INTRODUCTION TO ACCOUNTING

1 AND HUMANITIES

What should I expect?

At the end of the lesson, students should be able to -

 define accounting;
 describe the nature of accounting;
 narrate the history/origin of accounting;
 define external users and give examples; and
 define internal users and give examples.

What do I know?

TRUE or FALSE. Before each statement, write TRUE if the statement is correct or FALSE if
the statement is incorrect.

_______ 1. Sociological and psychological matters are within the scope of accounting.

_______ 2. Account is the basic storage of information in accounting.

_______ 3. Accounting is a process with the basic purpose of providing information about
economic systems intended to be useful in making economic decisions.

_______ 4. Accounting is a process of identifying, recording, and communicating economic

information that is useful in making economic decisions.

_______ 5. Accountable events are those that affect the assets, liabilities, equity, income,
and expenses of a business.

What do I remember?

Accounting is commonly called the “language of business”. Accounting is a means

through which information about a business entity is communicated. It delivers financial
information to different users through the financial statements which are the end-product
reports in accounting. It is true that every individual or group in a society must make
economic decisions about the future. One example is a manager of a company who has to
determine which product or products are not saleable. This information is necessary for the
manager who has to decide whether to stop selling those products to customers. Others will
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make investments only if a company is financially sound. National and local governments
need accounting information for tax purposes. Non-profit entities such as churches, civic
and charitable organizations need meaningful and easily-understood economic and
accounting information for planning and proper implementation of their programs. Because
accountants are known for their financial and analytical capabilities, they are often asked to
analyze the available financial data for clues that will serve as guides to the future.

What do I need to know?

DEFINITION OF ACCOUNTING

There are definitions of accounting given by different accounting bodies. The

American Institute of Certified Public Accountants (AICPA) defines accounting as:

“the art of recording, classifying, and summarizing in a significant manner, and in

terms of money, transactions, and events which are, in part at least of financial character,
and interpreting the results thereof.”

Another definition of accounting is:

“Accounting is a service activity. Its function is to provide quantitative information

primarily financial in nature about economic entities, that is intended to be useful in making
economic decision.”

The definition from AICPA will provide a better understanding in terms of the
following:

Accounting is considered as an art and a science.

Accounting is considered an art because it requires the use of skills and creative
judgment. One has to be trained in this discipline to be able to perform accounting functions
well.

Accounting is also considered a science because it is a body of knowledge. However,

accounting is not an exact science since the rules and principles are constantly changing
(improved).

Accounting involves interconnected phases.

Recording pertains to writing down or keeping records of business transactions.

Classifying involves grouping similar items that have been recorded. Once they are
classified, information is summarized into reports, which are called “financial statements”.

Accounting is concerned with transactions and events having financial character. For
example, hiring an additional employee is qualitative information
with no financial character. Hence, it is not recorded. However, the payment
of salaries, acquisition of an office building, sale of goods, etc. are recorded
because they involve financial value.

1. In accounting, business transactions are expressed in terms of money.

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 They are assigned amounts when processed in an accounting system.
Using one of the examples above, it is not enough to record that the company
paid salaries for April. It must include monetary figures - say for example,
P20,000 salary expense.

2. Interpreting the results

Interpreting results is part of the phases of accounting. Information is
useless if it cannot be interpreted and understood. The amounts, figures, and
other data in the financial reports have meanings that are useful to the users.

NATURE OF ACCOUNTING

Accounting is the systematic recording of financial transactions and

presentation of the related information of the appropriate persons. The basic
features of accounting are as follows:

1. Accounting is a process. A process refers to the method of performing any

specific job step by step according to the objectives or target. Accounting
is identified as a process as it performs the specific task of collecting,
processing, and communicating financial information. In doing so, it
follows some definite steps like collection of data, recording, classification,
summarization, finalization, and reporting.

2. Accounting is an art. Accounting is an art of recording, classifying,

summarizing, and finalizing the financial data. The word ‘art’ refers to the
way of performing something. It is a behavioral knowledge involving certain
creativity and skill that may help us to attain some specific objectives.
Accounting is a systematic method consisting of definite techniques, and
its proper application requires applied skill and expertise. So, by nature
accounting is an art.

3. Accounting is a means and not an end. Accounting finds out the financial
results and position of an entity and at the same time, it communicates this
information to its users. The users then take their own decisions on the
basis of such information. So, it can be said that mere keeping of accounts
can be the primary objective of any person or entity. On the other hand, the
main objective may be identified as taking decisions on the basis of financial
information supplied by accounting. Thus, accounting itself is not an objective;
it helps to attain a specific objective. So it is said that accounting is ‘a means
to an end’, and it is not ‘an end in itself.’

4. Accounting deals with financial information and transactions. Accounting

records the financial transactions and date after classifying the same and
finalizes their result for a definite period for conveying them to their users.
So, from start to the end, at every stage, accounting deals with financial
information. Only financial information is its subject matter. It does not deal
with non-monetary information of non-financial aspect.

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5. Accounting is an information system. Accounting is recognized and
characterized as a storehouse of information. As a service function, it
collects processes and communicates financial information of any entity.
This discipline of knowledge has been evolved to meet the need of financial
information required by different interested groups.

HISTORY AND ORIGIN OF ACCOUNTING

The history of accounting is as ancient and diversified as the history of

the evolution of human civilization. The beginning of the evolution of human
civilization and the beginning of the evolution of accounting is, so to say, twins.

Accounting made its beginning since the ancient period of time, but
when, where, and how the process of accounting practices exactly started is not
very much clear.

In the ancient period of time, when people happened to live in the

forests, jungles, and caves and hunted animals for livelihood, they used to
inscribe the records of their daily hunting on the walls of the caves.

With the passage of time, human beings gradually started their social
lives and started keeping their accounts by marking ticks on walls, making rope-
knots and using various symbols.

With the gradual increased demand of human needs and desires, the
necessity of accounting was felt sharply. At one stage, Luca Pacioli - the father of
Accounting, brought a revolutionary change in the field of accounting by writing
a book on Mathematics- “Summa de Arithmetica Geometria Proportioniet
Proportionlita” - containing a chapter - “De Computes it Scriptures”- in which
Double Entry System of book keeping was explained.

The Double Entry System is a recognized and generally accepted system

all over the world and till date, this system is being used widely with its basic
principles unchanged. On the basis of these basic principles, the accountants of
modern age have established a scientific accounting system.

USERS OF ACCOUNTING INFORMATION

The progress and reputation of any business firm are built upon the sound
financial footing. There are number of parties who are interested in accounting
information relating to business. Accounting is the language employed to
communicate financial information of a concern to such parties.

According to Slavin and Reynolds, ‘Conceptually, accounting is the

discipline that provides information on which external and internal users of the
information may base decisions that result in the allocation of economic
resources in society”.

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 Users of accounting information may be grouped into two classes: internal
users and external users.

1. INTERNAL USERS
Internal users of accounting information are those persons or groups
which are within the organization. Following are the examples of internal users:

1.1 Owners

The owners provide funds or capital for the organization. They possess
curiosity in knowing whether the business is being conducted on sound lines or
not and whether the capital is being employed properly or not.

Owners, being businessmen, always keep an eye on the returns from the
investment. Comparing the accounts of various years helps in getting good
pieces of information. Properly kept accounts are good proofs in dispute. They
determine the amount of goodwill and facilitate in assessing various taxes.

1.2 Management
The management of the business is greatly interested in knowing the
position of the firm. The accounts are the basis; the management can study the
merits and demerits of the business activity. Thus, the management is interested
in financial accounting to find whether the business carried on is profitable or
not. Financial accounting is the “eyes and ears of management and facilitates in
drawing future course of action, further expansion, etc.”

1.3 Employees
Payment of bonus depends upon the size of profit earned by the firm.
The more important point is that the workers expect regular income for the
bread. The demand for a wage rise, bonus, better working conditions etc.,
depends upon the profitability of the firm and in turn depends upon financial
position. For these reasons, this group is interested in accounting.

The process of developing and reporting financial information for internal

users is called management accounting.

2. EXTERNAL USERS

External users are those groups or persons who are outside the
organization for whom accounting function is performed. Following are
examples of external users:

2.1 Creditors

Creditors are the persons who supply goods on credit or bankers or

lenders of money. It is usual that these groups are interested to know the
financial soundness before granting credit. The progress and prosperity of the
firm, to which credits are extended, are largely watched by creditors from the
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point of view of security and further credit. Income Statement and Statement of
Financial Position are nerve centers to know the soundness of the firm.

2.2 Investors

The prospective investors, who want to invest their money in a firm, of

course, wish to see the progress and prosperity of the firm, before investing
their amount, by going through the financial statements of the firm. This is to
safeguard the investment. For this, this group is eager to go through the
accounting which enables them to know the safety of the investment.

2.3 Government

The government keeps a close watch on the firms which yield a good
amount of profits. The state and central governments are interested in financial
statements to know the earnings for the purpose of taxation. To compile
national accounts accounting is essential.

2.4 Consumers
These groups are interested in getting the goods at a reduced price.
Therefore, they wish to know the establishment of a proper accounting control,
which in turn will reduce the cost of production, in turn, less price to be paid by
the consumers.

2.5 Researchers
Accounting information, being a mirror of the financial performance of a
business organization, is of immense value to the research scholar who wants to
make a study on the financial operations of a particular firm. To make a study
into the financial operations of a particular firm, the research scholar needs
detailed accounting information relating to purchases, sales, expenses, cost of
materials used, current assets, current liabilities, fixed assets, long-term
liabilities, and shareholders’ funds which are available on the accounting records
maintained by the firm.

2.6 Financial Institutions

Bank and financial institutions that provide a loan to the business are
interested to know credit-worthiness of the business. The groups, who lend
money need accounting information to analyze a company’s profitability,
liquidity and financial position before making a loan to the company. Further,
they keep a constant watch on the operating results and financial position of the
business through accounting data.

2.7 Regulatory Agencies

Various government agencies such as Securities and Exchange
Commission (SEC), Bangko Sentral ng Pilipinas (BSP), etc., requires information

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to be filed with them under the law. By examining this accounting information,
they ensure that concerned companies are following the rules and regulations.

What should I remember?

There are three types of business, namely, service, merchandising and

manufacturing. Accounting falls under a service activity, and the function of
accounting is to provide quantitative information. When we say quantitative, it
means ‘number’ specifically, financial in nature. This information that accounting
provides is intended to be useful to internal and external users to make good
and sound decision in their business.

REFERENCES

Pineda, A. A. Fundamentals of Accountancy, Business and Management 1

Principles and Application. (2018) Mindshapers Co. Inc., Intramuros, Manila, pp.
18-19

De Guzman, A. A. Fundamentals of Accountancy, Business and Management 1,

(2018), Lorimar Publishing, Inc., Quezon City (pp 1-7; pp 13-16)

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 ACCOUNTING CONCEPTS AND
2 PRINCIPLES
AND

What should I expect?

