller of goods. It
indicates the types of goods to be purchased, quantity or number, agreed price, shipping terms and
conditions, delivery schedule, and payment date.
Making a purchase order is the first step in the whole process of the ordering system. It constitutes a
legal offer to buy the product or services. Acceptance of the purchase order by a seller is usually in the
form of contract. The purchase order must be duly approved by authorized personnel.
2. Invoice
An invoice is a commercial document issued by the seller to the buyer. This contains the description of
the product, quantity, prices, payment term, due date of payment, and discount terms and conditions.
An invoice indicates that an exchange has taken place. There is a value received and value parted with.
An invoice can either be a sales invoice or a purchase invoice.
An invoice is usually issued whenever the sale of goods or services is made on credit. Upon the receipt of
goods or services as supported by the invoice, there arises the obligation oof the buyer to pay and the
right of the seller to collect.
3. Official Receipt
An official receipt is a commercial document that indicates payment or receipt of cash. Impliedly, the
goods or services have already been delivered or rendered.
The existence of an official receipt signifies that a particular transaction has taken place – the payment
transaction. The seller of goods or services received the cash, while the buyer of goods or services paid
the cash.
4. Delivery Receipt
A document that serves as evidence that the goods or services have been received. As with the other
business documents, there is no prescribed design or format for delivery receipt.
It is assumed that the person receiving the goods or services, before signing the document, has
checked the completeness and condition of the goods in accordance with the purchase order. A delivery
receipt serves only as a proof of the delivery made and the receipt of goods.
No exchange of values takes place; hence, the information contained in the delivery receipt is not
recorded in the books of accounts.
5. Receiving Receipt
A document used within the business upon receipt of the goods shipped by courier or forwarder. This
document is prepared by the person receiving the goods. The basis of the receiving report is the delivery
receipt. The information contained in the receiving report is not recorded in the books of accounts.
6. Check
A check is a document that orders the payment of money from the current account maintained in the
bank. It serves as evidence of payment made. There is exchange of values in this type of business
document; hence, the transaction supported by the check should be recorded.
There are three persons involved in the issuance and payment of a check. They are the following:
1. Drawer – A depositor who maintains a current account in a bank that makes the order of
payment.
2. Drawee – Usually a bank, makes the payment according to the order of the drawer.
3. Payee – The person or business entity receiving the payment on account of goods sold or services
rendered.
LOCATING ERRORS
An inequality in the total of the debits and credits would automatically signal the presence of an error.
These errors include:
Error in posting a transaction to the ledger
a. An erroneous amount was posted to the account.
b. A debit entry was posted as a credit or vice versa.
c. A debit or credit posting was omitted.
Error in determining the account balances
a. A balance was incorrectly computed.
b. A balance was entered in the wrong balance column.
Error in preparing the trial balance
a. One of the columns of the trial balance was incorrectly added.
b. The amount of an account balance was incorrectly recorded on the trial balance.
c. A debit balance was recorded on the trial balance as a credit or vice versa, or a balance was omitted
entirely.
The following procedures when done in sequence may save considerable time and effort in locating
errors:
1. Prove the addition of the trial balance columns by adding these columns in the opposite direction.
2. If the error does not lie in addition, determine the exact amount by which the trial balance is out of
balance. The amount of discrepancy is often a clue to the source of the error.
3. Compare the accounts and amounts in the trial balance with that in the ledger. Be certain that no
account is omitted.
4. Recompute the balance of each ledger account.
5. Trace all postings from the journal to the ledger accounts. As this is done, place a check mark in the
journal and in the ledger after each figure is verified. When the operation is completed, look through
the journal and the ledger for unchecked amounts. In tracing postings, be alert not only for errors in
amount but also for debits entered as credits, or vice versa.
Note that even when a trial balance is in balance, the accounting records may still contain errors. A
balanced trial balance simply proves that, as recorded, debits equal credits. The following errors are not
detected by a trial balance:
1. Failure to record or post a transaction.
2. Recording the same transaction more than once.
3. Recording an entry but with the same erroneous debit and credit amounts.
4. Posting a part of a transaction correctly as a debit or credit but to the wrong account.
GENERALIZATION
The accounting cycle refers to a series of sequential steps or procedures performed to accomplish
the accounting process. The steps in the cycle follow: identification of events to be recorded; transactions
are recorded in the journal; journal entries are posted to the ledger; preparation of a trial balance;
adjusting journal entries are journalized and posted; preparation of the worksheet including adjusting
entries; preparation of the financial statements; closing journal entries are journalized and posted;
preparation of a post-closing trial balance; and, reversing journal entries are journalized and posted. This
cycle is repeated each accounting period.
THE ACCOUNTING BIG FOUR

These are huge organizations of professionals and experts from different fields, including
operations management, cybersecurity, strategic management, and international taxation. These groups
are called professional service firms, and one of their primary revenue streams is their audit arms.
External auditors lend credibility to the financial statements produced by businesses to give users of
financial statements a reasonable degree of assurance that companies make no unfair claims made on the
face of the statements.
Currently, there are four dominant firms in global audit practice, as enumerated:
Firm 2014 Revenues Headquarters Philippine Member Firm
Deloitte $ 34.2 billion United States Navarro Amper & Co
PwC $ 34.0 billion United Kingdom Isla Lipana & Co
EY $ 27.4 billion United Kingdom Sycip Gorres Velayo & Co
KPMG $ 24.8 billion Netherlands R. G. Manabat & Co
But no matter how complex their practice is and how expansive their area of expertise may be,
one thing remains true. The member firms of these professional service networks can be reduced to fit the
basic business model of a service organization. Their main revenue source is the rendition of services,
and not the sale of goods bought from somewhere else or manufactured in the company plant. In a service
firm, the “good” being sold is the professional conduct of, for example, audit services, be very qualified
auditors.
Auditors are expected to know a great deal of accounting, and in the Philippines, to be able to
audit the financial statements of publicly traded companies, one of the requirements is a Certified Public
Accountant license, the examination for which requires a degree in accountancy. The practice of
accountancy starts in the recording of business transactions.
BUSINESS TRANSACTIONS AND THEIR ANALYSIS AS APPLIED TO THE ACCOUNTING

CYCLE OF A SERVICE BUSINESS (PART I)
The accounting process begins with the identification of an event, the analysis of that event,
and the measurement of the impact of that event to the business’s financial statements. We are
talking about events, but later in this chapter, you will learn that not all events are actually recorded in the
financial statements. The following is a list of events. Some of which will be recorded in the company’s
books, and some will not be recorded. Which of these events do you think needs to be recorded? How do
you know if an event is to be recorded in the books or not?
LIST OF EVENTS
1. Firm buys a printer for the office for ₱5,500.
2. Firm hires two employees which will be paid ₱15,000 monthly.
3. Firm pays rent on the land where its building stands for ₱12,300.
4. Firm signs a subscription contract for an internet plan at ₱999 per month which will be due at the
end of each month.
5. Firm orders 20 packs of brown envelopes from the bookstore at ₱20 per pack.
Of the five events listed, only events 1 and 3 will be recorded. There is really no hard-and-fast
rule to determine which events need to be recorded in a business’s books of accounts. Generally, though,
accountants record an event if it affects any of the elements of the financial statements, and if there is a
monetary amount that can be assigned to it.
How do you determine whether to record or not a transaction in the books of accounts?
Here is a summary of our decision-making framework:
Does it affect the composition of either assets,
liabilities, equity, revenues, or expenses?
Is there a monetary amount that YES NO
can be assigned to the event? YES Record in the books. Do not record.
NO Do not record. Do not record.
In the previous chapter (Chapter 9), we discussed the uses and various types and formats of the
journals. After analyzing the transactions, these are recorded to the appropriate journals in a process aptly
named journalizing. Following the format, we recall that each journal entry will require a date, one or
more debit account titles, one or more credit account titles, amounts, and an explanatory note to express
in words what the transaction was made for. A final step is made when the journal entries are posted to
the ledgers.
Now that we know how to use debit (Dr.) and credit (Cr.), we can start journalizing the entries.
To understand how to record a variety of transactions, we will illustrate and analyze the business of Del
Mundo Landscape Specialist. Some transactions contain notes (in italics) for clarification and guidance.
For better appreciation of the nature of the affected accounts, the letter A (for asset), L (liability)
or OE (owner’s equity) is inserted after each entry. In addition, owner’s equity is further classified into
OE:I (income) and OE:E (expenses).
Note that the rules of double-entry system are observed in each transaction:
1. Two or more accounts are affected by each transaction.
2. The sum of the debits for every transaction equals the sum of the credits.
3. The equality of the accounting equation is always maintained.
What are the rules of debits and credits?
DEBIT CREDIT
(+) Assets (-) Assets
(-) Liabilities (+) Liabilities
(-) Equity (+) Equity
(-) Income (+) Income
(+) Expenses (-) Expenses
(+) Withdrawals (-) Withdrawals
1. Increases in assets are recorded by debits.
2. Decreases in assets are recorded by credits.
3. Increases in liabilities are recorded by credits.
4. Decreases in liabilities are recorded by debits.
5. Increases in owner’s equity are recorded by credits.
6. Decreases in owner’s equity are recorded by debits.
A service business generally uses their employees to provide intangible products or services to customers
that includes professional skills, advice, expertise, and other related products.
Illustration of using the accounting cycle in a service business:
Initial Investment
November 1: The owner of the Del Mundo Landscape Specialist, Galicano Del Mundo, invests ₱450,000
to open the business in the year 2020.
Analysis: Assets increased. Owner’s equity increased.
2020
November 1 Cash (A) ₱450,000
Del Mundo, Capital (OE) ₱450,000
To record initial investment.
Rent Paid in Advance
November 1: Rented office space and paid three months’ rent in advance, ₱21,000. Given the length of
time, i.e., more than a month, that this contract is in effect, the matching principle requires that the
contract’s cost initially be recorded as an asset since it provides a future benefit.
Analysis: Assets increased. Assets decreased.

