FAR - 01:: introduction to accounting

 
BUSINESS
— is the activity of making one's living or making money by producing or buying and selling
products (such as goods and services).
— any activity or enterprise entered into for profit.
— Examples: online selling, sari-sari store, palamig, cellphone loading, computer shop/internet
café, poultry, water station, rental, tarpaulin printing, electronics repair, barbershop, martial
arts training, etc.
 
TYPES OF BUSINESSES
1. Sole proprietorship – is a business owned by one person.
2. Partnership – is a business owned by two or more persons associated as partners.
3. Corporation – is a company or group of people authorized to act as a single entity (legally a
person) and recognized as such in law.

ACCOUNTING
— is a service activity whose function is to provide quantitative information, primarily financial
in nature, about economic entities (businesses) that is intended to be useful in making
economic decisions, in making reasoned choices among alternative courses of action.
(Source: AICPA)
— is the process of identifying, recording, and communicating economic events of an
organization to interested users.
— usually understood as the “Language of Business” or “Language of Financial Decisions”.

OVERVIEW OF THE ACCOUNTING SYSTEM

People make decision.

Business transaction occur

Accountants prepare reports to show the results

of business operations

ILLUSTRATION #1

Mr. A’s new business commenced its operations on January 1, 2020. The following transactions
have occurred:

Jan. 1 Mr. A invested cash to the business. P 100,000

2 Purchased goods from Beta Co. on account. 110,000
4 Sold goods to Charlie Inc. 120,000
5 Bought furniture from Delta Co. 114,000
6-31 Various other transactions…

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MAIN BRANCHES OF ACCOUNTING
1. Financial accounting – deals with the preparation of financial statements for the basic
purpose of providing information to various interested groups like creditors,
banks, shareholders, financial institutions, government, consumers, etc. (generally
for external use).
2. Management accounting – facilitates the management by providing accounting
information in such a way so that it is conducive for policy making and running the
day-to-day operations of the business (internal use only).
3. Cost accounting – a variant of management accounting which aims to provide a detailed
break-up of cost of different departments, processes, jobs, products, sales territories,
etc., so that effective cost control can be exercised.

FINANCIAL STATEMENTS
— are formal records of the financial activities and position (condition) of a business, person, or
other entity.
— a collection of summary-level reports which represent the end-products or final outputs of
the accounting process.

ACCOUNTING/REPORTING ENTITY
— a business for which a separate set of accounting records is maintained.
— the business to whom the information from the financial statements are pertaining to.

ELEMENTS OF THE FINANCIAL STATEMENTS

1. Asset
— are present economic resources (or rights that have the potential to produce economic
benefits) controlled by the entity as a result of past events.
— are resources owned by a business (cash, buildings, equipment, etc.).
2. Liabilities
— are present obligations of the entity to transfer economic resources as a result of past
events.
— are the claims of external parties against the assets of the business (debts to suppliers and
other creditors).
3. Equity
— is the residual interest in the assets of the entity after deducting all its liabilities.
— are claims the of owners from the assets of the business.
4. Income
— are increases in assets, or decreases in liabilities, that result in increases in equity, other than
those relating to contributions from holders of equity claims.
5. Expenses
— are decreases in assets, or increases in liabilities, that result in decreases in equity, other
than those relating to distributions to holders of equity claims.

ACCOUNTING EQUATION
• Basic: Assets = Liabilities – Equity
• Expanded: Assets = Liabilities – Equity + Income - Expenses
Note: These equations apply to all economic entities regardless of size, nature of business or
form of business organization.

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ACCOUNTING TRANSACTIONS
— are the economic events of the enterprise recorded by accountants.
— All accounting transactions (e.g., purchase, sale, etc.) are events but not all events (e.g.,
signing of contract to be executed at a future time) are accounting transactions.
— In order to be considered as an accountable transaction, an event must have an effect to the
assets, liabilities and/or equity of an business.

KINDS OF TRANSACTIONS
1. External transactions
— are those economic activities which involve two parties that can affect the accounting
equation (the reporting entity and another party).
— Example: The sale of a product by a party is the purchase of the same by another entity.
2. Internal transactions
— are those economic activities within a company that can affect the accounting equation.
— Example: The production of finished goods from raw materials happens within the reporting
entity only.

SIDES OF THE ACCOUNTING EQUATION

1. Debit (Dr.) – from the Latin word debere, is the left side of the accounting equation.
2. Credit (Cr.) – from the Latin word credere, is the right side of the accounting equation.

T-ACCOUNT
— is a visual representation of individual accounts that looks like a “T” so that all additions and
subtractions (debits and credits) to the account can be easily tracked and represented
visually.