At the end of the lesson, students should be able to

 explain the varied accounting concepts and principles;

 solve exercises on accounting principles as applied in various cases;
 illustrate the accounting equation; and
 perform operations involving simple cases with the use of accounting
equation.

What do I know?

Answer each question briefly.

1. What are generally accepted accounting principles?

2. Give some examples of GAAP.

What do I remember?

There are three types of business, namely, service, merchandising and

manufacturing. Accounting falls under a service activity, and the function of
accounting is to provide quantitative information. When we say quantitative, it
means ‘number’ specifically financial in nature. This information that accounting
provides are intended to be useful to internal and external users to make good
and sound decision in their business.

What do I need to know?

Because it is important that all who will receive accounting reports are
able to interpret them, a set of principles were developed that will provide
guidelines for financial accounting. The term used to describe these principles is
generally accepted accounting principles (GAAP).

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 Generally Accepted Accounting Principles encompasses the conventions,
rules, and procedures necessary to define accepted accounting practice at a
particular time. These “principles” are not like the unchangeable laws of nature
found in chemistry or physics. They are developed by accountants and
businesses to serve the needs of decision makers, and they can be changed or
altered as better methods are developed or as circumstances change.

Generally Accepted Accounting Principles

There are general rules and concepts that govern the field of accounting.
These general rules are referred to as basic accounting principles and guidelines
from the groundwork on which more detailed, complicated, and legalistic
accounting rules are based. For example, the Financial Accounting Standards
Board (FASB) uses the basic accounting principles and guidelines as a basis for
their own detailed and comprehensive set of accounting rules and standards.

The phrase “generally accepted accounting principles” (GAAP) consists of

three important set of rules:

1. the basic accounting principles and guidelines;

2. the detailed rules and standards issued by FASB and its predecessor, the
Accounting Principles Board (APB); and

3. the generally accepted industry practices.

If a company distributes its financial statements to the public, it is required

to follow generally accepted accounting principles in the preparation of those
statements. Further, if a company’s stock is publicly traded, federal law requires
the company’s financial statements to be audited by independent public
accountants. Both the company’s management and the independent
accountants must certify that the financial statements and the related notes to
the financial statements have been prepared in accordance with GAAP.

GAAP is exceedingly useful because it attempts to standardize and

regulate accounting definitions, assumptions, and methods. Because of
generally accepted accounting principles, we are able to assume that there is
consistency from year to year in the methods used to prepare a company’s
financial statements. Although variations may exist, we can make reasonably
confident conclusions when comparing one company to another, or comparing
one company’s financial statistics to the statistics for its industry. Over the years
the GAAP have become more complex because financial transactions have
become more complex.

Basic Accounting Principles and Guidelines

Since GAAP is founded on the basic accounting principles and guidelines,

we can better understand GAAP if we understand those accounting principles.

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The following is a list of the ten main accounting principles and guidelines
together with a highly condensed explanation of each.

1. Economic Entity Assumption

The accountant keeps all of the business transactions of a sole

proprietorship separate from the business owner’s personal transactions. For
legal purposes, a sole proprietorship and its owner are considered to be one
entity, but for accounting purposes they are considered to be two separate
entities.

2. Monetary Unit Assumption

Economic activity is measured in U.S. dollars, and only transactions that

can be expressed in U.S. dollars are recorded.

Because of this basic accounting principle, it is assumed that the dollar’s

purchasing power has not changed over time. As a result, accountants ignore
the effect of inflation on recorded amounts. For example, dollars from a 1960
transaction are combined (or shown) with dollars from a 2016 transaction.

3. Time Period Assumption

This accounting principle assumes that it is possible to report the complex

and on-going activities of a business in relatively short, distinct time intervals
such as the five (5) months ended May 31, 2016, or the five (5) weeks ended
May 1, 2016. The shorter the time interval, the more likely the need for the
accountant to estimate amounts relevant to that period. For example, the
property tax bill is received on December 15 of each year. On the income
statement for the year ended December 31, 2015, the amount is known; but for
the income statement for the three months ended March 31, 2016, the amount
was not known and an estimate had to be used.

4. Cost Principle

From an accountant’s point of view, the term “cost” refers to the amount
spent (cash or the cash equivalent) when an item was originally obtained,
whether that purchase happened last year or thirty years ago. For this reason,
the amounts shown on financial statements are referred to as historical cost
amounts.

5. Full Disclosure Principle

If certain information is important to an investor or lender using the

financial statements, that information should be disclosed within the statement
or in the notes to the statement. It is because of this basic accounting principle
that numerous pages of “footnotes” are often attached to financial statements.

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 As an example, let us say a company is named in a lawsuit that demands a
significant amount of money. When the financial statements are prepared it is
not clear whether the company will be able to defend itself or whether it might
lose the lawsuit. As a result of these conditions and because of the full disclosure
principle, the lawsuit will be described in the notes to the financial statements.

A company usually lists its significant accounting policies as the first note
to its financial statements.

6. Going Concern Principle

This accounting principle assumes that a company will continue to exist

long enough to carry out its objectives and commitments and will not liquidate
in the foreseeable future. If the company’s financial situation is such that the
accountant believes the company will not be able to continue on, the
accountant is required to disclose this assessment.

The going concern principle allows the company to defer some of its
prepaid expenses until future accounting periods.

7. Matching Principle

This accounting principle requires companies to use the accrual basis of

accounting. The matching principle requires that expenses be matched with
revenues. For example, sales commission expense should be reported in the
period when the sales were made (and not reported in the period when the
commissions were paid). Wages to employees are reported as an expense in the
week when the employees worked and not in the week when the employees are
paid. If a company agrees to give its employees 1% of its 2016 revenues as a
bonus on January 15, 2017, the company should report the bonus as an expense
in 2016 and the amount unpaid on December 31, 2016 as a liability. (The
expense is occurring as the sales are occurring.)

Because we cannot measure the future economic benefit of things such as

advertisements (and thereby we cannot match the ad expense with related
future revenues), the accountant charges the ad amount to expense in the
period that the ad is run.

8. Revenue Recognition Principle

Under the accrual basis of accounting (as opposed to the cash basis of
accounting), revenues are recognized as soon as a product has been sold or a
service has been performed, regardless of when the money is actually received.
Under this basic accounting principle, a company could earn and report a
P20,000 of revenue in its first month of operation but receive P0 in actual cash
in that month.

For example, if ABC Consulting completes its service at an agreed price of

P1,000, ABC should recognize P1,000 of revenue as soon as its work is done. It
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does not matter whether the client pays the P1,000 immediately or in 30 days.
Do not confuse revenue with a cash receipt.

9. Materiality

Because of this basic accounting principle or guideline, an accountant

might be allowed to violate another accounting principle if an amount is
insignificant. Professional judgment is needed to decide whether an amount is
insignificant or immaterial.

An example of an obviously immaterial item is the purchase of a P15,000

printer by a highly profitable multi-million company. Because the printer will be
used for five years, the matching principle directs the accountant to expense the
cost over the five-year period. The materiality guideline allows this company to
violate the matching principle and to expense the entire cost of P15,000 in the
year it is purchased. The justification is that no one would consider it misleading
if P15,000 is expensed in the first year instead of P3,000 being expensed in each
of the five years that it is used.

Because of materiality, financial statements usually show amounts

rounded to the nearest hundred, nearest thousand, or to the nearest million
depending on the size of the company.

10. Conservatism

If a situation arises where there are two acceptable alternatives for

reporting an item, conservatism directs the accountant to choose the alternative
that will result in less net income and/or less asset amount. Conservatism helps
the accountant to “break a tie”. It does not direct accountants to be
conservative. Accountants are expected to be unbiased and objective.

The basic accounting principle of conservatism leads accountants to

anticipate or disclose losses, but it does not allow a similar action for gains. For
example, potential losses from lawsuits will be reported on the financial
statements or in the notes, but potential gains will not be reported. Also an
accountant may write inventory down to an amount that is lower than the
original cost, but will not write inventory up to an amount higher than the
original cost.

QUALITATIVE CHARACTERISTICS OF FINANCIAL INFORMATION

1. RELEVANCE – The concept of relevance implies that financial statements can

have predictive value and feedback value. This means the financial
statements are accurate and can be used to predict future company
performance. There are three main characteristics of relevant accounting
information: predictive value, feedback, and timeliness. Financial
information must have all of these characteristics in order to be considered
relevant.

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2. PREDICTIVE VALUE – refers to the fact that quality financial information can
be used to base predictions, forecasts, and projections on. Financial analysts
and investors can use past financial statements to chart performance trends
and make predictions about future performance and profitability.
3. FEEDBACK VALUE – Quality information has a feedback value when it can
confirm or correct previous expectations. In other words, users can examine
financial information and confirm or adjust their predictions made on
previous performance trends. Based on this feedback, users can make future
decisions.
4. TIMELINESS – one of the most important factors in relevant information. Out
of date information does not do investors or creditors any good when they
are trying to make current and future decisions. Financial reporting must be
timely and current in order to be used by investors and creditors.

5. RELIABILITY – the concept of reliability implies that financial information can

be verified by many sources with evidence and that all financial information
is presented. In other words, the favorable and unfavorable financial
information are presented in the financial statements. The three attributes
that all reliable financial information has verifiability, representational
faithfulness, and neutrality.
Verifiability – financial information is verifiable when multiple, independent
measures are used to come up with the same result. In other words, auditors
and other third parties can measure and evaluate the company’s financial
statement accounts and end up with the same result. If the auditors can’t
verify financial information, the editors can’t issue an unqualified opinion.
Representational Faithfulness – simply means that the financial statements
represent reality or what actually happened during the year. For example, if
a company reported the cost of goods sold as P100,000 when the cost was
actually P159,000, the financial statements wouldn’t accurately reflect
reality or what actually happened. In reality, this company incurred P159,000
of costs and must show that on their financial statements.
Neutrality – finally, in order for financial statements to be reliable they must
be neutral. By definition, financial statements that are prepared by company
management are somewhat biased because the management wants to see
the company improve. This means they are more likely to report increased
performance and neglect to report unfavorable events. Neutrality requires
that management prepare completely unbiased financial statements.

6. Comparability – is a quality of accounting information that addresses the

usability of financial information. Information that is prepared using the
same measurement techniques and reported in a similar fashion is
considered comparable information because this information is similar and
can be judged side by side other similar financial information. Comparability
is extremely important to the end users of financial statements. If financial
statements can’t be compared with other statements, what good are they?

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 Without being able to compare and benchmark financial statements, the
accounting information would be pretty useless.

THE ACCOUNTING EQUATION

The accounting equation, also called the basic accounting equation, forms
the foundation for all accounting systems. In fact, the entire double-entry
accounting concept is based on the basic accounting equation. This simple
equation illustrates two facts about a company: what it owns and what it owes.

The accounting equation equates a company’s assets to its liabilities and

equity. This shows all company assets are acquired by either debt or equity
financing. For example, when a company is started, its assets are first purchased
with either cash the company received from loans or cash the company received
from investors. Thus, all of the company’s assets stem from either creditors or
investors example, liabilities, and equity.