November 1 Prepaid Rent (A) ₱21,000
Cash (A) ₱21,000
To record advance payments in rent.
Vehicle Acquired by Issuing a Note
November 2: Del Mundo purchases a ₱300,000 used truck by paying ₱200,000 in cash and signing a
₱100,000 note payable which is due in eighteen months.
Analysis: Assets increased. Assets decreased. Liabilities increased.
November 2 Vehicles (A) ₱300,000
Cash (A) ₱200,000
Notes Payable (L) ₱100,000
To record the purchased of vehicle in
cash and on account signed into notes.
Equipment Acquired for Cash

November 3: Del Mundo purchases mechanical lawn mowers for ₱54,000 in cash.
Analysis: Assets increased. Assets decreased.
November 3 Equipment (A) ₱54,000
Cash (A) ₱54,000
To record the purchase of mechanical
lawn mowers.
Expenses incurred and Paid
November 4: Del Mundo purchases ₱1,500 worth of gasoline
Analysis: Assets decreased. Owner’s equity decreased.
November 4 Utilities Expense (OE:E) ₱1,500
Cash (A) ₱1,500
To record payment for gasoline.
Insurance Premiums Paid
November 5: Del Mundo pays ₱24,000 for a one-year insurance contract that protects his business from
November 1 – October 31 of the following year.
Analysis: An asset increased. Another asset decreased.
Prepaid Insurance (A)
November 5 ₱24,000
Cash (A)
₱24,000
To record payment for insurance
premiums.
Supplies Purchased on Account
November 8: Del Mundo purchases ₱1,000 worth of office supplies, placing the purchase on his account
with the store rather than paying cash. Supplies are a prepaid expense (an asset) until they are used and
thereby become a cost of doing business (an expense). Accounts payable differ from notes payable.
Accounts payable are amounts the entity owes based on the good credit of the entity or the owner,
whereas notes payable are amount the entity owes under formal obligations.
Analysis: Assets increased. Liabilities increased.
November 8 Supplies (A) ₱1,000
Accounts Payable (L) ₱1,000
To record the purchased of supplies
on account.
Revenues Earned and Cash Collected
November 14: The Del Mundo Landscape Specialist cuts grass for seven customers, receiving ₱2,500
from each.
November 14 Cash (A)
₱17,500
Service Income (OE:I)
₱17,500
To record the receipt of cash from
service rendered to customers.
Unearned Revenues Collected
November 20: Del Mundo receives ₱13,500 from a customer for six future maintenance visits. An
advance deposit from a customer is an obligation to perform work in the future. It is a liability until the
work is performed, at which time it becomes revenue. Therefore, the advance deposit is call unearned
revenues.
Analysis: Assets increased. Liabilities increased.
Cash (A)
Unearned Revenues (L)
₱13,500
To record the receipt of advance
payment of cash customer.
Revenues Earned on Account
November 22: Del Mundo Landscape Specialist cut grass for eight customers, billing each one ₱2,500
but receiving no cash. In accordance with the revenue recognition principle, revenue is recognized upon
the completion of a service or the delivery of a product, even if no cash changes hands at that time.
Accounts Receivable (A)
Service Income (OE:I)
₱20,000
To record the service rendered to
eight customers on account.
Salaries Paid
November 26: Del Mundo pays ₱4,000 in salaries to a part-time employee.
November 26 Salaries Expense (OE:E) ₱4,000
Cash (A) ₱4,000
To record the payment of salaries.
Advertising Paid
November 28: Del Mundo pays ₱1,750 to print advertising fliers.
Advertising Expense (OE:E)
Cash (A)
₱1,750
To record the payment of advertising
fliers.
Withdrawal of Cash by Owner
November 29: Del Mundo withdraws ₱5,000 for personal use.
Del Mundo, Withdrawals (OE)
Cash (A)
₱5,000
To record the cash withdrawal of the
owner.
Accounts Receivable Partially Collected
November 30: Five of the eight customers billed last November 22 each pay ₱2,500.
Analysis: An asset increased. Another asset decreased.
Cash (A)
Accounts Receivable (A)
₱12,500
To record the partial cash receipt
from customers on account.
To have a clearer view and understanding of the journal entries made, let us take a look on the
general journal of Del Mundo Landscape Specialist:
Del Mundo Landscape Specialist
GENERAL JOURNAL
November
2020
1 Cash ₱450,000
Del Mundo, Capital ₱450,000
To record initial investment.
Prepaid Rent ₱21,000
Cash ₱21,000
To record advance payments in rent.
2 Vehicles ₱300,000
Cash ₱200,000
Notes Payable ₱100,000
To record the purchased of vehicle in
cash and on account signed into notes.
3 Equipment ₱54,000
Cash ₱54,000
To record the purchase of mechanical
lawn mowers.
4 Utilities Expense ₱1,500
Cash ₱1,500
To record payment for gasoline.
5 Prepaid Insurance ₱24,000
Cash ₱24,000
To record payment for insurance
premiums.
8 Supplies ₱1,000
To record the purchased of supplies on
account.
14 Cash ₱17,500
To record the receipt of cash from service
rendered to customers.
20 Cash ₱13,500
Unearned Revenues ₱13,500
To record the receipt of advance payment
of cash customer.
22 Accounts Receivable ₱20,000
To record the service rendered to eight
customers on account.
26 Salaries Expense ₱4,000
Cash ₱4,000
To record the payment of salaries.
28 Advertising Expense ₱1,750
Cash ₱1,750
To record the payment of advertising
fliers.
29 Del Mundo, Withdrawals ₱5,000
Cash ₱5,000
To record the cash withdrawal of the
owner.
30 Cash ₱12,500
To record the partial cash receipt from
customers on account.
When analyzing transactions, the accountant refers to the chart of accounts to identify the
pertinent accounts to be increased or decreased. If an appropriate account title is not listed in the chart, an
additional account may be added. Presented below is the chart of accounts for the illustration:

Chart of Accounts
Balance Sheet Accounts Income Statement Accounts
Assets Income
110 Cash 410 Service Income
120 Accounts Receivable
130 Supplies Expenses
140 Prepaid Rent 510 Salaries Expense
150 Prepaid Insurance 520 Supplies Expense
160 Vehicles 530 Rent Expense
165 Accumulated Depreciation – Vehicles 540 Insurance Expense
170 Equipment 550 Utilities Expense
175 Accumulated Depreciation – Equipment 560 Advertising Expense
570 Interest Expense
Liabilities 580 Depreciation Expense – Vehicles
210 Accounts Payable 590 Depreciation Expense – Equipment
220 Notes Payable
230 Salaries Payable
240 Interest Payable
250 Unearned Revenues
Owner’s Equity
310 Del Mundo, Capital
320 Del Mundo, Withdrawals
330 Income Summary
Now that we’re done journalizing and we have the chart of accounts of Del Mundo Landscape Specialist,
let us now post the entries in the ledger accounts:
Account: Cash Account No. 110
.
2020
November Investment of capital by owner. J1 ₱450,000 ₱450,000
1
1 Rent paid in advance. J1 ₱21,00 429,000
0
2 Partial payment for the vehicle acquired. J1 200,00 229,000
0
3 Purchased of equipment. J1 54,000 175,000
4 Payment for the gasoline. J1 1,500 173,500
5 Payment for the insurance premiums. J1 24,000 149,500
14 Receipt of cash from service rendered. J1 17,500 167,000
20 Receipt of advance payment from customer. J1 13,500 180,500
26 Payment of salaries to part-time employee. J1 4,000 176,500
28 Payment of print advertising fliers. J1 1,750 174,750
29 Personal withdrawal of the owner. J1 5,000 169,750
30 Partial cash receipt from customers on J1 12,500 182,250
account.
30 Balance ₱182,250
Account: Accounts Receivable Account No. 120
.
2020
November Rendered service to customers on account. J1 ₱20,000 ₱20,000
22
30 Partial cash receipt from customers on J1 ₱12,50 7,500
account. 0
30 Balance ₱7,500
Account: Supplies Account No. 130
.
2020
November Purchased of supplies on account. J1 ₱1,000 ₱1,000
8
30 Balance ₱1,000
Account: Prepaid Rent Account No. 140
.
2020
November Advance payment of rent. J1 ₱21,000 ₱21,000
1
30 Balance ₱21,000
Account: Prepaid Insurance Account No. 150
.
2020
November Payment of insurance premiums for one J1 ₱24,000 ₱24,000
5 year.
30 Balance ₱24,000
Account: Vehicles Account No. 160
.
2020
November Acquisition of vehicle. J1 ₱300,000 ₱300,000
2
30 Balance ₱300,000
Account: Equipment Account No. 170
.
2020
November Purchased of mechanical lawn mowers. J1 ₱54,000 ₱54,000
3
30 Balance ₱54,000
Account: Accounts Payable Account No. 210
.
2020
November Purchased of supplies on account. J1 ₱1,000 ₱1,000
8
30 Balance ₱1,000
Account: Notes Payable Account No. 220
.
2020
November Purchased of vehicle, balance on account J1 ₱100,0 ₱100,000
2 and signed a note. 00
30 Balance ₱100,000
Account: Unearned Revenues Account No. 250
.
2020
November Payment received for service to be J1 ₱13,500 ₱13,500
20 rendered in the future.
30 Balance ₱13,500
Account: Del Mundo, Capital Account No. 310
.
2020
November Initial investment made by the owner J1 ₱450,00 ₱450,000
1 0
30 Balance ₱450,000
Account: Del Mundo, Withdrawal Account No. 320
Date Explanation J.R Debit Credi Balance
. t
2020
November Withdrawal of cash for personal use. J1 ₱5,000 ₱5,000
29
30 Balance ₱5,000
Account: Service Income Account No. 410
.
2020
November Service rendered to seven customers, J1 ₱17,50 ₱17,500
14 receiving cash. 0
22 Service rendered on account. J1 20,000 37,500
30 Balance ₱37,500
Account: Salaries Expense Account No. 510
.
2020
November Payment of salaries to part-time employee. J1 ₱4,000 ₱4,000
26
30 Balance ₱4,000
Account: Utilities Expense Account No. 550
Date Explanation J.R Debit Credi Balance
. t
2020
November Payment for gasoline used. J1 ₱1,500 ₱1,500
4
30 Balance ₱1,500
Account: Advertising Expense Account No. 560
.
2020
November Payment for print advertising fliers. J1 ₱1,750 ₱1,750
28
30 Balance ₱1,750
Now that we’re done posting the entries to the ledger, let us now prepare a trial balance of Del
Mundo Landscape Specialist for the month of November to review and verify if our entries in the debits
and credits are balance.
What is a trial balance?
The trial balance is a list of all accounts with their respective debit or credit balances. It is
prepared to verify the equality of debits and credits in the ledger at the end of each accounting period
or at any time the postings are updated.
What are the procedures in the preparation of a trial balance?
1. List the account titles in numerical order.
2. Obtain the account balance of each account from the ledger and enter the debit balances in the
debit column and the credit balances in the credit column.
3. Add the debit and credits columns.
4. Compare the totals.
The trial balance is a control device that helps DEBIT CREDIT