DOUBLE ENTRY SYSTEM

— means that for every business transaction, amounts must be recorded in a minimum of two
accounts. The double-entry system also requires that for all transactions, the amounts
entered as debits must be equal to the amounts entered as credits.

ACCOUNTING EQUATION REPRESENTED AS T-ACCOUNT

DEBIT
Assets
Expenses

CREDIT
NORMAL BALANCE (SIDE) OF ELEMENTS
Liabilities
• Assets and expenses have DEBIT as their normal balance.
• Liabilities, equity and income have CREDITEquity
as their normal balance.
Income
RELATIONSHIP BETWEEN THE ELEMENTS AND THE SIDES OF THE T-ACCOUNT
• An account’s value is increased when entered into the side which is its normal balance.
• An account’s value is decreased when entered into the side which is not its normal balance.

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EFFECTS OF A DEBIT OR A CREDIT TO EACH ACCOUNT
NORMAL  EFFECT OF  EFFECT OF 
ELEMENT BALANCE DEBIT CREDIT
Assets
Debit Increase Decrease
Expenses
Liabilities
Equity Credit Decrease Increase
Income

STEPS IN THE ACCOUNTING CYCLE

Recording phase:
1. Analyzing the transaction
2. Journalizing
3. Posting
Summarizing phase:
4. Preparing the unadjusted trial balance (optional)
5. Preparing adjusting entries
6. Preparing the adjusted trial balance (optional)
7. Preparing financial statements
8. Preparing closing entries
9. Preparing the post closing trial balance (optional)
10. Preparing reversing entries (optional)

STEP 1: ANALYZING THE TRANSACTION

— This is where the accountant gathers information from source documents and determines
the impact of the transaction on the financial position as represented by the equation “assets
equals liabilities plus equity”.

BUSINESS/SOURCE DOCUMENT
— are the physical basis upon which business transactions are recorded.

SAMPLE TRANSACTIONS AND CORRESPONDING SOURCE DOCUMENT

SOURCE
TRANSACTION DESCRIPTION
DOCUMENT
Purchase of products or
is the bill issued by a vendor for goods
services from a Vendor’s sales
delivered or services rendered to a
vendor/supplier/service invoice
customer.
provider

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SOURCE
TRANSACTION DESCRIPTION
DOCUMENT
a document issued by the seller
(supplier) of goods or services to the
Credit memo
Return of goods by the reporting entity, reducing the amount
issued by
reporting entity to supplier that the buyer (reporting entity) owes to
supplier
the seller under the terms of an earlier
invoice.
a document that orders a bank to pay a
specific amount of money from the
Check payable to
Cash payment to supplier reporting entity’s account to the
supplier
supplier in whose name the check has
been issued.
a standard form used to document a
Cash voucher
cash payment.
is a document sent by a provider of a
Sale of products or services product or service to the purchaser. The
to a customer Sales invoice invoice establishes an obligation on the
part of the purchaser to pay, creating an
account receivable.
a document issued by the seller
(reporting entity) of goods or services
Return of goods by a Credit memo
to the reporting entity, reducing the
customer to the reporting issued by the
amount that the buyer (customer) owes
entity reporting entity
to the seller under the terms of an
earlier invoice.
a document that orders a bank to pay a
Check payable to specific amount of money from the
Cash payment from
the reporting customer’s account to the reporting
customer
entity entity whose name the check has been
issued.
is issued by the seller (reporting entity)
to the buyer (customer) as written
Official receipt
evidence on sale of services or leasing
issued by the
of properties, as well as
reporting entity
acknowledgement on collection of cash
payment on services rendered

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STEP 2: JOURNALIZING
— This is the process of recording the transactions in the appropriate journals.

JOURNAL
— is a chronological record of transactions also known as the book of original entry.

KINDS OF JOURNAL
1. General journal – can be used to record all company transactions based on the time
sequence.
2. Special journal – usually used to record large number of similar transactions .
Note: Special journals are used primarily for efficiency of recording transactions. If a
transaction cannot be recorded in a special journal, it is entered in the general journal.

KINDS OF SPECIAL JOURNAL

3. Sales journal – only sales of merchandise on account are recorded.
4. Cash receipts journal – all types of cash receipts are recorded.
5. Purchase journal – used to record all purchases on account (merchandise, equipment and
supplies)
6. Cash disbursement journal –all payments of cash for any purpose are recorded.

JOURNAL ENTRY
— is used to record a business transaction in the accounting records of a business.