THE BASIC ACCOUNTING EQUATION:

Assets = Liabilities + Equity

The accounting equation is simply, assets equal the sum of liabilities and
owner’s equity. This makes sense because liabilities and equity are essentially
just sources of funding for companies to purchase assets.

The equation is generally written with liabilities appearing before

owner’s equity because creditors usually have to be repaid before investors in
case of a bankruptcy. In this sense, the liabilities are considered more current
than the equity. This is consistent with financial reporting where current assets
and liabilities are always reported before long-term assets and liabilities.

This equation holds true for all business activities and transactions.
Assets always equal liabilities and owner’s equity. If assets increase, either
liabilities or owner’s equity must increase to balance out the equation. The
opposite is true if liabilities or equity increase.

With the basic understanding of the equation, the next thing to look at is
the accounting equation components starting with the assets.

ACCOUNTING EQUATION COMPONENTS

Assets (pagmamay-ari ng business)

An asset is a resource that is owned or controlled by the company to be

used for future benefits. Some assets are tangible like cash while others are
theoretical or intangible like goodwill or copyrights.

Another common asset is a receivable. This is a promise to be paid from

another party. Receivable arises when a company provides a service or sells a
product to someone on credit.
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 All of these assets are resources that a company can use for future
benefits.

Here are some examples of assets:

1. Current Assets
a. Cash
b. Accounts Receivable
c. Prepaid Expenses
2. Fixed Assets
a. Vehicle
b. Buildings
c. Intangible Assets
d. Goodwill
e. Copyrights
f. Patents

Liabilities (utang)

A liability, in its simplest terms, is an amount of money owed to another

person or organization. Said a different way, liabilities are creditors’ claims on
company assets because this is the amount of assets creditors would own if the
company liquidated.

A common form of liability is a payable. Payables are the opposite of

receivables. When a company purchases goods or services from other
companies on credit, a payable is recorded to show that the company promises
to pay the other companies for their assets.

Here are examples of some of the most common liabilities.

1. Accounts Payable
2. Bank Loans
3. Lines of Credit
4. Personal Loans
5. Officer Loans
6. Unearned Income

Equity

Equity represents the portion of company assets that shareholders or

partners own. In other words, the shareholders or partners own the remainder
of assets once all of the liabilities are paid off.

Owners can increase their ownership share by contributing money to the

company or decreasing equity by withdrawing company funds. Likewise,
revenues increase equity while expense decreases equity. To summarize:

Two things that increases equity:

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 1. Additional Investment
2. Revenues

Two things that decreases equity:

1. Withdrawal
2. Expenses

Here are some common equity accounts:

1. Owner’s Capital
2. Owner’s Withdrawals
3. Officers’ Loans
4. Unearned Income
5. Common Stock
6. Paid-In-Capital

Illustrative Examples – Accounting Equation

Let us take a look at the formation of a company to illustrate how the

accounting equation works in a business situation.

Edsel is an entrepreneur who wants to start a wellness center (gym). After

saving up money for a year, Edsel decides it is time to officially start his business
and contributes P500,000 to the company. This business transaction increases
company cash and increases equity by the same amount. The effect in the
accounting equation will be:

Assets Liabilities Equity

Cash Increase P500,000 Edsel Capital Increase P500,000

You will note that in this example, the accounting equation is still
maintained to be in balance which is P500,000 Assets = P500,000 Equity.

After the business formation, Edsel needs to buy some equipment for the
gym, so he purchased P200,000 of various equipment from a manufacturer in
cash. In this case, he uses his cash to buy another asset. Thus, the effect in the
accounting equation will be the asset account is decreased from the
disbursement of cash and increased by the addition of gym equipment.

Assets Liabilities Equity

Cash Decrease P200,000

Gym Equipment Increase P200,000

Based on the above table, the accounting equation is still maintained with
both assets and equity having a balance of P500,000.

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 After 6 months, Edsel business is growing rapidly and generates cash of
P1,500,000 from clients using the gym. The effect on the accounting equation will
be:

Assets Liabilities Equity

Cash Increase Capital Increase
P1, 500,000 P1, 500,000

For now, the accounting equation is still in balance with assets

(Cash = P1,800,000 = Gym Equipment = P200,000) and

Equity (Capital = P2,000,000) both having a total of P2,000,000.

Edsel needs to purchase additional gym equipment worth P2,000,000 to

accommodate more clients. Since he does not have P2,000,000 in cash, he must take
out a loan from the bank. Edsel purchased P2,000,000 of gym equipment by paying
P500,000 in cash and taking out a P1,500,000 loan. This business transaction
decreases assets by the P500,000 of cash disbursed, increases assets by the new
P2,000,000 gym equipment and increases liabilities by the new P1,500,000 loan.

Assets Liabilities Equity

Cash Decrease P500,000 Loan Payable Increase
P1,500,000
Gym Equipment Increase
2,000,000

Given all the transactions, the accounting equation will now be composed of:

1. Assets = P3,500,000 (Cash = P1,300,000 + Gym Equipment = P2,200,000),

2. Liabilities = P1,500,000 (Loan Payable), and
3. Equity of = P2,000,000 (Capital)

Presenting the transactions using the accounting equation, it will show:

Assets Liabilities Equity

P3,500,000 P1,500,000 P2,000,000

As you can see, all of these transactions always balance out the
accounting equation. This is one of the fundamental rules of accounting. The
accounting equation can never be out of balance. Assets will always equal
liabilities and owner’s equity.

17
 What should I remember?

When analyzing business transactions using the accounting

equation, the following points should be considered:

 Determine whose point of view the transactions are to be analyzed.

 Determine the account titles affected by the transaction. At least two
account titles may be affected by every transaction.
 Determine the effect of the transaction on the account titles. The effect
can either be an increase or a decrease.
 Determine the amount of the transaction.
 Always remember that using this method of analysis, the left side of the
equation should always equal the right side.

REFERENCES

Pineda, A. D., Fundamentals of Accountancy, Business and Management 1

Principles and Application, 2018, Mindshapers Co., Inc., Intramuros Manila, pp.
18-19

De Guzman, A. A., Fundamentals of Accountancy, Business and Management 1

2018, Lorimar Publishing, Inc., Quezon City, (pp 1-7; pp 13-16)

18
 THE FIVE MAJOR ACCOUNTS
3

What should I expect?

At the end of the lesson, students should be able to

 discuss the five major accounts, and

 prepare a Chart of Accounts.

What do I know?

IDENTIFICATION
___________ 1. A type of business that changes basic inputs into products that are sold
to individual customers.
___________ 2. A type of business that purchases products from other businesses and
sells them to customers.
___________ 3. A business owned by one individual.
___________ 4. A business owned by two or more individuals.
___________ 5. An artificial being created by operation of law having the right of
succession and the powers and attributes expressly authorized by law or
incident to its existence.

What do I remember?

When analyzing business transactions using the accounting equation, the following
points should be considered:

 Determine whose point of view the transactions are to be analyzed.

 Determine the account titles affected by the transaction. At least two account titles
may be affected by every transaction.
 Determine the effect of the transaction on the account titles. The effect can either
be an increase or a decrease.
 Determine the amount of the transaction.

 Always remember that using this method of analysis, the left side of the
equation should always equal the right side.
19
 What do I need to know?

Accounts are at the foundation of financial accounting. Each business

transaction increases or decreases balance in one account or another. The entire
accounting concept is based on maintaining a chart of accounts, but what is an
account? An account is simply a record of all changes to a specific asset, liability
or equity item. You can think of an account like a notepad. Each accounting item
has its own notepad that is used to document all of the increases and decreases
to that item over time. For instance, the asset account records all of the changes
in assets over time like asset purchases and sales.

Accounts are typically named and numbered in order to categorize and

keep track of them. Accounts can also have sub-accounts. For example, the cash
in a bank account is a sub-account of the main asset account “cash”.

All accounts are kept or recorded in the general ledger. This is just a folder
that will keep all of the account notepads in.

TYPES OF MAJOR ACCOUNTS

Asset Accounts

An asset is defined as a resource that is owned or controlled by a company

that can be used to provide a future economic benefit. In other words, assets
are items that a company uses to generate future revenues or maintain its
operations.

Asset accounts generally have a debit balance. This means that entries
created on the left side (debit entries) of an asset T-account increase the asset
account balance while journal entries created on the right side (credit entries)
decrease the account balance.

Examples

Pretty much, all accounting systems separate groups of assets into

different accounts. These accounts are organized into current and non-current
categories. A current asset is one that has a useful life of one year or less. Non-
current assets have a useful life of longer than one year.

Here’s a list of some of the most common asset accounts found in a chart
of accounts:

Current Assets:

1. Cash – is the most liquid asset a company can own. It includes any form of
currency that can be readily traded including coins, checks, money orders,
and bank account balances.

20
 Cash, huwag po gawing komplikado. Pag sinabing cash, pera.  Basta can
be used as a medium of exchange, considered cash po yun.

2. Accounts Receivable – is an asset that arises from selling goods or services

to someone on credit. The receivable is a promise from the buyer to pay the
seller according to the terms of the sale. This is an unusual asset because it
isn’t an asset at all. It is more of a claim to an asset. The seller has a claim on
the buyer’s cash until the buyer pays for the goods or services.
Pag sinabi naman nating Accounts Receivable, ang ibig sabihin nito
ganito. Halimbawa, ikaw meron kang business. Say for example, nagbebenta
ka ng mga pagkain, and then pumunta sa’yo yung kaibigan mo, sabi nya “uy
mare/pare pautang naman ako ng tinitinda mong pagkain, bayaran ko din
next week pag nakuha ko allowance ko”. At syempre ikaw dahil mabait ka,
pinautang mo. Now, sa part mo bilang seller, meron kang receivable dun sa
kaibigan mong nangutang sa’yo. Kasi binentahan mo sya ng goods na
binebenta mo, pero utang. Meaning to say may inaasahan kang
matatanggap dun sa kaibigan mo, meron kang accounts receivable. Sa part
naman ng kaibigan mo, meron syang accounts payable. Mamaya
madidiscuss ito sa liability. Ganun din ang concept kung ikaw naman ay
nagbibigay ng serbisyo. Napag aralan na din natin ito nung nakaraang
lesson. Di ba kapag service business, nag-ooffer ka ng service and then
babayaran ka ng customer, in return dun sa service na binigay mo. Say for
example, isa kang accountant, gumawa ka ng financial statements ng isang
company. Tapos mo na gawin yung financial statements nung company pero
di ka pa nababayaran. On your part bilang nag provide ng service, meron ka
ulit accounts receivable. Sana po nagets natin  Basta kapag accounts
receivable nag benta ka or nag provide ka ng service sa customer, pero si
customer hindi ka pa nababayaran, kaya sya receivable, kasi may inaasahan
kang matatanggap kay customer. Or kung hindi pa din gets, halimbawa,
yung classmate mo nangutang sayo ng 50 pesos. Ikaw na nagpautang, may
receivable kay classmate mo, tapos si classmate mo may payable sayo.