minimize accounting errors. When the totals are equal, the (+) Assets (-) Assets
trial balance is in balance. This equality provides an interim (-) Liabilities (+) Liabilities
proof of the accuracy of the records but it does not signify (-) Equity (+) Equity
the absence of errors. For example, the bookkeeper failed to (-) Income (+) Income
record payment, the trial balance columns are equal but in (+) Expenses (-) Expenses
reality, the accounts are incorrect since rent expense is (+) Withdrawals (-) Withdrawals
understated and cash overstated. The trial balance for the
illustration follows:

Trial Balance
November 2020
Cash 182,250
Accounts Receivable 7,500
Supplies 1,000
Prepaid Rent 21,000
Prepaid Insurance 24,000
Vehicles 300,000
Equipment 54,000
Accounts Payable 1,000
Notes Payable 100,000
Unearned Revenues 13,500
Del Mundo, Capital 450,000
Del Mundo, Withdrawals 5,000
Service Income 37,500
Salaries Expense 4,000
Utilities Expense 1,500
Advertising Expense 1,750
₱602,000 ₱602,000
GENERALIZATION
The accounting process begins with the identification of an event, the analysis of that event, and
the measurement of the impact of that event to the business’s financial statements. The rules of debits and
credits are: increases in assets are recorded as debits; decreases in assets are recorded as credits; increases
in liabilities are recorded as credits; decreases in liabilities are recorded as debits; increases in owner’s
equity are recorded as credits; and, decreases in owner’s equity are recorded as debits. The trial balance
shows all accounts with their corresponding balances, segregated into debit and credit columns. The trial
balance is prepared to prove the equality of the debits and the credits in the journal entries.
What would probably most likely to happen to the accounting of a business entity if: (a) advance
payments to rents, supplies and the likes have expired; (b) rendered service or delivered the goods which
payment has already received prior to the fulfilment of obligation; and (c) expenses already incurred but
not yet paid at the end of accounting period?
Those are common transactions and situations a business entity encounters in the day-to-day
operation of the business that can affect the overall performance of the entity. For this week, let us study
how do businesses treat these kinds of situations and how these events affect the accounting records of a
business entity.
Analyzing, journalizing, and posting are done all year-round. Collectively, these steps constitute
what is called the recording phase of the accounting process. The summarizing phase starts with the
preparation of the trial balance, where the ending balances of the ledgers are taken and summarized in
a tabular presentation, together with the proper debit and credit balances.
Why is there a need for adjustments?
Accountants make adjusting entries to reflect in the accounts information on economic activities
that have occurred but have not yet been recorded. Adjusting entries assign revenue to the period in
which they earned, and expenses to the period in which they are incurred. These entries are needed to
measure properly the profit for the period, and to bring related asset and liability accounts to correct
balances for the financial statements.
In short, adjustments are needed to ensure that the revenue recognition and expense
recognition principles are followed thus resulting to financial statements reporting the effects of all
transactions at the end of the period.
Adjusting entries involve changing account balances at the end of the period from what is
the current balance of the account to what is the correct balance for proper financial reporting. Without
adjusting entries, financial statements may not fairly show the solvency of the entity in the balance
sheet and the profitability in the income statement.
Revenue recognition principle, revenue is recognized when it is probable that economic benefits will
flow to the enterprise and these economic benefits can be measured reliably. It shall be measured at the
fair value of the consideration received or receivable. In most cases, revenue is earned in the accounting
period when the services are rendered or the goods sold are delivered.
Expense recognition principle is the basis for recording expenses. Expenses are recognized in the income
statement when it is probable that a decrease in future economic benefits related to a decrease in an
asset or an increase of a liability has arisen, and that the decrease in economic benefits can be measured.
What are Deferrals and Accruals?

Accountants use adjusting entries to apply accrual accounting to transactions that cover more than
one accounting period. There are two general types of adjustments made at the end of the accounting
period – deferrals and accruals.
Each adjusting entry affects a balance sheet account (an asset or a liability account) and an income
statement account (income or expense account).
DEFERRAL
Deferral is the postponement of the recognition of “an expense already paid but not yet incurred,” or of
“a revenue already collected but not yet earned”. This adjustment deals with an amount already recorded
in a balance sheet account; the entry, in effect, decreases the balance sheet account and increases an
income statement account. Deferrals would be needed in two cases:
1. Allocating assets to expense to reflect expenses incurred during the accounting period (e.g.,
prepaid insurance, supplies and depreciation).
2. Allocating revenues received in advance to revenue to reflect revenues earned during the
accounting period (e.g., subscription).
ACCRUAL
Accrual is the recognition “of an expense already incurred but unpaid”, or “revenue earned but
uncollected”. This adjustment deals with an amount unrecorded in any account; the entry, in
effect, increases both a balance sheet and an income statement account. Accruals would be required in
two cases:
1. Accruing expenses to reflect expenses incurred during the accounting period that are unpaid
and unrecorded.
2. Accruing revenues to reflect revenues earned during the accounting period that are uncollected
and unrecorded.
The Del Mundo Landscape Specialist case is continued to illustrate the adjustment process. The
letters A, L, OE, OE:I and OE:E are still used to ensure a better understanding of the nature of the
accounts affected.
ADJUSTMENTS FOR DEFERRALS

ALLOCATING ASSETS TO EXPENSES
Entities often make expenditures that benefit more than one period. These expenditures are
generally debited to an asset account. At the end of each accounting period, the estimated amount that has
expired during the period or that has benefited the period is transferred from the asset account to an
expense account. Two of the more important kinds of adjustments are prepaid expenses, and
depreciation of property and equipment.
What are Prepaid Expenses?
Some expenses are customarily paid in advance. These expenditures (e.g., supplies, rent and
insurance) are called prepaid expenses. Prepaid expenses are assets, not expenses. At the end of the
accounting period, a portion or all of these prepayments may have expired. The portion of an asset that
has expired becomes an expense. Prepaid expenses expire either with the passage of time or through
use and consumption. The flow of costs from the balance sheet to the income statement is illustrated
below:
If adjustments for prepaid expenses are not made at the end of the period, both the balance sheet
and the income statement will be misstated. First, the assets of the entity will be overstated; second, the
expenses of the entity will be understated. For this reason, owner’s equity in the balance sheet and profit
in the income statement will both be overstated. Besides prepaid rent, Del Mundo Landscape Specialist
has prepaid expenses for supplies and insurance, both accounts need adjusting entries.
Prepaid Rent (Adjustment A). Del Mundo makes an adjusting entry to record the expiration of one
month of the three months’ advance rent paid on November 1.
Transaction: Expiration of one month’s rent.
Entries:
Dr. Cr.
Rent Expense (OE:E) ₱7,000
Prepaid Rent (A) ₱7,000
After adjustments, the prepaid rent account has a balance of ₱14,000 (prepayment of ₱21,000 less the
₱7,000 expired portion); the rent expense account reflects the ₱7,000 (₱21,000/3 months) expense for the
month.
Prepaid Insurance (Adjustment B). Del Mundo records the expiration of one-twelfth of the entity’s
one-year insurance policy taken last November 5.
Transaction: Expiration of one month’s insurance.
Entries:
Dr. Cr.
Insurance Expense (OE:E) ₱2,000
Prepaid Insurance (A) ₱2,000
The prepaid insurance account has a balance of ₱22,000 (₱24,000 prepayment less ₱2,000) and insurance
expense reflects the expired cost of ₱2,000 (₱24,000/12 months) for the month.
Supplies (Adjustment C). Del Mundo discovers that he used ₱500 worth of supplies during November.
He makes the necessary adjusting entry.
Transaction: Consumption of supplies.
Entries:
Dr. Cr.
Supplies Expense (OE:E) ₱500
Supplies (A) ₱500
The asset account supplies now reflect the adjusted amount of ₱500 (November 8 supplies purchase of
₱1,000 less ₱500). In addition, the amount of supplies expensed during the accounting period is reflected
as ₱500.
What are Depreciations of Property and Equipment?