TYPES OF JOURNAL ENTRIES

1. Simple journal entry – one which contains a single debit and a single credit element.
2. Compound journal entry – one which has two or more elements and often representing two
or more transactions.

ACCOUNTS
— are the storage units of accounting information and used to summarize changes in assets,
liabilities and equity including income and expenses.

KINDS OF ACCOUNTS
1. Real account – statement of financial position or so called permanent accounts. These
accounts are not closed and carryover to the next accounting period. (ex. Cash, AR and
PPE)
2. Nominal account – income statement or temporary capital accounts. these accounts are
closed at the end of the accounting period. (ex. Sales and expenses)
3. Mixed account – a combination of real and nominal accounts. (ex. Prepaid expenses)
4. Clearing account – holds temporarily certain information pending transfer to other ledger
accounts.
5. Controlling account – the general ledger account that summarizes the detailed information
in a subsidiary ledger.
6. Suspense account – is an account that holds temporarily certain information pending for
disposition.
7. Reciprocal account – has a counterpart in another book with in the entity or in another
ledger or another entity.
8. Principal account – an account that is independent or can stand alone.
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9. Auxiliary account – an account that cannot stand alone and are technically neither assets,
liabilities nor income and expenses.
10. Summary account

CHART OF ACCOUNTS
— a complete listing of every account in an accounting system.

ILLUSTRATION #2
CHART OF ACCOUNTS

ASSETS
Cash
Accounts receivable
Notes receivable
Advances to employees
Prepaid expenses
Inventory
Office supplies
Prepaid rent
Prepaid advertising
Prepaid insurance
Land
Building
Machinery and equipment
Accumulated depreciation
Other assets

LIABILITIES
Accounts payable
Rent payable
Utilities payable
Salaries payable
Income tax payable
Notes payable

The following are transactions of Nadya Trading for the month ending August 31, 2020.
EQUITY
Nadya, capital
Aug. 2
Nadya, drawingThe proprietor Nadya, invested the following:
Income summary Cash (OR#001) P 80,000
Tables and chairs 55,000
IINCOME Merchandise 53,500
Sales Accounts payable to Ideal Trading 51,500
3
Sales discount Paid P1,500 for municipal licenses and privilege tax
(CV#100,
Sales returns and Chk#200)
allowances
4 Paid P2,000 for municipal licenses and privilege tax (CV#101, Chk#201)
EXPENSES5 Bought typewriters, filing cabinets, etc. from Royal Business Machine,
Purchases P5,000 Terms: 2/10, n/30 (PI#69696)
Purchase discounts
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Supplies expense
 FAR - 01:: introduction to accounting
Aug 7 Received a 15-day, 12% note from Nelia’s Store for goods sold, P5,000 (SI#100).
7 Discounted a 90-day note for P6,000 at 6% with Security Financing (OR#002)..
8 Paid outstanding account with Ideal trading (CV#102, Chk#202).
8 Made purchases of goods from United Wholesalers, P2,000 Terms 2/10, n/30
(PI#88888).
8 Made purchases of goods from Champion Distributors, P1,800 Terms: n/5
(PI#123476).
9 Sold goods to Selecta Store, P6,000, Terms: P1,200 down payment; a 90-day
note for P1,800; balance: 2/10, n/30 (SI#101, OR#003).
10 Champion Distributors had granted our request for P500 on account of
defective merchandise returned to them (CM# 234).
10 Bought office supplies from Vasques Bros, P500 Terms: Cash less 3%, 2%
(PI#2567, CV#103, Chk#203).
11 Issued a check for P3,000 for goods bought from Ideal Trading (CV#104,
Chk#204).
12 The account with Royal Business Machine was paid in full (CV#105, Chk#205)
12 Issued a credit memo to Selecta Store to cover a P750 allowance on the
purchase it made on the 9th. (CM#100).
13 The account with Champion Distributor was settled by the issuance of a 10-day,
non-interest bearing note dated today.
13 Received cash refund of P300 from Ideal Trading for merchandise returned
(CM#7658, OR#004).
14 Paid P500 to United Wholesaler (CV#106, Chk#206).
14 Cash sales to date, P6,000 (SI#102, OR#005)
15 Payroll of P2,500 was paid (deduction of P100 for withholding taxes) (CV#107,
Chk#207)
16 Goods bought from Emerald Store were delivered today, P1,200 Terms C.O.D.
(PI#882244, CV#108, Chk#208)

STEP 3: POSTING

— It is the process of transferring data from the journal to the appropriate accounts in the
general ledger and subsidiary ledger. This process classifies all accounts that were recorded
in the journals.