3. Notes Receivable – A note is a written promise to repay money. A company

that holds notes signed by another entity has an asset recorded as a note.
Unlike accounts receivable, notes receivable can be long-term assets with a
stated interest rate.
Parehas lang po ito ng concept ng accounts receivable. Ang pinag kaiba lang
po, kapag notes receivable, meron pong kasulatan. And pwede po itong
maging long-term asset, meaning, kapag meron kang notes receivable
pwede mo yun mareceive in a span of more than a year. Hindi kagaya sa
accounts receivable, ang accounts receivable kasi short term asset yan,
meaning marereceive mo yun ng hindi lalagpas sa isang taon, pwedeng next
month or next week mareceive mo na yung accounts receivable. And also,
kapag note receivable, usually po meron po itong interest or yung tubo na
sinasabi natin. Halimbawa ulit, simplehan nalang natin. Di ba kanina

21
 example natin may nangutang sayo na classmate mo, kaya meron kang
accounts receivable. Ngayon ibahin natin ng kaunti yung eksena, nangutang
sayo yung classmate mo tapos ikaw sabi mo “o sige pauutangin kita pero
gagawa tayo ng kasulatan ha, nakalagay dun kung kailan mo ko babayaran,
tsaka kung magkano yung tubo” (O, di ba segurista ka pag dating sa
pagpapautang). Now, yung eksena na yan, ikaw meron kang notes
receivable and then si classmate meron siyang notes payable sa’yo. Itong
example na ito ay para lang maintindihan natin ang konsepto kapag sinabing
notes receivable. Sa mga susunod na lesson mas maiintindihan natin ito. Sa
ngayon, ito muna. 

4. Prepaid Expenses like prepaid insurance are expenses that have been paid in
advance. Like accounts receivable, prepaid expenses are assets because they
are a claim to assets. If six months’ worth of insurance is paid in advance, the
company is entitled to insurance (a service) for the next six months in the
future.
Pag prepaid expenses naman, ito yung mga expenses na binaran ni business
in advance. Halimbawa, may inuupahan kang building para sa business mo,
kapag nagbayad ka ng 6 months’ rent in advance, meron kang prepaid
expense, kasi advance payment yung nangyari. On your part meron kang
asset, which is prepaid expense. Wag pong malilito, ang prepaid expense po
ay asset, hindi po expense.

5. Inventory - consists of goods owned by a company that is in the business of

selling those goods. For example, a car would be considered inventory for a
car dealership because it is in the business selling of cars. A car would not be
considered inventory for a pizza restaurant looking forward to selling its
delivery car.

Classification of inventory:
1. Held for sale in the ordinary course of business
2. In the process of production for such sale
3. In the form of materials or supplies to be consumed in the production
process or in the rendering of services

6. Supplies. Many companies have miscellaneous assets that are entirely in

product production that are too small and inexpensive to capitalize. These
assets are expenses when they are purchased. A good example is a car
factory’s bolts. It’s difficult to account for each bolt as it is used in the
assembly process, so they are just expense.

Non-Current or Long-term Assets

1. Fixed Assets – include equipment, vehicles, machinery, and even
computers. These assets generally have a useful life of more than one
year and are usually more expensive business purchases.

22
 2. Intangible Assets – Not all assets are physical. Some assets like
goodwill, stock investments, patents, and websites can’t be touched.
These intellectual assets can be quite substantial, however.

There are many more types of assets and this is just the basic list. Other
assets accounts used are dependent on the type of business activities or
industries.

Liability Accounts
Liabilities are defined as debts owed to other companies. In a sense, a
liability is a creditor’s claim on a company’s assets. In other words, the creditor
has the right to confiscate assets from a company if the company doesn’t pay its
debts. Most state laws also allow creditors the ability to force debtors to sell
assets in order to raise enough cash to pay off their debts.

Debt financing is often used to fund operations or expansions. These debts

usually arise from business transactions like purchases of goods and services. For
example, a business looking to purchase a building will usually take out a
mortgage from a bank in order to afford the purchase. The business then owes
the bank for the mortgage and contracted interest.

Liability accounts have a credit balance. This means that entries created
on the left side (debit entries) of a liability T-account decrease the liability
account balance while journal entries created on the right side (credit entries)
increase the account balance.

Current Liabilities

Accounts Payable – Many companies purchase inventory on credit from vendors

or suppliers. When the supplier delivers the inventory, the company usually has
30 days to pay for it. This obligation to pay is referred to as payments on account
or accounts payable. No written contract needs to be in place. The promise to
pay can either be oral or even implied.

Accrued Liabilities – Since accounting periods rarely fall directly after an

expense period, companies often incur expenses but don’t pay them until the
next period. These expenses are called accrued liabilities. Take utilities for
example. The current month’s utility bill is usually due the following month.
Once the utilities are used, the company owes the utility company. These utility
expenses are accrued and paid in the next period.

Non-Current Liabilities

Bonds Payable – Many companies choose to issue bonds to the public in order
to finance future growth. Bonds are essentially contracts to pay the bondholders
the face amount plus interest on the maturity date. Bonds are almost always
long-term liabilities.

23
Notes Payable – A note payable is a long-term contract to borrow money from a
creditor. The most common notes payable are mortgages and personal notes.

Unearned Revenue – Unearned revenue is slightly different from other liabilities

because it doesn’t involve direct borrowing. Unearned revenue arises when a
company sells goods or services to a customer who pays the company but
doesn’t receive the goods or services. In effect, this customer paid in advance
for its purchase. The company must recognize a liability because it owes the
customer for the goods or services the customer paid for.

*That was a short list of liability accounts. We will discuss more liabilities
in depth later in the accounting course. Right now it’s important just to know the
basic concepts.

Equity Accounts

Equity is defined as the owner’s interest in the company assets. In other words,
upon liquidation after all the liabilities are paid off, the shareholders own the
remaining assets. This is why equity is often referred to as net assets or assets
minus liabilities.

Equity can be created by either owner’s contributions or by the company

retaining its profits. When an owner contributes more money into the business
to fund its operations, equity in the company increases. Likewise, if the company
produces net income for the year and doesn’t distribute that money to its
owner, equity increases.

Equity accounts, like liabilities accounts, have credit balances. This means
that entries created on the left side (debit entries) of an equity T-account
decrease the operations, equity balance while journal entries created on the
right side (credit entries) increase the account balance.

Capital. Capital consists of initial investments made by owners. Stock

purchases or partnership buy-ins are considered capital because both comprise
of cash contributions made by the owners to the company. Capital accounts
have a credit balance and increase the overall equity account.

Withdrawal. Owners’ withdrawals are the opposite of contributions. This

is where the company distributes cash to its owners. Withdrawals have a debit
balance and always reduce the equity account.

Revenues – are the monies received by a company or due to a company

for providing goods or services. The most common examples of revenues are
sales, commissions earned, and interest earned. Revenue has a credit balance
and increases equity when it is earned.

Expenses – Expenses are essentially the costs incurred to produce

revenue. Costs like payroll, utilities, and rent are necessary for business to

24
operate. Expenses are contra equity accounts with debit balances and reduce
equity.

Examples of Expenses

1. Rent Expenses
2. Depreciation Expense
3. Bad Debt Expense
4. Wages Expenses
5. Utilities Expense
6. Advertising Expense
7. Supplies Expense
8. Interest Expense

Chart of Accounts

The chart of accounts is a list of every account in the general ledger of an

accounting system. Unlike a trial balance that only lists accounts that are active
or have balances at the end of the period, the chart lists all of the accounts in
the system. It’s a simple list of account numbers and names. It doesn’t include
any other information about each account like balances, debits, and credits like
a trial balance does.

This is like an index cards of accounts that the bookkeeper and the
accounting software can use to record transactions, make reports, and prepare
financial statements throughout the year.

Each account is typically assigned a number based on the order it appears

on the financial statements. Financial Position or Balance Sheet accounts are
usually presented first followed by income statement accounts. Thus, accounts
are assigned numbers and listed in this order: assets, liabilities, equity, income,
expenses, others.

Most companies use a numbering system that groups account into

financial statement categories. For example, all asset accounts might have a
prefix of 1 while liability accounts might have a prefix of 2. This numbering
system looks like this:

ACCOUNTS NUMBER CODES

Assets 100-199
Liabilities 200-299
Equity 300-399
Revenues 400-499
Expenses 500-599

This numbering system helps bookkeepers and accountants keep track of

accounts along with what category they belong to. For instance, if an account’s
name or description is ambiguous, the bookkeeper can simply look at the prefix
25
 to know exactly what it is. Take insurance for example. An account may simply
be named “insurance offset.” What does that mean? Is it a prepaid asset or an
expense that was paid out? The bookkeeper would be able to tell the difference
by the account number. An asset would have the prefix of 1 and an expense
would have a prefix of 5. This structure can avoid confusion in the bookkeeper
process and ensure the proper account is selected when recording transactions.

Although most accounting software packages like QuickBooks come with a

standard or default list of accounts, bookkeepers can set up and customize their
account structure to fit their business and industry.

For example, many companies have different departments that incur

similar costs like supplies. Management may want to evaluate the supplies
expenses for each department to see which one is using its resources most
efficiently. To make this comparison easier, the bookkeeper could tag the
expenses to different departments of simply use different numbered accounts
for each department. Department 1 could use 501-1 for its supplies expense
while department 2 could use 501-2 to differentiate it from the other
departments.

Example:

There are many different ways to structure a chart of accounts, but the
important thing to remember is that simplicity is a key. The more accounts are
added to the chart and the more complex the numbering system is, the more
difficult it will be to keep track of them and actually use the accounting system.
Simple is always better than complicated.

Here’s a standard example chart of accounts.

CHART OF ACCOUNTS
Number Description Acct. Type Financial Statements
Statement of Financial Position
101 Cash Asset (BS)
Statement of Financial Position
111 Accounts Receivable Asset (BS)
Statement of Financial Position
121 Prepaid Expenses Asset (BS)
Statement of Financial Position
131 Inventory Asset (BS)
Statement of Financial Position
141 Fixed Assets Asset (BS)
Accumulated Statement of Financial Position
151 Depreciation Asset (BS)
Statement of Financial Position
161 Other Assets Asset (BS)
Statement of Financial Position
201 Accounts Payable Liability (BS)
211 Accrued Expenses Liability Statement of Financial Position
26
 (BS)
Statement of Financial Position
221 Taxes Payable Liability (BS)
Statement of Financial Position
231 Notes Payable Liability (BS)
Statement of Financial Position
301 Capital Equity (BS)
Statement of Financial Position
302 Drawings Equity (BS)
401 Revenue Revenue Income Statement
411 Other Revenue/Income Revenue Income Statement
501 Salaries Expense Expense Income Statement
511 Rent Expense Expense Income Statement
521 Supplies Expense Expense Income Statement
531 Utilities Expense Expense Income Statement
541 Other Expense Expense Income Statement

Each account is listed numerically in financial statement order with the number in
the first column and the name or description in the second column.