When an entity acquires long-lived assets such as buildings, service vehicles, computers or office
furniture, it is basically buying or prepaying for the usefulness of that asset. These assets help generate
profit for the entity. Therefore, a portion of the cost of the assets should be reported as expense in each
accounting period. Proper accounting requires the proper allocation of the cost of the asset over its
estimated useful life. The estimated amount allocated to any one accounting period is depreciation or
depreciation expense. Three factors are involved in computing depreciation expense:
1. Asset cost is the amount an entity paid to acquire the depreciable asset.
2. Estimated salvage value is the amount that the asset can probably be sold for at the end of its
estimated useful life.
3. Estimated useful life is the estimated number of periods that an entity can make use of the asset.
Useful life is an estimate, not an exact measurement.
Accountants estimate periodic depreciation. They have developed a number of methods for
estimating depreciation. The simplest procedure is called the straight-line method. The formula for
determining the amount of depreciation expense for each period using this method is:
Asset Cost xx
Less: Estimated Salvage Value (xx)
Depreciable Cost xx
Divided by: Estimated Useful Life xx
Depreciation Expense for each Time Period xx
When recording depreciation expense, the asset account is not directly reduced. Instead, the
reduction is recorded in a contra account called accumulated depreciation. A contra account is used to
record reduction in a related account and its normal balance is opposite that of the related account. Use of
the contra account – accumulated depreciation – allows the disclosure of the original cost of the related
asset in the balance sheet. The balance of the contra account is deducted from the cost to obtain the book
value of the property and equipment.
Vehicle and Equipment (Adjustments D and E). Del Mundo bought a truck and lawn mowers last
November 2 and 3, respectively. Del Mundo allocates a full month’s depreciation for property and
equipment bought on or before the 15th day of the month; otherwise, it is half-month’s depreciation. It is
estimated that the truck will have a useful life of five years and a salvage value of ₱30,000, while the
lawn mowers, four-and-a-half years useful life without salvage value. Del Mundo then computes the
depreciation expenses for the truck as ₱4,500 a month [(₱300,000 - ₱30,000) / 60 months] and for the
lawn mowers, ₱1,000 (₱54,000/54 months).
Transaction: Recording depreciation expense.
Entries:
Dr. Cr.
Depreciation Expense-Vehicles (OE:E) ₱4,500
Accumulated Depreciation-Vehicles (A) ₱4,500
Depreciation Expense-Equipment (OE:E) ₱1,000

Accumulated Depreciation-Equipment (A) ₱1,000
After adjustments, the property and equipment section of the balance sheet for Del Mundo Landscape
Specialist will be:
Partial Balance Sheet
November 30, 2020
Property and Equipment (Net):
Service Vehicle ₱300,000
Less: Accumulated Depreciation (4,500) ₱295,500
Office Equipment ₱54,000
₱348,500
Allocating Revenues Received in Advance to Revenues

There are times when an entity receives cash for services or goods even before service is rendered
or goods are delivered. When such is received in advance, the entity has an obligation to perform services
or deliver goods. The liability referred to is unearned revenue.
For example, publishing entities usually receive payments for magazine subscriptions in advance.
These payments must be recorded in a liability account. If the entity fails to deliver the magazines for the
subscription period, subscribers are entitled to a refund. As the entity delivers each issue of the magazine,
it earns a part of the advance payments. This earned portion must be transferred from the unearned
subscription revenues account to the subscription revenues account.
Unearned Referral Revenues (Adjustment F). On November 20, Del Mundo received a ₱13,500
prepayment for six future visits. Since Del Mundo completed one of these visits in November, he makes
an adjusting entry to reflect this.
Transaction: Recognition of income where cash is received in advance.
Analysis: Liabilities decreased. Owner’s equity increased.
Entries:
Dr. Cr.
Unearned Revenues (L) ₱2,250
Service Income (OE:I) ₱2,250
The liability account, unearned revenues, reflects the lawn cutting revenues still to be earned, ₱11,250.
The revenues account reflects the amount of lawn cutting already completed and considered as revenues
during the month, ₱2,250 (₱13,500/6 visits).
ADJUSTMENTS FOR ACCRUALS

What are Accrued Expenses?
An entity often incurs expenses before paying for them. Cash payments are usually made at
regular intervals of time such as weekly, monthly, quarterly or annually. If the accounting period ends on
a date that does not coincide with the scheduled cash payment date, an adjusting entry is needed to reflect
the expense incurred since the last payment. This adjustment helps the entity avoid the impractical
preparation of hourly or daily journal entries just to accrue expenses. Salaries, interest, utilities (e.g.,
electricity, telecommunications and water) and taxes are examples of expenses that are incurred before
payment is made.
Accrued Salaries (Adjusting G). Del Mundo records an expense for the salaries of his part-time
employee who earned ₱1,600 during the last four days of November but will not be paid until December
10.
Transaction: Accrual of unrecorded expense
Analysis: Liabilities increased. Owner’s equity decreased.
Entries:
Dr. Cr.
Salaries Expense (OE:E) ₱1,600
Salaries Payable (L) ₱1,600
The liability of ₱1,600 (₱400 daily rate x 4 days) is now correctly reflected in the salaries payable
account. The actual expense incurred for salaries during the month is ₱5,600 (November 26 salaries
payment of ₱4,000 + ₱1,600).
Interest is a charge for the use of money over time. Interest expense is matched to a particular
period during which the benefit – the use of borrowed money – is received. The interest is a fixed
obligation and accrues regardless of the results of the entity’s operations. Interest rates are expressed as
annual rates, so if interest is being calculated for less than a year, the calculation must express time as a
portion of a year. Interest calculations usually exclude the day that loans occur and include the day that
loans are paid off.
Accrued Interest (Adjustment H). Del Mundo’s ₱100,000 notes payable, which he signed on
November 2, carries an 18% interest rate. Del Mundo uses the formula (for simple interest) below to
calculate how much interest expense accrued during the final 28 days of November.
Interest = Principal x Interest Rate x Length of Time
Interest = ₱100,000 x 18% per year x 28/360 of a year
Interest = ₱1,400
Transaction: Accrual of unrecorded expense.
Analysis: Liabilities increased. Owner’s equity decreased.
Entries:
Dr. Cr.
Interest Expense (OE:E) ₱1,400
Interest Payable (L) ₱1,400
At the end of November, Del Mundo owed the bank ₱1,400 for interest in addition to the ₱100,000 loan.
What are Accrued Revenues?

An entity may provide services during the period that are neither paid for by clients nor billed at the
end of the period. The value of these services represents revenue earned by the entity. Any revenue that
has been earned but not recorded during the accounting period calls for an adjusting entry that debits an
asset account and credits an income account.
Accrued Service Income (Adjustment I). During the afternoon of November 30, Del Mundo cuts one
lawn, and he agrees to mail the customer a bill for ₱2,500 which he does on December 2. Del Mundo
makes an adjusting entry in accordance with the revenue recognition principle.
Transaction: Accrual of unrecorded revenue.
Entries:
Dr. Cr.
Accounts Receivable (A) ₱2,500
Service Income (OE:I) ₱2,500
A total of ₱42,250 (₱37,500 + ₱2,250 + ₱2,500) in consulting revenues was earned by the entity during
the month.
The Del Mundo Landscape Specialist illustration did not tackle entries related to uncollectible accounts
SUMMARY OF ADJUSTING ENTRIES
Type of Account Balances Before Adjusting Entry
Adjustment Adjustments
Balance Sheet Income Account Debited Account Credited
Account Statement
Account
Prepaid Expenses:
Asset Method Assets Overstated Expenses Understated Expense Prepaid Expense (A)
Expense Method Assets Understated Expenses Overstated Prepaid Expense (A) Expense
Depreciation Assets Overstated Expenses Understated Expense Contra Asset
Unearned Revenues:
Liability Method Liabilities Overstated Income Understated Unearned Revenues (L) Revenues
Income Method Liabilities Understated Revenues Overstated Revenue Unearned Revenues (L)
Accrued Expenses Liabilities Understated Expenses understated Expense Payable (L)
Accrued Revenues Assets Understated Income Understated Receivable (A) Revenues
ADJUSTMENTS ARE JOURNALIZED AND POSTED

The adjustment process is a key element of accrual basis accounting. The worksheet helps in the
identification of the accounts that need adjustments. The adjusting entries are directly entered in the
worksheet. Most accountants prepare the financial statements immediately after completing the
worksheet. The adjustments are journalized and posted as the closing entries are made. This step in the
accounting cycle brings the ledger into agreement with the data reported in the financial statements
Illustration. The adjustments pertinent to the Del Mundo Landscape Specialist illustration follow:
Date Account Title and Explanation P.R. Debit Credit
2020
November 30 Rent Expense 530 ₱7,000
Prepaid Rent 140 ₱7,000
30 Insurance Expense 540 ₱2,000

Prepaid Insurance 150 ₱2,000
30 Supplies Expense 520 ₱500

Supplies 130 ₱500
30 Depreciation Expense – Vehicles 580 ₱4,500

Accumulated Depreciation – Vehicles 165 ₱4,500
30 Depreciation Expense – Equipment 590 ₱1,000

Accumulated Depreciation – Equipment 175 ₱1,000
30 Unearned Revenues 250 ₱2,250

Service Income 410 ₱2,250
30 Salaries Expense 510 ₱1,600

Salaries Payable 230 ₱1,600
30 Interest Expense 570 ₱1,400

Interest Payable 240 ₱1,400
30 Accounts Receivable 120 ₱2,500
Service Income 410 ₱2,500
GENERALIZATION
Adjusting entries are prepared at the end of an accounting period to unrecorded revenue that has
been earned and unrecorded expenses that have been incurred during the accounting period. Each
adjusting entry has the following characteristics: (1) each entry is recorded at the end of an accounting
period; (2) each entry has at least one balance sheet account and at least one income statement account;
and (3) each entry has no cash account in either the debit of the credit side.
There are questions that the owner of a business periodically asks – How much did the business
entity earn? What is the financial condition of the business? How much is the owner’s interest in the
entity today? What happened to the cash receipts? Where did cash go? Investors, creditors, taxing
authorities and other users have their own questions about the business which need to be answered.
Those are just the typical questions commonly raised in the business and as an ABM student, it
also triggers your mind and curiosity to look into and analyze what is really happening in the business
entity. That is what we are going to learn about in this week’s lesson as we are going to dwell on the
preparation of financial statements and the remaining steps to complete the accounting cycle of a service
business.
What is the Worksheet?