LEDGER
— also known as book of final entry, is used to classify and summarize financial information
from journals as debits and credits, and shows their current balances.

KINDS OF LEDGERS
1. General ledger – includes all accounts appearing on the financial statements.
2. Subsidiary ledgers – contains additional detail in support of certain general ledger
accounts.

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STEP 4: PREPARING THE UNADJUSTED TRIAL BALANCE

— A list of general ledger accounts with their respective debit or credit balance. The purpose of
the unadjusted trial balance is to provide evidence that the total debits in the general ledger
equal the total credits and prepares the accounts for adjustments.

WORKSHEET
— is a tool used to help bookkeepers and accountants complete the accounting cycle and
prepare year-end reports like unadjusted trial balances, adjusting journal entries, adjusted
trial balances, and financial statements.

STEP 5: PREPARING ADJUSTING ENTRIES

— are journal entries made at the end of an accounting cycle to update certain revenue and
expense accounts and to make sure the reporting entity complies with the matching
principle.
— always involve one nominal account and one real account.

MATCHING PRINCIPLE
— expenses have to be matched to the accounting period in which the income paying for them
is earned.

TYPICAL EXAMPLES OF ITEMS REQUIRING ADJUSTING ENTRIES

1. Prepayments and deferrals – the cash flow precedes the income or expense recognition.

PREPAID EXPENSE
ASSET METHOD EXPENSE METHOD
Initial JE: Initial JE:
Prepaid expense (Asset) xx Expense xx
Cash xx Cash xx

Adjusting JE: Adjusting JE:

Expense xx Prepaid expense (Asset) xx
Prepaid expense xx Expense xx

DEFERRED OR UNEARNED INCOME

LIABILITY METHOD INCOME METHOD

Initial JE: Initial JE:
Cash xx Cash xx
Unearned income xx Income xx

Adjusting JE: Adjusting JE:

Unearned income xx Income xx
Income xx Unearned income xx

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2. Accruals - income or expense recognition precedes the cash flow.
a. Accrued income – Income already earned but not yet received. A receivable is
always debited and income is recognized (credited).
b. Accrued expenses – Expenses already incurred but not yet paid. An expense is
recognized (debited) and a liability is always credited.
3. Estimates - adjusting entries that do not involve cash flows.
a. Doubtful accounts/Bad debt – a monetary amount owed to a creditor that is unlikely
to be paid and, or which the creditor is not willing to take action to collect for various
reasons.
b. Accrued expenses – Expenses already incurred but not yet paid. An expense is
recognized (debited) and a liability is always credited.
4. Ending inventory – an adjustment to set up the year-end physical count of the inventory.
This only applies if the periodic inventory system is used.

STEP 6: PREPARING THE ADJUSTED TRIAL BALANCE

— a trial balance containing the updated balances of all the accounts after adjusting entries
have been prepared.

STEP 7: PREPARING THE FINANCIAL STATEMENTS

KINDS OF FINANCIAL STATEMENTS

1. Statement of financial position or balance sheet – presents the financial position
(condition as represented by the assets, liabilities and equity) of the reporting entity at a
given date.
2. Statement of comprehensive income or income statement – presents the reporting entity’s
financial performance in terms of net profit or loss over a specified period.
3. Statement of cash flows – presents the movement in cash and bank balances over a
period.
4. Statement of changes in equity – details the movement in shareholders’ equity over a
period.
5. Notes to financial statements – presents disclosures and other narrative or computational
explanations relevant to the other financial statements.

STEP 8: PREPARING THE CLOSING ENTRIES

— Recorded and posted for the purpose of closing all nominal or temporary accounts to the
income summary account and the resulting net income or loss is afterwards closed to the
capital account.

STEP 9: PREPARING THE POST-CLOSING TRIAL BALANCE

— A listing of general ledger accounts and their balances after closing entries have been made.
The post closing trial balance is the same with the year-end statement of financial position,
the only difference is that valuation accounts like allowances for assets are found in the
credit side instead of being deducted from the related asset account.

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STEP 10: PREPARING THE REVERSING ENTRIES
— are made at the beginning of the new accounting period to reverse certain adjusting entries
from the succeeding accounting period.
— The purpose of reversing entries is a matter of convenience for accruals and consistency for
the adjustments in the following year for prepaid expenses and deferred income when the
income statement method was used to record the cash flow.

ADJUSTING ENTRIES THAT MAY BE REVERSED

1. Accrued income
2. Accrued expense
3. Prepaid expense, only if the expense method was used in recording the payment
4. Unearned income, only if the income method was used in recording the collection

– END –

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