The things to be considered in creating a chart of accounts for any business are as follows:

1. Numbering – Don’t use all concurrent numbers for each accounts. There will
be a need later to add accounts in the future. If there are no gaps in between
each number, there will be difficulty in adding new accounts in the right
order. For example, assume the cash account is 101 and the accounts
receivable account is 102, and there is a need to add a petty cash account.
This account should be listed between the cash and accounts receivable in the
chart, but there isn’t a number in between them.

2. Size – Set up the chart to have enough accounts to record transactions

properly, but without going overboard. The more accounts, the more difficult
it will be to consolidate them into financial statements and reports. It’s also
important to periodically look through the chart and consolidate duplicate
accounts.

3. Changes – It’s inevitable that there will be a need to add accounts to the chart
in the future, without drastically changing the numbering structure and total
number of accounts. A big change will make it difficult to compare accounting
record between these years.

What should I remember?

The five major accounts are assets, liabilities, equity, income and expense.
Assets are the resources controlled by the business. Liabilities are present
obligations of the enterprise arising from past events. Equity is the residual

27
interest in the assets of the enterprise after deducting all its liabilities. The
definition of income encompasses both revenue and gains. Revenue arises in the
course of the ordinary activities of an enterprise and is referred to by a variety of
different names including sales, fees, interest, dividends, royalties, and rent.
Gains represent other items that meet the definition of income and may, or may
not, arise in the course of the ordinary activities of an enterprise. The definition of
expenses encompasses losses as well as those expenses that arise in the course of
the ordinary activities of the enterprise. Losses represent other items that meet
the definition of expenses and may, or may not, arise in the course of the
ordinary activities of the enterprise.

REFERENCES

Ariel D. Pineda (2018), Fundamentals of Accountancy, Business and Management 1,

Principles and Application, Mindshapers Co., Inc. (pp.18-19), Intramuros, Manila

Angeles A. De Guzman (2018) Fundamentals of Accountancy, Business and

Management 1, Lorimar Publishing, Inc. (pp 1-7; pp 13-16). Quezon City

28
 4 BOOKS OF ACCOUNTS

What should I expect?

At the end of the lesson, students should be able to:

 Illustrate the format of general and special journals.
 Illustrate the format of a general and subsidiary ledger.

What do I know?

IDENTIFICATION

1. Used to record sales transactions. ___________

2. Used to record cash receipts. _______________
3. Used to record cash payments. _____________
4. A record of all transaction data of individual customers. ____________
5. A record or document that contains account summaries for accounts used by a
company. ______________

What do I remember?

The five major accounts are assets, liabilities, equity, income, and expense. Assets are
the resources controlled by the business. Liabilities are present obligations of the enterprise
arising from past events. Equity is the residual interest in the assets of the enterprise after
deducting all its liabilities. The definition of income encompasses both revenue and gains.
Revenue arises in the course of the ordinary activities of an enterprise and is referred to by
a variety of different names including sales, fees, interest, dividends, royalties, and rent.
Gains represent other items that meet the definition of income and may, or may not, arise
in the course of the ordinary activities of an enterprise. The definition of expenses
encompasses losses as well as those expenses that arise in the course of the ordinary
activities of the enterprise. Losses represent other items that meet the definition of
expenses and may, or may not, arise in the course of the ordinary activities of the
enterprise.

29
 What do I need to know?

GENERAL JOURNAL

The general journal is a collection of all journal entries in an accounting system. In

other words, the general journal contains a record of every transaction the business has
ever made. Obviously, this would be quite large for even the smallest businesses. A print out
of a small company’s GL could be 200-500 pages. That is why most modern companies use
accounting software or general ledger software like QuickBooks to maintain their general
ledgers.

FORMAT OF GENERAL JOURNAL

Most journals are formatted the same way with columns for the transaction dates,
titles of the accounts, debit and credit columns, as well as a brief description of the
transaction. This is a typical journal entry format. That’s what a journal is. It’s just a list of
journal entries stacked on top of each other. Here’s a general journal template example.

Journal Entry Format

Date Account Name Debit Credit
xx
January 1 Debited Account x
xx
Credited Account x
Description of the Journal Entry

Accounting Ledger

The accounting ledger is most often called the general ledger because it contains a
listing of all general accounts in the accounting system’s chart of accounts. Most modern
companies use a computerized general ledger, like the one in QuickBooks software
packages, to track their business transactions.

General Ledger

A general ledger or accounting ledger is a record or document that contains account

summaries for accounts used by a company. In other words, a ledger is a record that details
all business accounts and account activity during a period. Remember our notebook analogy
in the account explanation? You can think of an account as a notebook filled with business
transactions from a specific account, so the cash notebook would have records of all the
business transactions involving cash.
By this same analogy, a ledger could be considered a folder that contains all of the
notebooks or accounts in the chart of accounts. For instance, the ledger folder could have a
cash notebook, accounts receivable notebook, and notes receivable notebooks in it. In a
sense, a ledger is a record or summary of the account records.

30
 A ledger is often referred to as the book of final entry because business
events are first recorded in journals. After the journals are completed for the
period, the account summaries are posted to the ledger.

Format of a General Ledger

General Ledger
Account
Account Number Description Debit Credit
1 Assets 100
2 Liabilities 10
3 Equity 90
Total
Accounts are usually listed in the general ledger with their account
numbers and transaction information. Here’s what a general ledger template
looks like in debit and credit format.

The columns are used for the account numbers, account titles, and debit
or credit balances. The debit and credit format makes the ledger look similar to a
trial balance. Other ledger formats list individual transaction details along with
account balances.

Accounting ledgers can be displayed in many different ways, but the

concept is still the same. Ledgers summarize the balances of the accounts in the
chart of accounts.

Subsidiary Ledger

General ledger may not be able to maintain all individual transactions of a

company. This is especially true in large organizations where there may be
thousands of transactions each day. In such cases, subsidiary ledgers and special
journals are used.

Subsidiary ledgers – whether in a manual or automated accounting system – are

important because they help maintain records of similar types in a central
location and not clutter the general ledger. A subsidiary ledger is a group of
accounts/records of similar types (e.g., accounts payable).

Three Common Examples of Subsidiary Ledgers:

1. Accounts Receivable Subsidiary Ledger

Accounts receivable subsidiary ledger is a record of all transaction data of

individual customers. A control account for this type of subsidiary ledger is Trade
Accounts Receivable.

2. Accounts Payable Subsidiary Ledger

31
 Accounts Payable subsidiary ledger is a record of all transaction data of
individual creditors. A control account for this type of subsidiary ledger is Trade
Accounts Payable.

3. Fixed Asset Subsidiary Ledger

A fixed asset subsidiary ledger is a record of all transaction data for individual
fixed assets. This subsidiary ledger may have several control accounts (e.g., Fixed
Assets – Buildings).

Advantages of Subsidiary Ledgers

 Show transactions affecting one customer or one creditor in a single account.

 Free the general ledger of excessive details.
 Help locate errors in individual accounts.
 Reduce the number of accounts in one ledger by using control accounts.
 Division of labor in posting
 One employee posts to the general ledger.
 Another employee posts to the subsidiary ledger.

Specials Journals

In addition to the general journal, there are several special journals or subsidiary
journals that are used to help divide and organize business transactions. For example, the
cash receipts journal contains all of the cash sale transactions. The accounts receivable or
credit sales journal contains all the transactions for credit sales. A special journal is used to
record similar types of transactions.

Advantages of Special Journal

 One-line entry – saves time not necessary to write out four account titles for each
transaction.
 Only totals are posted to the general ledger – saves posting time and reduces the
possibilities of errors in posting.
 Division of labor – one individual may take responsibility for the sales journal.

Types of Special Journals

Recording each transaction directly in the general ledger may become burdensome
and unnecessary. Instead, transactions can be recorded in special journals and totals can
then be posted to subsidiary ledgers and general ledger.

1. Sales Journal

A sales journal is used to record sales transactions. This type of journal is used to
accumulate information about sales on account. For example, if a company sells a product
for P10,000.00 on account, it will be recorded in the sales journal.

Other journals like the sales journal and cash disbursements journal are also used to help
management organize and analyze accounting information.
32
 2. Purchases Journal
A purchase journal is used to record purchases of merchandise/inventory. When
a purchase on account is made, it is recorded in this journal.

3. Cash Receipts Journal

A cash receipts journal is used to record cash receipts. Such receipts may include
cash from sales of merchandise, collection of balances due from customers and
so on.

4. Cash Disbursements Journal

A cash disbursement journal is used to record cash payments. When a

company pays for merchandise purchased on account, for supplies, etc., such payments are
recorded in the cash disbursements journal.

What should I remember?

An accounting journal, also called the book of first entry, is a record of business
transactions and events for a specific account. In other words, a journal chronologically
stores all the journal entries for a specific account or group of accounts in one place, so
management and bookkeepers can analyze the data.
Accounting journals are often called the book of first entry because this is where
journal entries are made. Once a business transaction is made, the bookkeeper records that
event in the form of a journal entry in one of the accounting journals. Then, at the end of a
period, the journals are posted to accounting ledgers for reporting purposes.
Companies use many different journals depending on their accounting system and
industry, but all companies use the general journal.

REFERENCES
Pineda, A. D, Fundamentals of Accountancy, Business and Management 1, Principles and
Application, (2018), Mindshapers Co., Inc., Intramuros, Manila, (pp.18-19). Intramuros,

De Guzman, A. A., Fundamentals of Accountancy, Business and Management 1, (2018),

Lorimar Publishing, Inc. Quezon City, (pp 1-7; pp 13-16)

33
 BUSINESS TRANSACTIONS AND THEIR
ANALYSIS AS APPLIED TO THE ACCOUNTING
5 CYCLE OF A SERVICE BUSINESS

What should I expect?

By the end of the lesson, students should be able to:

 give examples of business transactions;
 describe the nature and give examples of business transactions;
 identify the different types of business documents;
 analyze common business transactions using the rules of debit and credit;
and
 solve simple problems and exercises in the analyses of business transaction.

What do I know?

Multiple Choice: Read and analyze each item. Circle the letter of the best answer.

1. Which of the following lists the steps of the accounting process in the correct order?
a. Recording, measuring, identifying, journalizing
b. Analyzing, measuring, posting, journalizing
c. Journalizing, posting, preparing a trial balance, recording
d. Analyzing, journalizing, posting, preparing a trial balance

2. All of these are done in the pre-recording phases of the accounting cycle, EXCEPT
a. Journalizing
b. Analyzing
c. Measuring
d. Identifying

3. When would an event qualify as a business transaction?

I. When it affects one or more elements of the financial statements.
II. When it has a measurable monetary value assignable to it.
III. When it results in a change in assets.
IV. When the event is related to the operations of the business.
a. When I and II are satisfied
b. When I, II and IV are satisfied
c. When III is satisfied
d. When I and IV are satisfied
34
4. Which of the following best describes a debit?
a. An increase in the balance of an account.
b. A movement in the left side of an account.
c. A change in the balance of an account.
d. An unprofitable movement in an account

5. This is referred to as the side of an account where increases in the balance of such
account are recorded.
a. Debit balance
b. Credit balance
c. Trial balance
d. Normal balance

What do I remember?