Accountants often use a worksheet to help transfer data from the unadjusted trial balance to
the financial statements. This multi-column document provides an efficient way to summarize the data
for financial statements. The accountant generally prepares a worksheet when it is time to adjust the
accounts and prepare financial statements. Note, however, that it is possible to prepare financial
statements directly from the adjusted trial balance at the end of the accounting period if the business has
relatively few accounts.
The worksheet simplifies the adjusting and closing process. It can also reveal errors. The
worksheet is not part of the ledger or the journal, nor is it a financial statement. It is a summary device
used by the accountant for his/her convenience.
What is the complete set of financial statements?
An entity shall present with equal prominence all of the financial statements in a complete set of
financial statements. Per revised International Accounting Standards (IAS) No. 1, a complete set of
financial statements comprises:
1. A statement of financial position at the end of the period;
2. A statement of comprehensive income for the period;
3. A statement of changes in equity for the period;
4. A statement of cash flows for the period;
5. Notes, comprising a summary of significant accounting policies and other explanatory
information; and
6. A statement of financial position as at the beginning of the earliest comparative period when an
entity applies an accounting policy retrospectively or makes a retrospective restatement of items
in its financial statements or when it reclassifies items in its financial statements.
What is the essence of Financial Statements?
The financial statements are the means by which the information accumulated and processed in
financial accounting is periodically communicated to the users. Without accounting information
embodied in the financial statements, users may not be able to arrive at a sound economic-decisions. The
objective of financial statements is to provide information about the financial position, financial
performance, and cash flows of an entity that is useful to a wide range of users in making economic
decisions.
How to prepare the financial statements?
Once the worksheet is completed, it is easy to prepare the financial statements for the account
balances have been extended to the appropriate income statement and balance sheet columns. Most of the
information needed to prepare the income statement, statement of changes in equity and balance sheet are
available from the worksheet. The statements presented are those of Del Mundo Landscape Specialist.
Note that financial statements shall be presented at least annually.
INCOME STATEMENT
The income statement is a formal statement showing the performance of the enterprise for a given
period of time. It summarizes the revenues earned and expenses incurred for that period of time. The
income statement for Del Mundo Landscape Specialist is prepared directly from the income statement
columns of the worksheet.
Income Statement
For the Month Ended November 30, 2020
Revenues
Expenses
Salaries Expense ₱5,600
Supplies Expense 500
Rent Expense 7,000
Insurance Expense 2,000
Advertising Expense 1,750
Depreciation Expense – Vehicles 4,500
Depreciation Expense – Equipment 1,000
Interest Expense 1,400
Total (25,250)
Profit ₱17,000
Information about the performance of an enterprise, in particular its profitability, is required in

order to assess potential charges in the economic resources that is likely to control in the future. It is
also useful in predicting the capacity of the enterprise to generate cash flows from its existing
resource base.
STATEMENT OF CHANGES IN EQUITY

The statement of changes in equity summarizes the changes that occurred in owner’s equity. This
statement is now a required statement. Changes in an enterprise’s equity between two balance sheet dates
reflect the increase or decrease in its net assets during the period.
In the case of sole proprietorship, increases in owner’s equity arise from additional investments by
the owner and profit during the period. Decreases result from withdrawals by the owner and from loss for
the period.
Statement of Changes in Equity
For the Month Ended November 30, 2020
Del Mundo, Owner’s Equity, 11/1/2020 ₱450,000
Add: Additional Investments by Del Mundo ₱-0-
Profit 17,000 17,000
Total ₱467,000
Less: Withdrawals (5,000)
Del Mundo, Owner’s Equity, 11/30/2020 ₱462,000
BALANCE SHEET
The balance sheet is a statement that shows the financial position or condition of an entity by
listing the assets, liabilities and owner’s equity as at a specific date. The information needed for the
balance sheet items are the net balances at the end of the period, rather than the total for the period as in
the income statement. This statement is also called the statement of financial position.
FORMAT
The balance sheet can be presented in either the report format or the account format. The report
format simply lists the assets, followed by the liabilities then by the owner’s equity in vertical sequence.
The account format lists the assets on the left and the liabilities and owner’s equity on the right. Either
balance sheet format is acceptable.
CLASSIFICATION
It is proper to present a classified balance sheet; that is, the assets and liabilities are separated into
various categories. Assets are sub-classified as current assets and non-current assets; while liabilities as
current liabilities and non-current liabilities.
To make accounting information useful to decision-makers, the items in the balance sheet may be
grouped and arranged in accordance with the following guidelines:
 Assets are classified and presented in decreasing order of liquidity. Cash is the most liquid.
Assets that are least likely to be converted to cash are listed last.
 Liabilities are generally classified and presented based on time of maturity such that obligations
which are currently due are listed first.
The classified balance sheet of Del Mundo Landscape Specialist in report format is:
Balance Sheet
November 30, 2020
Assets
Current Assets
Cash ₱182,250
Supplies 500
Prepaid Rent 14,000
Total Current Assets ₱228,750
Property and Equipment (Net)
Vehicles ₱300,000
Equipment ₱54,000
Less: Accumulated Depreciation (1,000) 53,000 348,500
Total Assets ₱577,250
Liabilities
Current Liabilities
Salaries Payable 1,600
Interest Payable 1,400
Total Current Liabilities ₱115,250
Owner’s Equity
Del Mundo, Capital, 11/30/2020 462,000
Total Liabilities and Owner’s Equity ₱577,250
What are the remaining steps in the accounting cycle?

A. CLOSING ENTRIES ARE JOURNALIZED AND POSTED
Income, expense and withdrawal accounts are temporary accounts that accumulate information
related to a specific accounting period. These temporary accounts facilitate income statement preparation.
At the end of each year, the balances of these temporary accounts are transferred to the capital
account. Thus, the balance of the owner’s capital account represents the cumulative net result of income,
expenses, and withdrawal transactions. This phase of the cycle is called the closing procedure.
A temporary account is said to be closed when an entry is made such that its balance becomes zero.
Closing simply transfers the balance of one account to another account. In this case, the balances of the
temporary accounts are transferred to the capital account. A summary account – Income Summary is used
to closed the income and expense accounts. The steps in closing the accounts of an entity will be
illustrated using Del Mundo Landscape Specialist case.
Close the Income Account
Income accounts have credit balances before the closing entries are posted. For this reason, an entry
debiting each revenue account in the amount of its balance is needed to close the account. The credit is
made to the income summary account. The entry to close the income accounts for the Del Mundo
Landscape Specialist is as follows:
2020
November 30 Service Income 410 ₱42,250
Income Summary 330 ₱42,250
The dual effect of the entry is to make the balances of the income accounts equal to zero, and to transfer
the balances in total to the credit side of the income summary account. Note that the data for closing the
income accounts can be found in the credit side of the income statement columns of the worksheet.
Close the Expense Accounts
Expense accounts have debit balances before the closing entries are posted. For this reason, a compound
entry is needed crediting each expense account for its balance and debiting the income summary for the
total. These data can be found in the debit side of the income statement columns of the worksheet.
2020
November 30 Income Summary 33 ₱25,250
0
Salaries Expense 51 ₱5,600
0
Supplies Expense 52 500
0
Rent Expense 53 7,000
0
Insurance Expense 54 2,000
0
Utilities Expense 55 1,500
0
Advertising Expense 56 1,750
0
Interest Expense 57 1,400
0
Depreciation Expense – Vehicles 58 4,500
0
Depreciation Expense – Equipment 59 1,000
0
The dual effect of posting the closing entry is to reduce the expense account balances to zero and to
transfer the total of the account balances to the debit side of the income summary account.
Close the Income Summary Account
After posting the closing entries involving the income and expense accounts, the balance of the income
summary account will be equal to the profit or loss for the period. A profit is indicated by a credit balance
and a loss by a debit balance. The income summary account, regardless of the nature of its balance, must
be closed to the capital account. For the Del Mundo Landscape Specialist, the entry is as follows:
2020
November 30 Income Summary 330 ₱17,000
Del Mundo, Capital 310 ₱17,000
The effect of posting this closing entry is to close the income summary account balance and to transfer
the balance to Del Mundo’s capital account for the profit.
Close the Withdrawal Account
The withdrawal account shows the amount by which capital is reduced during the period by withdrawals
of cash or other assets of the business by the owner for personal use. For this reason, the debit balance of
the withdrawal account must be closed to the capital account as follows:
2020
November 30 Del Mundo, Capital 310 ₱5,000
Del Mundo, Withdrawal 320 ₱5,000
The effect of posting this closing entry is to close the withdrawal account and to transfer the balance to
the capital account.
B. PREPARATION OF A POST-CLOSING TRIAL BALANCE
It is possible to commit an error in posting the adjustments and closing entries to the ledger accounts;
thus, it is necessary to test the equality of the accounts by preparing a new trial balance. This final trial
balance is called post-closing trial balance.
 The post-closing trial balance verifies that all the debits equal the credits in the trial balance.
 The trial balance contains only balance sheet items such as assets, liabilities, and ending capital
because all income and expense accounts, as well as the withdrawal account, have zero balances.
Notice that only the balance sheet accounts have balances because at this point, all the income statement
accounts have been closed.
Post-Closing Trial Balance
November 30, 2020
Cash ₱182,250
Supplies 500
Prepaid Rent 14,000
Vehicles 300,000
Accumulated Depreciation - Vehicles ₱4,500
Equipment 54,000
Accumulated Depreciation - Equipment 1,000
Accounts Payable 1,000
Salaries Payable 1,600
Interest Payable 1,400
Del Mundo, Capital 462,000
₱582,750 ₱582,750
C. REVERSING ENTRIES
Preparing the post-closing trial balance may not be the last step in the accounting cycle. Some
entities elect to reverse certain end-of-period adjustments on the first day of the new period. A reversing
entry is a journal entry which is the exact opposite of a related adjusting entry made at the end of the
period. It is basically a bookkeeping technique made to simplify the recording of regular transactions in
the next accounting period.
It should be emphasized that reversing entries are optional. Also, the act of reversing a previously
recorded adjusting entry should not lead us to the conclusion that the entries reversed are unnecessary or
inaccurate.
Even when an entity follows the policy of making reversing entries, not all adjusting entries should
be reversed. Generally, a reversing entry should be made for any adjusting entry that increased an asset or
a liability account. Therefore, all accruals are reversed but only deferrals initially recorded in income
statement – income or expense – accounts are reversed.
GENERALIZATION
The adjusted trial balance is simply the unadjusted trial balance plus the effects of the adjusting
entries. Closing entries reduce the balances of the temporary accounts to zero to prepare them for
accumulating amounts for another accounting period. The post-closing trial balance proves the equality of
debits and credits after the preparation of closing entries.
What makes the accounting procedure and the preparation of financial statements of a merchandising
business different from other types of business? What is the most significant factor that needs to be
consider in the accounting cycle? And, how does this type of business treat the goods in transit in their
accounting books?
For this week, let us learn more on the operations and accounting procedures of a merchandising
business.
BUSINESS TRANSACTIONS AND THEIR ANALYSIS AS APPLIED TO THE ACCOUNTING