An accounting journal, also called the book of first entry, is a

record of business transactions and events for a specific account. In other words,
a journal chronologically stores all the journal entries for a specific account or
group of account in one place, so management and bookkeepers can analyze the
data.

Accounting journals are often called the book of first entry because this is
where journal entries are made. Once a business transaction is made, the
bookkeeper records that event in the form of a journal entry in one of the
accounting journals. Then, at the end of a period, the journals are posted to
accounting ledgers for reporting purposes.

Companies use many different journals depending on their accounting

system and industry, but all companies use the general journal.

What do I need to know?

Business Transactions

In accounting, the business transaction (also known as financial

transaction) is an event that must be measurable in terms of money and that
essentially impacts the financial position of the business. For example, in a
merchandising business, selling some goods to a customer for P25,000 cash, is
an event that can be measured in terms of money and that impacts the financial
position of the business, so it is a transaction. Similarly, the payment of P4,000
cash to a salesman as payment of salary is also a transaction because it has a
monetary value of P4,000.00 and it has a financial impact in the business. Only
those events that can be measured in monetary terms are included in
accounting records of the business.

35
 However, there may be numerous events related to a business that
cannot be reliably assigned a peso value. Such conditions or events cannot be
called business or financial transactions. For example, the CEO of a company
delivers a motivational lecture to the employees. This event may be of great
benefit for the company’s business but assigning a monetary value to it is not
possible, so it is not a business transaction, and therefore, cannot become a part
of accounting records.

Characteristics of a Business Transaction

The following are the five important characteristics of a valid business

transaction that every bookkeeper or accountant must take care of before
entering the transaction in the journal.

1. It is a monetary event.
2. It affects the financial position of the business.
3. It belongs to the business not to the owner or any other person managing
the business.
4. It is initiated by an authorized person.
5. It is supported by a source document.

Types of Business Transactions

In accounting, the transactions may be classified as:

1. Cash transactions and credit transactions

A transaction in which cash is paid or received immediately at the time

when transaction occurs is known as cash transaction.

Example:

Selling some goods to Mr. Cruz for P500.00 and Mr. Cruz immediately
pays P500.00 cash for the goods purchased. It is a cash transaction because the
business immediately received cash for the goods sold to the customer.
Similarly, buying furniture for the company for P7,500.00 will require payment
immediately of P7,500.00 cash to the supplier and in return the company have
the possession of furniture. It is also a cash transaction.

In today’s modem business world, cash transactions are not limited to

the use of currency notes or coins for making or receiving payments, all
transactions made using debit or credit cards issued by financial institutions are
also categorized as cash transactions.

In a credit transaction, the cash does not change the hands immediately
at the time when transaction occurs. In other words, the cash is received or paid
at a future date.

Example:

36
 Buying some merchandise from vendor for P1,000. Upon request, the
vendor agrees to receive the payment of P1,000 for goods sold next week. The
possession of the goods was transferred and transported to the buyer.

It is a credit transaction because payment was not made immediately in

cash immediately at the time of purchase of goods. Similarly, selling some goods
to Mr. Sam for P1.500. Mr. Sam requested to receive the payment of P1,500
next month. Upon agreement, Mr. Sam takes the goods for use. This is also a
credit transaction because payment has not been received in cash at the time of
sale of goods to Mr. Sam.

In today’s business world, goods are mostly purchased and sold on

credit.

2. Internal transactions and External transactions

Internal transactions (also known as non-exchange transactions) are

those transactions in which no external parties are involved. These transactions
do not involve the exchange of values between two parties but the event
constituting the transaction is measurable in monetary terms and impacts the
financial position of the business. Examples of such transactions include
recording depreciation of fixed assets and realizing the loss of assets caused by
fire etc.

External transactions (also known as exchange transactions) are

transactions in which a business exchanges value with external parties.
Normally, all transactions other than internal transactions are external
transactions. These are the usual transactions that a business performs on daily
basis. Examples of external transactions include purchase of goods from
suppliers, sale of goods to customers, purchase of fixed assets for business use,
payment of rent to owner, payment of gas, electricity or water bills, payment of
salary to employees etc. Normally, a large portion of transactions performed by
any business consists of external transactions.

Business Documents

Each transaction is recorded by making a journal entry by a bookkeeper

or accountant. Since each transaction impacts financial position of the business,
the bookkeeper or accountant must make sure that it has been authorized by a
responsible person and is properly supported by one or more source documents
before recording it in the journal.
A source document is a document that provides basic information
needed to record a transaction in the journal. Usual examples of source
documents include sales invoices, purchase invoices, cash receipts, payment
vouchers, statement of accounts, bills of exchange, promissory notes, and any
other document containing the basic transaction details which can be presented
as a proof of valid transaction.
37
 Summary of Rules of Debit and Credit

Debit Means Credit Means Normal

Balance
Increase in Asset Decrease in Asset Debit
Decrease in Liability Increase in Liability Credit
Decrease in Owner’s Equity Increase in Owner’s Equity Credit
Decrease in Income Increase in Income Credit
Increase in Expense Decrease in Expense Debit

Sample of Transactions

Example 1:

Jan. 1 - Juan Cruz invested cash of P100,000 in his business, Cruz Company.

Analysis:

a. The transaction is to be analyzed from the point of view of the business. So,
what accounts of the business are affected by the transaction?
b. Asset, Cash and Capital, Juan Cruz, Capital are the account titles affected.
c. Cash increased by P100,000 and Juan Cruz, Capital increased by P100,000.
d. So, in the analysis, both account titles increased.
e. Apply the rules of debit and credit:
Cash + ------> debit
Juan Cruz, Capital + ------> credit
f. The amount is P100,000 for each account.
g. So, the entry is:
Debit Cash P100,000
Credit Juan Cruz, Capital P100,000
h. The debit amount, P100,000 is equal to the credit amount, P100,000.

Example 2:

Jan. 3 - The business bought a computer costing P60,000 paying P40,000 down
payment and the balance to be paid on February 15.

Analysis:

a. Assets - Cash and Equipment, and Liability – Accounts Payable, are the
account titles affected.
b. Cash decreased P40,000
Equipment increased P60,000
Accounts Payable increased P20,000
c. Apply the rules of debit and credit:
Cash - ------> credit 40,000
Equipment - ------> debit 60,000
Accounts Payable + ------> credit 20,000
38
d. So, in the entry there are two credit titles and one debit title.
e. So, the entry is:
Debit Equipment P60,000
Credit Cash 40,000
Credit Accounts Payable 20,000
f. The debit amount of P60,000 is equal to the total credit amount of P40,000 and
P20,000.

The following are the steps or procedures in journalizing transactions in a

2-column journal, assuming a manual accounting system.

1. Date Column

 The date has 2 columns. Write the year in small figures on top of the first
line of the first column. The month is written below the year on the first
line
 The day is written on the first line of the second column.
 The year and the month are not written again on the same page unless
the month changes.
 The day of each transaction is written regardless of the number of
transactions completed on the same date.

2. Description Column

 The title of the account debited is written on the first line on the extreme
left of the description column.
 The title of the account credited is written on the second line indented
by about one-half inch from the debit.
 A brief explanation of the transaction is written on the next line indented
again by about one-half inch from the credit.

3. Posting reference column

 The account numbers of the account titles debited and credited are
written on this column. However, this column is filled up only during the
posting stage.

4. Debit Column

 The amount of the debit account title is written in the debit column.

5. Credit Column

 The amount of the credit account title is written in the credit column.

Additional points to be remembered when recording using the two-column

journal.

a. Peso signs are not used.

39
 b. Leave one space after each journal entry.
c. When there are no centavos, a dash is usually placed in the centavo
column.
d. When money columns are used, comma or period is omitted in the
amount columns of the journal.

What should I remember?

 The various transaction details we need in order to proceed with the

analyzing, identifying, and measuring phases are found in a document
called a source document.

 The rules of debits and credits are:

i. Increases in assets are recorded as debits; decreases are
recorded as credits.
ii. Increases in liabilities are recorded as credits; decreases are
recorded as debits.
iii. Increases in equity are recorded as credits; decreases are
recorded as debits.

REFERENCES

Pineda, A. D., Fundamentals of Accountancy, Business and Management 1

Principles and Application, 2018, Mindshapers Co., Inc.. Intramuros Manila

De Guzman, A. A. (2018). Fundamentals of Accountancy, Business and

Management 1. Lorimar Publishing, Inc., Quezon City, (pp.18-19)

40
 THE ACCOUNTING CYCLE OF A

6 SERVICE BUSINESS

What should I expect?

At the end of the lesson, students should be able to-

 record transactions of a service business in the general journal;

 post transactions in the ledger; and
 prepare a trial balance.

What do I know?

Give the journal entry of the following independent transactions:

1. Edi invested P280,000 in cash.

2. ABC Company bought materials costing P20,000 from DEF Company on account.
3. XYZ Company borrowed P50,000 from ABC Bank through a Note Payable.
4. Moon Company sold goods to Star Company at P100,000 on account.
5. Star Company paid the P100,000 receivable of Moon Company.

What do I remember?

 The various transaction details we need in order to proceed with the analyzing,
identifying, and measuring phases are found in a document called a source
document.
 The rules of debits and credits are:
1. Increases in assets are recorded as debits; decreases are recorded as credits.
2. Increases in liabilities are recorded as credits; decreases are recorded as
debits.
3. Increase in equity are recorded as credits; decreases are recorded as debits.

41
 What do I need to know?

THE LEDGER

A group of accounts is called a ledger. A general ledger contains the entire

set of accounts used by a business. Each account has an individual record in the
ledger. It is in this individual record that we summarize all the effects of business
transaction affecting each and every account.

POSTING

Posting is the process of transferring the entries from the journal to the
accounts in the ledger. If an account title is debited in the journal, the posting
will be on the debit side of the account. If an account title is credited in the
journal, then the posting will be on the credit side of the account in the ledger.

The first journal entry of Juan Cruz is shown below.

General Journal

Date Description Post Ref. Debit Credit

2019
June 1 Cash 101 200,000
Juan Cruz, Capital 301 200,000
To record cash investment by
the owner in his business.

POSTING:
CASH Account No. 101

Post
Date Items Post Ref. Debit Date Items Ref. Credit
2019
June 1 1 200,000

Juan Cruz, Capital Account No. 301

Post
Date Items Post Ref. Debit Date Items Ref. Credit
2019
June 1 1 200,000

42
 The steps in posting are as follows:

1. Locate in the ledger the debit account named in the journal entry.
2. Enter the date of the transaction and, in the Post Ref. column of the ledger, the
journal page number from which the entry comes.
3. Enter in the debit column of the ledger account the amount of the debit as it
appears in the journal.
4. Enter in the Post Ref. column of the journal the account number to which the
amount was posted.
5. Repeat the preceding four steps for the credit side of the journal entry.