CYCLE OF A MERCHANDISING BUSINESS
A merchandising business is a company that buys goods and resells these goods, without
making any modifications, at a price higher than its purchase price for the purpose of making profit. This
type of business is much common in the Philippines and can range from small to large-sized entities.
Examples would be the neighborhood sari-sari stores, department stores, grocery shops, and those selling
in wholesale.
Hence, inventory is the most important asset of a merchandising business as this is where the
company derives its regular revenue streams.
What is the Operating Cycle of a Merchandising Business?

The merchandising entity purchases inventory, sells the inventory and uses the cash to purchase
more inventory – and the cycle continues. For cash sales, the cycle is from cash to inventory and back to
cash. For sales on account, the cycle is from
cash to inventory to accounts receivable and
back to cash. In any industry, the manager
strives to shorten the cycle. The faster the
sale of inventory and the collection of cash,
the higher the profit. The following
illustrates the operating cycle of a
merchandiser:
What is the difference in the Income Statement of a Service and Merchandising Business?
Service entities perform services for a fee. In ascertaining profit, a basic income statement is all that
is needed. In Figure 1, profit is measured as the difference between revenues from services and
expenses. In contrast, merchandising entities earn profit by buying and selling goods. These entities use
the same basic accounting methods as service entities, but the process of buying and selling merchandise
requires some additional accounts and concepts. This process results in a more complex income
statement. To provide a better measure of performance, the income statement of a merchandising
business is presented with additional items:
Service Merchandising
Income Statement Income Statement
Revenues from Services Net Sales
minus minus
Cost of Sales
equals
Gross Profit
add or minus
Expenses Income or Expenses
(see details below)
equals equals
Profit Profit
Figure 1 – Components of Income Statement for Service and Merchandising Entities
In a merchandising Theodore Calaguas Traders

business, net sales arise Income Statement
from the sale of goods For the Year Ended December 31, 2016
while cost of sales or cost Net Sales ₱ 2,393,250
of goods sold represents the Cost of Sales (1,313,600)
cost of inventory the entity Gross Profit ₱ 1,079,650
has sold to customers. The Operating Expenses (586,040)
difference between net sales Operating Profit ₱ 493,610
and cost of sales is Finance Costs (38,400)
called gross profit. Then, Profit ₱ 455,210
other operating income is Exhibit 1 – Parts of an Income Statement for a Merchandising Entity
added and operating expenses (like distribution costs, administrative expenses and other operating
expenses) are deducted from gross profit to arrive at operating profit. Investment revenues, other gains
and losses, and finance costs (e.g., interest expense) are considered to arrive at profit before tax then
income tax expense is deducted to have profit from continuing operations. Finally, profit from
discontinued operations (net of tax) is taken to account to get profit for the period.
What are the Source Documents of a Merchandise Business?

Merchandising businesses use various business forms and documents to help identify the
transactions that should be recorded in the books. These source documents contain vital information
about the nature and amount of the transactions.
 Sales Invoice is prepared by the seller of goods and sent to the buyer. This document contains the
name and address of the buyer, the date of sale and information – quantity, description and price –
about the goods sold. It also specifies the amount of sales, and the transportation and payment terms.
 The Bill of Lading is a document issued by the carrier – a trucking, shipping or airline – that
specifies contractual conditions and terms of delivery such as freight terms, time, place, and the
transportation and payment terms.
 The Statement of Account is a formal notice to the debtor detailing the accounts already due.
 The Official Receipt evidences the receipt of cash by the seller or the authorized representative. It
notes the invoices paid and other details of payment.
 Deposit Slips are printed forms with depositor’s name, account number and space for details of
the deposit. A validated deposit slip indicates that cash and checks with the supplied details were
actually deposited or credited to the account holder.
 A Check is a written order to a bank by a depositor to pay the amount specified in the check from his
checking account to the person named in the check. The entity issuing the check is the payor while
the receiver is the
 The Purchase Requisition is a written request to the purchaser of an entity from an employee or
user department of the same entity that goods be purchased.
 The Purchase Order is an authorization made by the buyer to the seller to deliver the
merchandise as detailed in the form.
 Receiving Report is a document containing information about goods received from a vendor. It
formally records the quantities and description of the goods delivered.
 A Credit Memorandum is a form used by the seller to notify the buyer that his account is being
decreased due to errors or other factors requiring adjustments.
TERMS OF TRANSACTIONS
Merchandise may be purchased and sold either on credit or for cash on delivery. When goods are sold on
account, a period of time called the credit period is allowed for payment. The length of the credit period
varies across industries and may even vary within an entity, depending on the product.
When goods are sold on credit, both parties should have an understanding as to the amount and time of
payment. These terms are usually printed on the sales invoice and constitute part of the sales
agreement. If the credit period is 30 days, then the payment is expected within 30 days from the invoice
date. The credit period is usually described as net credit period or net terms. The credit period of 30
days is noted as “n/30”. If the invoice is due ten days after the end of the month, it may be marked “n/10
eom”.
CASH DISCOUNTS
 Some businesses give discounts for prompt payment. If a trade discount is also offered, cash discount
is computed on the net after the trade discount. This practice improves the seller’s cash position by
reducing the amount of money in accounts receivable. Cash discount is designated by such notation
as “2/10” which means the buyer may avail of a two percent discount if the invoice is paid within ten
days from the invoice date. The period covered by the discount, in this case – ten days, is called
the discount period.
 Cash discounts are called purchase discounts from the buyer’s viewpoint and sales discount from the
seller’s point of view.
 It is usually worthwhile for the buyer to take a discount it offered although it may be necessary to
borrow money to make the payment.
Example 1:
This is read as “two ten, n thirty”. A term
like 5/10, n/30 means that a 5% cash discount is
granted the buyer if the account is paid
within 10 days from the date of
invoice/purchase. If the 10-day period has
elapsed, the buyer will be given 30 days from
the date of the invoice within which to pay
his or her account with additional charges
Example 2:
3
/10 = 2/15 = n/60
This is read as “three ten, two fifteen, n sixty”. It means that the buyer will be given 3% discount if he or
she pays within 10 days from the date of invoice; or 2% discount if he or she pays within 15 days from
the invoice date; or, if he or she failed to take advantage of the discounts being offered, he or she has to
pay within 60 days from the date of invoice.
Computing for Cash Discounts and Net Amount Due

Cash Discount = NIP x Cash Discount Rate
Net Amount Due = NIP – Cash Discount
where:
NIP = Net invoice Price
Example: Net Invoice Price: ₱3,060
Invoice Date: March 2