THE TRIAL BALANCE

The equality of debit and credit balances in the ledger should be tested
periodically by preparing a trial balance. The steps in preparing a trial balance
are as follow:

1. Determine the balance of each account in the ledger. This is done after posting
all the transactions in the ledger. The debit and credit columns of the accounts
are totaled. The process is called pencil footing. Then, the smaller total is
subtracted from the bigger total and the difference represents the balance of
the account.
2. List each ledger account that has a balance, with the debit balances in the left
column and the credit balances in the right column. Accounts are listed in the
order they appear in the ledger.
3. Add each column.
4. Compare the totals of each column. The two totals should be equal.

Comprehensive Example – VC Portrait

Vic Castro opened a portrait studio on December 1, 2019 and completed the
following transactions during the month:

Dec. 1 Began business by depositing P300,000 in the business checking account.

1 Paid two months’ rent in advance for the studio, P40,000
1 Bought photography equipment on account, P100,000
1 Purchased office equipment in cash P50,000
8 Purchased photography supplies in cash, P30,000
15 Received cash for portraits, P70,000
16 Billed customers for portraits, P25,000
21 Paid for one-half of the photography equipment purchased on December
1, P50,000
24 Paid for utility bill for December, P15,000
29 Received payment from customers billed on December 16, P12,000
30 Paid wages to assistant, P10,000
31 Withdrew cash for personal expenses, P20,000
31 Received cash for portraits, P22,000

43
 General Journal

Post
Date Description Ref. Debit Credit
2019
Dec 1 Cash 101 300,000
Vic Castro, Capital 301 300,000
To record cash investment by the owner
in his business

1 Prepaid Rent 104 40,000

Cash 101 40,000
Paid two months’ rent

1 Photography Equipment 105 100,000

Accounts Payable 201 100,000
Bought photography equipment on
account.

1 Office Equipment 107 50,000

Cash 101 50,000
Purchased office equipment for cash.

8 Photography Supplies 103 30,000

Cash 101 30,000
Bought photography supplies for cash.

15 Cash 101 70,000

Portrait Revenue 401 70,000
Received cash for portraits.

16 Accounts Receivable 102 25,000

Portrait Revenue 401 25,000
Billed customers for portraits.

21 Accounts Payable 201 50,000

Cash 101 50,000
Paid one-half of the photography
equipment

24 Utility Expense 502 10,000

Cash 101 10,000
Paid utilities for December.

29 Cash 101 12,000

Accounts Receivable 102 12,000
Received partial payment from
customers.

44
 30 Wages Expense 501 10,000
Cash 101 10,000
Paid wages to assistant.

31 Vic Castro, Personal 302 20,000

Cash 101 20,000
The owner withdrew cash for personal
use.

31 Cash 101 22,000

Portrait Revenue 401 22,000
Received cash for portraits.

Cash Account No. 101

Post
Date Items Ref. Debit
Date Items Post Ref. Credit
2019 2019
Dec. 1 1 300,000 Dec. 1 1 40,000
1
15 1 70,000 1 50,000
29 2 12,000 8 1 30,000
31 2 22,000 21 2 50,000
189,000 404,000 24 2 15,000
30 2 10,000
31 2 20,000
215,000

Accounts Receivable Account No. 102

Post Post
Date Items Ref. Debit Date Items Ref. Credit
2019 2019
1 2
Dec. 6 1 25,000 Dec. 9 2 12,000
13,000

Photography Supplies Account No. 103

Post Post
Date Items Ref. Debit Date Items Ref. Credit
2019
Dec. 8 1 30,000

45
 Prepaid Rent Account No. 104

Post Post
Date Items Ref. Debit Date Items Ref. Credit
2019
Dec. 1 1 40,000

Photography Equipment Account No. 105

Post Post
Date Items Ref. Debit Date Items Ref. Credit
2019
Dec. 1 1 100,000

Office Equipment Account No. 107

Post Post
Date Items Ref. Debit Date Items Ref. Credit
2019
Dec. 1 1 50,000

Accounts Payable Account No. 201

Post Post
Date Items Ref. Debit Date Items Ref. Credit
2019 2019
Dec. 21 2 50,000 Dec. 1 1 100,000
50,000

Vic Castro, Capital Account No. 301

Post Post
Date Items Ref. Debit Date Items Ref. Credit
2019
Dec. 1 1 300,000

Portrait Revenue Account No. 401

Post Post
Date Items Ref. Debit Date Items Ref. Credit
2019
Dec. 15 1 70,000
16 1 25,000
31 2 22,000
117,000
46
 Wages Expense Account No. 501

Post Post
Date Items Ref. Debit Date Items Ref. Credit
2019
Dec. 30 2 10,000

Utility Expense Account No. 502

Post Post
Date Items Ref. Debit Date Items Ref. Credit
2019
Dec. 24 2 15,000

VC Portrait
Trial Balance
December 31, 2019
Debit Credit
Cash P189,000
Accounts Receivable 13,000
Photography Supplies 30,000
Prepaid Rent 40,000
Photography Equipment 100,000
Office Equipment 50,000
Accounts Payable P50,000
Vic Castro, Capital 300,000
Vic Castro, Personal 20,000
Portrait Revenue 117,000
Wages Expense 10,000
Utility Expense 15,000
P467,000 P467,000

What should I remember?

 The journal is a chronological record of all company’s transactions listed by date.

It is often referred to as the book of original entry.
 The basic type of journal is the general journal. The general journal typically displays
the transaction’s date, account titles and explanations, references, and respective
amounts of corresponding accounts.
 The ledger is the grouping of all accounts of a company showing its respective
outstanding balances. It is also called the book of final entry of accounting
transactions.
 The general ledger contains all the asset, liability, and equity accounts of the
company.
 When recording transaction, debit and credit side should always be equal.
47
REFERENCES

Pineda, A. D., Fundamentals of Accountancy, Business and Management 1 Principles and

Application (2018), Mindshapers Co., Inc., Intramuros, Manila, (pp.18-19)

De Guzman, A. A., Fundamentals of Accountancy, Business and Management 1, (2018),

Lorimar Publishing, Inc. Quezon City, (pp. 1-7; pp. 13-16)

48
 ADJUSTING ENTRIES
7

What should I expect?

By the end of the lesson, students should be able -

 to prepare adjusting entries and

 complete the accounting cycle.

What do I know?

Multiple Choice.
Read and analyze each item. Circle the letter of the best answer.

1. Which of the following is NOT a step in the summarizing phase of the accounting
process?
a. Preparation of the adjusted trial balance
b. Preparation of adjusting entries
c. Analyzing business transactions
d. Preparation of closing entries
2. Which is NOT a type of adjusting entry?
a. Unearned Revenues
b. Accrued Expenses
c. Prepaid Expenses
d. Unearned Expenses
3. Which of the following entries is proper adjusting entry?
a. Debit Cash and Credit Revenue
b. Debit Revenue and Credit Unearned Revenue
c. Debit Expense and Debit Payable
d. Debit Expense and Credit Payable
4. Which of the following statements is true about depreciation?
a. Using the straight-line method of depreciation, equal amounts would be
recognized as depreciation expense across the useful life of the asset, unless
other estimates change.
b. The residual value of a PPE increases the amount to be charged to
depreciation.

49
 c. Land is always depreciated using the straight-line method.
d. The depreciation expense represents the unexpired portion of the cost of a
PPE.
5. The trial balance is prepared from which accounting document?
a. Journal
b. Journal voucher
c. Ledger
d. Ledger voucher

What do I remember?

 The journal is a chronological record of all company’s transactions listed

by date. It is often referred to as the book of original entry.
 The basic type of journal is the general journal. The general journal
typically displays the transaction’s date, account titles and explanations,
references, and respective amounts of corresponding accounts.
 The ledger is the grouping of all accounts of a company showing its
respective outstanding balances. It is also called the book of final entry of
accounting transactions.
 The general ledger contains all the asset, liability, and equity accounts of
the company.
 When recording transaction, debit and credit side should always be
equal.

What do I need to know?

CASH AND ACCRUAL BASIS OF ACCOUNTING

As mentioned earlier, the cash basis recognizes revenues and expenses only when they are
received and paid, respectively whereas the accrual basis recognizes revenues when earned
and expenses when incurred, regardless of when collected or paid.

Generally Accepted Accounting Principle (GAAP) requires that a business use the accrual
basis of accounting.

TYPES OF ADJUSTING ENTRIES

ACCRUED EXPENSES – These are expenses incurred in one period but remain unrecorded
and unpaid as of the end of the period. They are also called accrued liabilities or unrecorded
expenses.

The pro-forma adjustment is:

Expense Account xxx

Liability Account xxx

50
 For example: A company’s accounting period is monthly, January 1-31, 2019. All
expenses incurred during the month of January must be recorded in January. Let us say,
taxes for the month of January amounting to P5,000 will be paid on February 5, 2019, the
adjusting entry will be:

2019
Jan 31 Taxes Expense xxx
Taxes Payable xxx

So since we are using the accrual basis of accounting, the question is when did the
company incur the expense? The answer of course is for the month of January; therefore,
we will record the expense in January. And since this will still be paid in February, we will
record a liability in January.
ACCRUED REVENUES – These are revenues earned in one period but remain
unrecorded and not received as of the end of the period. They are also called accrued assets
or unrecorded revenues.
The pro-forma adjustment is:

Asset Account xxx

Revenue Account xxx

For example: ABC Company’s accounting period is monthly, August 1-31, 2019. All
revenues earned during the month of August must be recorded in August. If the company is
in the business of renting apartment and one of its tenants has not paid the August rent for
P8,000, then the adjusting entry of ABC Company will be:

2019
Aug 31 Rent Receivable xxx
Rent Revenue xxx

PREPAID EXPENSES – These are expenses paid by the business in advance; or these
are expenses already paid in cash by the business but the expenses are not yet incurred or
only a portion of the amount paid was used up as expense. Prepaid expenses are also
termed as deferred expenses.

There are two methods of accounting for prepaid expenses:

Asset Method – if at the date of payment, the business debited an asset account, say
Prepaid Rent and credited Cash.

The pro-forma adjustment is:

Expense Account
Asset Account
} Used or expense
portion

51
 1. Expense Method – if at the date of payment, the business debited an expense
account, say Rent Expense and credited Cash.

The pro-forma adjustment is:

Asset Account
Expense Account
} Unused or asset
portion

To illustrate, assume that XYZ Company is using a monthly

accounting period. On January 1, 2019, the company paid P30,000 representing
3-month rent beginning January 1, 2019. The company adjusts and closes its
books every month. The entry to record the prepayment and the adjusting entry
at the end of the month will be:

ASSET METHOD EXPENSE METHOD

2019
Jan 1 Prepaid Rent 30,000 Rent Expense 30,000
Cash 30,000 Cash 30,000

2019
31 Rent Expense 10,000 Prepaid Rent 20,000
Prepaid Rent
Rent 10,000 Expense 20,000

Since P30,000 is for 3 months, the monthly rent is P10,000. For January, the used or
expense portion is one month or P10,000; therefore, the unused or asset portion will be two
months or P20,000 as of January 31.