3
Term: /15 = n/60
Find: a. Cash Discount b. Net Amount Due
Solution:
Cash Discount = NIP x Cash Discount Rate
Cash Discount = ₱3,060 x 0.03
Cash Discount = ₱91.80
Net Amount Due = NIP – Cash Discount
Net Amount Due = ₱3,060 - ₱91.80
Net Amount Due = ₱2,968.20
The foregoing implies that if the buyer pays not later than March 17, then he or she pays only ₱2,968.20
instead of ₱3,060. Beyond March 17, he or she pays the ₱3,060.
TRADE DISCOUNTS
Suppliers furnish smaller wholesalers or retailers with price list and catalogs showing suggested
retail prices for their products. These firms, however, also include a schedule of trade discounts from
the listed prices to enable customer to determine the invoice price to be paid. Trade discounts encourage
the buyers to purchase products because of markdowns from the list price. Trade discounts should not
be confused with cash discounts. This type of discount enables the suppliers to vary prices
periodically without the inconvenience of revising price lists and catalogs.
There is no trade discount account and there is no special accounting entry for this discount. Instead, all
accounting entries are based on the invoice price which is obtained by subtracting the trade discount from
the list price.
Illustration: Pinnacle technologies quoted a list price of ₱2,500 for each 64-gigabyte flash drive, less a
trade discount of 20%. If Video Fantastic ordered seven units, the invoice price would be as follows:
List Price (₱2,500 x 7) ₱ 17,500
Less: 20% Trade Discount (3,500)
Invoice Price ₱ 14,000
Trade discounts may be stated in a series. Assume instead that the trade discount given by Pinnacle to
Video Fantastic is 20% and 10%, the invoice price will be:
List Price (₱2,500 x 7) ₱ 17,500
Balance ₱ 14,000
Invoice Price ₱ 12,600
In the first example, both the buyer and the seller would record only the ₱14,000 invoice price while in
the second example, the invoice price will be ₱12,600.
TRANSPORTATION COSTS
When a merchandise is shipped by a common carrier – a trucking entity or an airline – the carrier
prepares a freight bill in accordance with the instructions of the party making the shipping arrangements.
The freight bill designates which party shoulders the costs, and whether the shipment freight
prepaid or freight collect.
Freight bills usually show whether the shipping terms are FOB shipping point or FOB destination.
F.O.B. is an abbreviation for “free on board”. When the freight the terms are FOB shipping point, the
buyer shoulders the shipping costs; ownership over the goods passes from seller to the buyer when the
inventory leaves the seller’s place of business – the shipping point. The buyer already owns the goods
while still in transit and therefore, shoulders the transportation costs.
If the terms are FOB destination, the seller bears the shipping costs. Title passes only when the
goods are received by the buyer at the point of destination; while in transit, the seller is still the owner of
the goods so the seller shoulders the transportation costs.
In freight prepaid, the seller pays the transportation costs before shipping the goods sold;
while in freight collect, the freight entity collects from the buyer. Payment by either party will not
dictate who should ultimately shoulder the costs.
Normally, the party bearing the freight cost pays the carrier. Thus, goods are typically shipped
freight collect when the terms are FOB shipping point; and freight prepaid when the terms are FOB
destination.
Sometimes, as a matter of convenience, the firm not bearing the freight cost pays the carrier. When
this situation occurs, the seller and the buyer simply adjust the amount of the payment for the
merchandise. Figure 3 shows which party – the buyer or the seller – shoulders the transportation costs and
pays the shipper for various freight terms:
Freight Terms Who shoulders the Who pays the

transportation costs? shipper?
FOB Destination, Freight Prepaid Seller Seller
FOB Shipping Point, Freight Collect Buyer Buyer
FOB Destination, Freight Collect Seller Buyer
FOB Shipping Point, Freight Prepaid Buyer Seller
Figure 3 – Treatment of Transaction Costs
The shipping costs borne by the buyer using periodic inventory system are debited
to transportation in account. In accounting, the cost of an asset – the merchandise inventory – includes all
costs (e.g., shipping costs) incurred to bring the asset to its intended use. In the cost of sales section of the
income statement, the balance in this account is added to purchases in computing for the net cost of
purchases for the period.
Shipping costs borne by the seller are debited to transportation out account. This account which is
also called delivery expense, is an operating expense in the income statement.
INVENTORY SYSTEMS
Merchandise inventory is the key factor in determining cost of sales. Because merchandise
inventory represents goods available for sale, there must be a method of determining both the quantity
and the cost of these goods. There are two systems available to merchandising entities to record events
related to merchandise inventory: the perpetual inventory system and the periodic inventory system. Refer
to the appendix of this chapter for the comparative illustrations.
Perpetual Inventory System
The perpetual inventory system is an alternative to the periodic inventory system. Under the
perpetual inventory system, the inventory account is continuously updated. Perpetually updating the
inventory account requires that at the time of purchase, merchandise acquisitions be recorded as debits to
the inventory account. At the time of sale, the cost of sales is determined and recorded by a debit to the
cost of sales account and a credit to the inventory account. With perpetual inventory system, both the
inventory and cost of sales accounts receive entries throughout the accounting period.
When an entity uses the perpetual inventory system, the ending inventory should reconcile with the
actual physical count at the end of the period assuming that no theft, spoilage, or error has occurred.
Even if there is a little chance for or suspicion of inventory discrepancy, most entities make a physical
count. At that time, the account is adjusted for any inaccuracies discovered. The count provides an
independent check on the amount of inventory that should be reported at the end of the period.
Periodic Inventory System
The periodic inventory system is primarily used by businesses that sell relatively inexpensive
goods and that are not yet using computerized scanning systems to analyze goods sold. A characteristic
of the periodic inventory system is that no entries are made to the inventory account as the
merchandise is bought and sold. When goods are purchased, a separate set of accounts – purchases,
purchases discounts, purchases returns and allowances, and transportation in – is used to accumulate
information on the net cost of the purchases. Only at the end of the period, when the inventory is counted,
will entries be made to the inventory account to establish its proper balance.
APPENDIX
Periodic and Perpetual Inventory Systems Compared
This appendix will demonstrate the entries typically used with the periodic inventory system,
contrasted to the entries used with the perpetual inventory system. Assume that the beginning inventory
for the year is ₱250,000. Assuming the transactions (nos. 1 to 7) were the only transactions for the entire
year, the balance in the inventory account at year-end under the periodic inventory system is ₱250,000.
The year-end balance in the inventory account under the perpetual inventory system is ₱231,860.
Under the perpetual inventory system, the inventory account is increased by purchases,
transportation in, and sales returns and is decreased by the cost of sales, purchases returns and allowances,
and purchases discounts.
At year-end, the physical inventory is taken, and it revealed that the actual inventory on hand is
₱231,500. The year-end journal entries (nos. 8 to 10) are then made to bring the inventory account
balance into agreement with the amount of the physical inventory. When posted to the general ledger,
both the periodic and perpetual inventory systems result in the same ending inventory amount, ₱231,500.
Exhibit 2
PERIODIC INVENTORY SYSTEM PERPETUAL INVENTORY SYSTEM
1. Sold merchandise on account costing ₱8,000 for ₱10,000; terms were 2/10, n/30:
Accounts Receivable 10,000 Accounts Receivable 10,000
Sales 10,000 Sales 10,000
Cost of Sales 8,000

Inventory 8,000
2. Customer returned merchandise costing ₱400 that had been sold on account for ₱500 (part of the
₱10,000 sale):
Sales Returns & Allowances 500 Sales Returns and Allowances 500
Accounts Receivable 500 Accounts Receivable 500
Inventory 400
Cost of Sales 400
3. Received payment from customer for merchandise sold above [cash discount taken: (₱10,000 sale -
₱500 return) x 2% discount = ₱190):
Cash 9,310 Cash 9,310
Sales Discounts 190 Sales Discounts 190
Accounts Receivable 9,500 Accounts Receivable 9,500
4. Purchased on account merchandise for resale for ₱6,000; terms were 2/10, n/30 (purchases
recorded at invoice price):
Purchases 6,000 Inventory 6,000
Accounts Payable 6,000 Accounts Payable 6,000
5. Paid ₱200 freight on the ₱6,000 purchase; terms were FOB shipping point, freight collect:
Transportation In 200 Inventory 200
Cash 200 Cash 200
6. Returned merchandise costing ₱300 (part of the ₱6,000 purchase):

Accounts Payable 300 Accounts Payable 300
Purchases Returns & 300 Inventory 300
Allowances
7. Paid for merchandise purchased, refer to no.4 [cash discount taken: (6,000 purchase - ₱300 return)
x 2% discount = ₱114]:
Accounts Payable 5,700 Accounts Payable 5,700
Purchase Discounts 114 Inventory 114
Cash 5,586 Cash 5,586
8. To transfer the beginning inventory balance to the Income Summary account (part of the closing
entries under the periodic inventory system):
Income Summary 250,000 (No entry required)
Inventory 250,000
9. To record the ending inventory balance (part of the closing entries under the periodic inventory
system):
Inventory 231,500 (No entry required)
Income Summary 231,500
10. To adjust the ending perpetual inventory balance for the shrinkage during the year:
Shrinkage already effected in the no. 9 entry Cost of Sales 360
Inventory 360
What makes the preparation of income statement of a merchandising inventory harder and more
complex compare to others? How to solve and identify the balance of inventory? How does the
merchandising business arrive at a profit?
Why is there a need for a physical count of inventory?
In the periodic inventory system, purchases of merchandise are accumulated in the purchases account.
During the accounting period, no entry is made to the merchandise inventory account such that its balance
at the end of the period, before adjusting and closing entries, is the same as the beginning inventory. With
no perpetual record of the cost of sales during the period, the only way to obtain the cost of the ending
inventory is to make a physical count.
It should be noted that the ending inventory amount is needed in the computation of the cost of sales. To
recapitulate, ending inventory is deducted from goods available for sale to obtain cost of sales. The steps
involved in the physical count follows:
a. All merchandise owned by the entity is counted.
b. The quantity counted is multiplied by the cost per unit for each inventory item.
c. The costs of various items are added to determine the total cost of inventory.
The resulting total cost of inventory is the ending inventory; this amount will appear as a deduction in the
cost of sales section of the income statement, and as a current asset in the balance sheet. The physical
count is made at or near the balance sheet date.
How to prepare the worksheet of a merchandising business?
The worksheet of a merchandising business is the same as that of a service business except that it has to
deal with the new accounts related to merchandising transactions. These accounts include sales, sales
returns and allowances, sales discounts, purchases, purchases returns and allowances, purchases
discounts, transportation in, merchandise inventory and transportation out.
How to prepare the Income Statement of a merchandising business?
The statement may be prepared by referring to the income statement columns of the worksheet. Per
revised IAS No. 1, an enterprise should present an analysis of expenses using a classification based on
either the nature of expenses or their function within the entity, whichever provides information that is
reliable and more relevant. Entities are encouraged to present the analysis of expenses on the face of the
income statement.
Nature of Expense Method or The Single-Step Approach
Expenses are aggregated or combined in the income statement according to their nature and are not
reallocated among various functions within the entity. This method is simple to apply in many smaller
enterprises because no allocation of operating expenses between functional classifications is necessary.
Example include raw materials and consumables used, employee benefits expense, depreciation and
amortization expense, transportation costs, advertising costs and other operating expenses.
Revenues ₱ xxx
Less: Expenses (xx)
Profit (Loss) ₱ xxx
Note: This method is commonly used by service businesses.
Function of Expense Method or The Multi-Step Approach
Net Sales ₱ xxx
Cost of Sales (xxx)
Gross Profit ₱ xxx
Other Operating Income xx
Total ₱ xxx
Operating Expenses
Distribution Costs ₱ xx
Administrative Expenses xx
Other Operating Expenses xx (xx)
Operating Profit ₱ xxx
Finance Costs (xx)
Investment Revenues xx
Profit from Continuing Operations ₱ xxx
Profit from Discontinued Operations x
Profit ₱ xxx
This method, also referred to as the “cost of sales” method, classifies expenses according to their
function as part of cost of sales, distribution/selling, administrative and other operating activities. This
presentation often provides information that is more relevant to users than the nature of expense method
but the allocation of costs to functions can be arbitrary and involves considerable judgment. This method
provides multiple classifications and intermediate differences to highlight significant relationships.
In a merchandising business, net sales arise from the sale of goods while cost of sales or cost of
goods sold represents the cost of inventory the entity has sold to customers. The difference between net
sales and cost of sales is called gross profit.
Then, other operating income is added and operating expenses (like distribution costs, administrative
expenses and other operating expenses) are deducted from gross profit to arrive at operating profit.
Investment revenues, other gains and losses, and finance costs (e.g., interest expense) are considered
to arrive at profit before tax then income tax expense is deducted to arrive at profit from continuing
operations. Finally, profit from discontinued operations (net of tax) is taken to account to get profit for
the period.
The difference between the two methods lies in the items above operating profit. The standard does
not prescribe any format. The choice between the two methods depends on historical and industry factors
and the nature of the entity.
WORKSHEET IN A PERPETUAL INVENTORY SYSTEM

The worksheet is prepared after all transactions for the year have been journalized and posted. However,
the following items should be noted:
1. The inventory amount in the trial balance is the year-end balance since the inventory account is
perpetually updated. There will be no merchandise inventory adjusting or closing entry unlike
when the periodic inventory system is used. The year-end inventory balance will simply be
extended to the debit column of the balance sheet.
2. The cost of sales account is a ledger account in the perpetual system. There will be no accounts
for purchases, purchases returns and allowances, purchases discounts and transportation in
because information related to these items is recorded directly in the inventory account. When the
closing entries are made, cost of sales will be closed with the other temporary accounts with debit
balances.
3. The adjustments are handled in exactly the same way as they are handled in the periodic
worksheet.
4. An adjusting entry is necessary when the year-end inventory account balance does not tally with
the physical inventory amount.
Exhibit 1 shows the income statement for T. Calaguas traders using the function of expense method:
Theodore Calaguas Traders
Income Statement
For the Year Ended December 31, 2016
Net Sales
Gross Sales ₱2,463,500
Less: Sales Returns & Allowances ₱27,500
Sales Discounts 42,750 (70,250)
Net Sales ₱2,393,250
Cost of Sales
Merchandise Inventory, 1/1/2016 ₱528,000
Purchases ₱1,264,000
Less: Purchases Returns & Allowances ₱56,400
Purchases Discount 21,360 (77,760)
Net Purchases ₱1,186,240
Transportation In 82,360
Net Cost of Purchases 1,268,600
Goods Available for Sale ₱1,796,600
Less: Merchandise Inventory. 12/31/2016 (483,000)
Cost of Sales 1,313,600
Gross Profit ₱1,079,650
Operating Expenses
Selling Expenses
Sales Salaries ₱225,000
Transportation Out 57,400
Store Supplies Expense 15,400
Insurance Expense – Selling 5,600
Total Selling Expenses ₱303,400
Administrative Expenses
Office Salaries Expense ₱171,000
Depreciation Expense – Building 26,000
Depreciation Expense – Office Equipment 22,000
Office Supplies Expense 12,040
Insurance Expense – General 3,600
Total Administrative Expenses 282,640
Total Operating Expenses (586,040)
Operating Profit ₱493,610
Finance Costs (38,400)
Profit ₱455,210
Exhibit 1 – Income Statement (Using the Function of Expense Method)

SAMPLE EXERCISE
Missing Elements – Reconstruction
To test your knowledge of the relationships of these items, insert the missing figures in the following
income statement. Note that the gross profit is 40% of net sales and profit is 10% of net sales.
Net Sales
Gross Sales ₱
Less: Sales Returns & Allowances ₱45,000
Sales Discounts 15,000
Net Sales ₱
Cost of Sales
Merchandise Inventory, 1/1/2016 ₱220,000
Purchases ₱985,000
Less: Purchases Returns & Allowances ₱31,000
Purchases Discount 20,000
Net Purchases ₱
Transportation In 36,000
Net Cost of Purchases
Goods Available for Sale ₱
Less: Merchandise Inventory. 12/31/2016
Cost of Sales
Gross Profit ₱620,000
Operating Expenses
Profit ₱
GENERALIZATION
Income statement reports all income and expenses during the period. There are two types of
income statement: the nature of expense method and the function of expense method. Nature of expense
method groups all revenue items together and all expense items together and it is generally used by small
businesses and service business. Meanwhile, the function of expense method classifies expenses
according to their function as part of cost sales, distribution/selling, administrative and other operating
activities.

FABM Module

Uploaded by

Copyright:

Available Formats

FABM Module

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

FABM Module

Uploaded by

Copyright:

Available Formats

FUNDAMENTALS OF ACCOUNTANCY

AND BUSINESS MANAGMENT

What is a journal? When does a company record a transaction in the journal?

THE GENERAL JOURNAL

Date Account Titles and Explanation P.R Debit Credit

What are the essential parts of a general journal?

THE SPECIAL JOURNAL

Account: Cash Account No. 101

Account: Accounts Receivable Account No. 111

Account: Inventory Account No. 121

Account: Property, Plant and Equipment Account No. 140

Account: Accounts Payable Account No. 201

Account: Shayne, Capital Account No. 301

Account: Shayne, Drawing Account No. 302

Account: Sales Account No. 400

Account: Sales Return Account No. 401

Account: Cost of Goods Sold Account No. 500

Account: Salaries Expense Account No. 405

Accounts Receivable Ledger – Used in tracking individual accounts receivable balances of

Ianbabes & Co.

Jowsie & Co.

Ryanbear & Co.

Barney WaitForlt Stinson & Co.

THE ACCOUNTING CYCLE

What should you keep in mind in identifying transactions?

What are the common examples of source documents?

THE ACCOUNTING BIG FOUR

BUSINESS TRANSACTIONS AND THEIR ANALYSIS AS APPLIED TO THE ACCOUNTING

3. Increases in liabilities are recorded by credits.

4. Decreases in liabilities are recorded by debits.

5. Increases in owner’s equity are recorded by credits.

6. Decreases in owner’s equity are recorded by debits.

Date Account Titles and Explanation P.R. Debit Credit

Equipment Acquired for Cash

Del Mundo Landscape Specialist

The trial balance is a control device that helps DEBIT CREDIT

Del Mundo Landscape Specialist

What are Deferrals and Accruals?

ADJUSTMENTS FOR DEFERRALS

What are Depreciations of Property and Equipment?

Depreciation Expense-Equipment (OE:E) ₱1,000

Allocating Revenues Received in Advance to Revenues

ADJUSTMENTS FOR ACCRUALS

What are Accrued Revenues?

ADJUSTMENTS ARE JOURNALIZED AND POSTED

30 Insurance Expense 540 ₱2,000

30 Supplies Expense 520 ₱500

30 Depreciation Expense – Vehicles 580 ₱4,500

30 Depreciation Expense – Equipment 590 ₱1,000

30 Unearned Revenues 250 ₱2,250

30 Salaries Expense 510 ₱1,600

30 Interest Expense 570 ₱1,400

What is the Worksheet?

Information about the performance of an enterprise, in particular its profitability, is required in

STATEMENT OF CHANGES IN EQUITY

What are the remaining steps in the accounting cycle?

BUSINESS TRANSACTIONS AND THEIR ANALYSIS AS APPLIED TO THE ACCOUNTING

What is the Operating Cycle of a Merchandising Business?

In a merchandising Theodore Calaguas Traders