The effects of these entries are shown in the following T-Accounts:

Asset Method
Prepaid Rent Rent Expense

2019 2019 2019

Jan. 1 30,000 Jan. 3 20,000 Jan. 31 10,000

20,000

52
 Expense Method

Rent Expense Prepaid Rent

2019 2019 2019

Jan. 1 30,000 Jan. 31 20,000 Jan. 31 20,000

10,000

Regardless of which method a business used in any particular case, the amount
reported as expense in the income statement and the amount reported as asset in the
balance sheet will be the same.

Both methods of accounting for prepayment are acceptable although most

companies employ the expense method due to its simplicity. A business must also use a
method consistently for a particular type of prepayment, say asset method for rent while
expense method for supplies.

UNEARNED REVENUES – These are revenues collected or received by the business in

advance; or these are revenues already collected in cash by the business but the revenues
are not yet earned or only a portion of the amount received was earned or became revenue.
Unearned revenues are also termed as deferred revenues.

There are two methods of accounting for unearned revenues:

1. Liability Method – if at the date of collection, the business credited a liability

account, say Unearned Rent and Debited Cash.

The pro-forma adjustment is:

}
Liability Account earned or income
Revenue Account portion

2. Revenue Method – if at the date of collection, the business credited a revenue

account, say Rent Revenue and debited Cash.

The pro-forma adjustment is:

Revenue Account
Liability Account } Unearned or liability
portion
To illustrate, assume that ABC Company is using a monthly accounting period. On
January 1, 2019, the company collected or received P30,000 representing 3-month rent
beginning January 1, 2019. The company adjusts and closes its books every month. The
entry to record the advance collection and the adjusting entry at the end of the month will
be:

53
 LIABILITY METHOD REVENUE METHOD

2019
Jan 1 Cash 30,000 Cash 30,000
Unearned
Rent 30,000 Rent Income 30,000

2019
31 Unearned Rent 10,000 Rent Income 20,000
Unearned
Rent Income 10,000 Rent 20,000

Since P30,000 is for 3 months, the monthly rent is P10,000. For January, the earned
or income portion is one month or P10,000; therefore, the unearned or liability portion will
be two months or P20,000 as of January 31.

The effects of these entries are shown in the following T-Accounts:

Liability Method

Unearned Rent Rent Income

2019 2019 2019

Jan. 31 10,000 Jan. 1 20,000 Jan. 31 10,000

20,000

Revenue Method

Rent Income Unearned Rent

2019 2019 2019

Jan. 31 20,000 Jan. 1 20,000 Jan. 31 20,000

10,000

Regardless of which method a business used in any particular case, the amount
reported as income in the income statement and the amount reported as liability in the
balance sheet will be the same.
Both methods of accounting for unearned or deferred revenues are acceptable
although most companies employ the revenue or income method due to its simplicity. A
business must also use a method consistently for a particular type of unearned or deferred
revenue, say liability method for rent while income or revenue method for subscription.
DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT

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 Physical resources that are owned and used by a business which are permanent in
nature or have a long useful life are called fixed assets or plant assets. Examples are land,
building, equipment, trucks, automobiles, a computer, store fixtures, or office furniture.
These assets help generate income for the business. Therefore, it is important and proper
that a portion of the asset be recorded as expense in each accounting period.

Property, plant and equipment are recorded at their acquisition cost, which comprises:
a. The purchase price;
b. Freight, insurance, installation and other related expenses in bringing the assets
for use; and
c. The initial estimate of the costs of dismantling and removing the item at the end
of its useful life.

Fixed assets, with the exception of land have limited useful lives and as such are
subject to depreciation.
Depreciation is the systematic allocation of the cost of the fixed asset over its useful
life. Depreciation is not a process of asset valuation.

There are three factors to be considered in computing depreciation:

 Cost of the asset
 Residual value or the estimated amount that the fixed asset can be sold at its
useful life. Other terms used are salvage value, scrap value or trade-in value.
 Useful life or the estimated number of years or number of units or hours the
asset can be used during its life.

The pro-forma adjustment for depreciation is:

Depreciation Expense – Name of the Asset xxx

Accumulated Depreciation – Name of the Asset xxx

There are different methods of computing depreciation. We will discuss here only
the simplest and the most commonly used method which is the straight-line method. This
method will result into equal periodic charges for depreciation. Also take note that in the
adjusting entry for depreciation the account credited is the account Accumulated
Depreciation. This is a contra-asset account which will be deducted from the related fixed
asset account in the balance sheet. The credit is not made directly to the fixed asset account
in order to preserve the original cost of the fixed asset in the balance sheet.

To illustrate, assume that on January 1, 2019, DEF Company bought a delivery truck
for a total cost of P500,000. Its estimated life is 10 years and the estimated residual value is
P50,000. The company is using the straight-line method of computing depreciation and it is
using an annual accounting period.

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The entries of DEF Company for the above transactions are:

2019
January 1 Delivery Truck 500,000
Cash 500,000
To record the purchase of delivery truck

The adjusting entry on December 31, 2019:

2019
Dec 31 Depreciation Expense – Delivery Truck 500,000
Accumulated Depreciation – Delivery Truck 500,000

Computations will be:

Annual Depreciation = Cost – Residual Value

Estimated Life

= P500,000 – 50,000

10

= P45,000

Other computation for straight-line method is:

Annual Depreciation = (Cost – Residual Value) x Depreciation rate

= (P500,000 – 50,000) x 10%

= P45,000

The depreciation rate can be computed by getting the reciprocal of the life.
Example: 10 years is equal to 1/10 or 10%.

The balance of the Depreciation Expense account is shown in the income statement.
In the balance sheet as of December 31, 2019, the carrying amount or the book value of the
asset is P455,000, as shown below:

Delivery Truck P500,000

Less: Accumulated Depreciation 45,000

Carrying Amount or Book Value P455,000

The depreciation of the fixed asset will be recorded at the end of each year (for ten
years). The same adjusting entry will be recorded for 10 years. Assuming a balance sheet will
be made on December 31, 2024:

Delivery Truck P500,000

Less: Accumulated Depreciation 270,000

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 Carrying Amount or Book Value P230,000

At the end of ten years, the Accumulated Depreciation account will have a balance of
P450,000. At this point, the book value of the asset will be equal to the residual value of
P50,000.

After making all the necessary adjustments, you can now prepare the adjusted trial
balance.

REMINDERS FOR ACCOUNTING CYCLE

Follow these steps in producing financial statements:

1. Analyze the given transactions.

2. Journalize the transactions.
3. Post the general journal entry to a ledger. We call this posting.
4. Prepare the unadjusted trial balance. From this point you cannot still
produce financial statements because there are still some items that need to
be adjusted.
5. Journalize the adjusting entries.
6. Prepare the adjusted trial balance.
7. You can now make the major financial statements namely: Statement of
Financial Position, Statement of Comprehensive Income and Statement of
Changes in Owner’s Equity.

What should I remember?

 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 (e.g., asset or liability); and (3) each entry has
no cash account in either the debit or the credit side.
 In the accounting process of a service firm, there are six classifications of
adjusting entries: depreciation, bad debts, prepaid expenses, accrued
expenses, deferred revenues, and accrued revenues.

REFERENCES

Pineda, A. D., Fundamentals of Accountancy, Business and Management 1 Principles and

Application, 2018, Mindshapers Co., Inc., Intramuros, Manila, pp. 18-19

De Guzman, A. A. Fundamentals of Accountancy, Business and Management 1, 2018,

Lorimar Publishing, Inc., Quezon City, pp. 1-7; pp. 13-16

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 8 ELEMENTS OF THE FINANCIAL
STATEMENTS

What should I expect?

By the end of the lesson, students should be able to -

 understand and know the basic financial statements; and

 prepare basic financial statements by applying the accounting cycle.

What do I know?

Identification:

1. These are claims against debtors or customers arising from the provision of services
or delivery of goods on credit. ___________________
2. These are amounts due to creditors arising from the purchase of merchandise or
services on account. ___________________
3. These are expenses paid by the business in advance. ___________________
4. Revenues collected by the business in advance. ___________________
5. Revenues earned by selling merchandise to customers. ___________________

What do I remember?

 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 (e.g., asset or liability); and (3) each entry has no cash account in either the
debit or the credit side.
 In the accounting process of a service firm, there are six classifications of adjusting
entries: depreciation, bad debts, prepaid expenses, accrued expenses, deferred
revenues, and accrued revenues.
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 What do I need to know?

In financial reporting, there are several financial statements which serve

different purposes, some of which are:

 INCOME STATEMENT
 STATEMENT OF FINANCIAL POSITION/BALANCE SHEET
 STATEMENT OF CHANGES IN OWNERS EQUITY
 STATEMENT OF CASH FLOWS

Let’s discuss first the INCOME STATEMENT

Under Income Statement, we can see here the revenue and expenses of the
business. This is the first financial statement to be prepared.

TWO TYPES OF INCOME:

 Service Income
 Sales

EXPENSES
 Rent Expense
 Supplies Expense
 Depreciation Expense
 Interest Expense
 Bad Debt Expense

After preparing the Income Statement, next to prepare is the Statement of Owner’s
Equity. See the example below.

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After the Statement of Owner’s Equity, you can now prepare the Financial
Statement/Balance Sheet

Under SFP, we can see here the ASSETS, LIABILITIES and EQUITY. Assets should
always be equal to Liabilities and Equity. Since we’re already done discussing these items in
the previous chapters, we will just have a summary of these items.

ASSETS – resources owned by the business (pag-mamay-ari ng business). Accounts

under assets are:

 Cash
 Accounts Receivable
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  Notes Receivable
 Inventories
 Prepaid Expenses
 Property, Plant and Equipment

LIABILITIES – amounts owed by the business arising from past events (utang ng
business). Accounts under liabilities are:
 Accounts Payable
 Notes Payable
 Accrued Liabilities
 Unearned Revenues
 Mortgage Payable

OWNER’S EQUITY/CAPITAL – initial investment of the owner to the business.

Two things that cause Owner’s Equity to increase.

o Investments of assets by owner into the business.

o Revenue

One thing that cause Owner’s Equity to decrease.

o Withdrawals of assets by owner out of the business.

What should I remember?

In the preparation of financial statements, it is very important to follow the

accounting cycle, and the first statement that you have to prepare is the Income Statement
(IS). You can neither start from Statement of Changes in Owner’s Equity (SCE) nor in
Statement of Financial Position (SFP). Income Statement should always be done first. It is
also important to complete the headings of each statement. Say for example in Income
Statement, you should always provide the name of the statement, the name of the
company and the date covered of the statement. In IS and SCE, when it comes to date
covered you can always write like “for the month ended”, or “for the year ended”, but when
it comes to SFP you can only write “as of December 31”

REFERENCES

Florendo, J. G., Fundamentals of Accountancy, Business and Management 1, 2016, Rex

Bookstore, Sampaloc, Manila (pp.227-230)

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