BASIC ACCOUNTING NOTES

What is Accounting and Why is it Important for Business?

Accounting is relevant in all walks of life, and it is absolutely essential in the world of business.
As business and society become more complex, accounting develops new concepts and
techniques to meet the ever-increasing needs for financial information. Accounting quantifies the
business communication – for this reason accounting is called language of business.

Without accounting, a business couldn’t function optimally; it wouldn’t know where it stands
financially, whether it is making profit or not, and it wouldn’t know its financial situation.

WHAT IS ACCOUNTING?
It is a service activity. Its function is to provide quantitative information, primarily financial in
nature, about economic entities that is intended to be useful in making economic decisions.
(Statement of Financial Accounting Standards No.1, “Basic Concepts and Accounting Principles
Underlying Financial Statements of Business Enterprises”, Manila: Accounting Standards
Council, 1983, par.1).
1. It is an information system that measures, processes and communicates financial
information about an identifiable economic entity.
2. It is the process of identifying, measuring and communicating economic information
to permit informed judgments and decisions by users of the information.
3. Accounting is the science of recording and presenting the financial data of an
economic entity by observing, detecting, investigating, and identifying the economic
events via established collecting, testing, analyzing and presenting methods.
4. Accounting is the art of recording, classifying and summarizing in a significant
manner and in terms of money, transactions and events which are, in part at least, of a
financial character, and interpreting the results thereof.

PURPOSE AND PHASES OF ACCOUNTING

· Measure
· Record
· Classify
· Summarize
· Interpret
Measure
Before the effects of transactions can be recorded, they must be measured. In order that
accounting information will be useful, it must be expressed in terms of a common financial
denominator - money.
 Transactions must be expressed in terms of a common financial denominator - money.
 Money serves as both a medium of exchange and a measure of value.
 Business transaction must be determined when it occurred, what value to place on the
transaction and how the components of the transaction should be classified.
Record
The accounting function is part of the broader business system, and does not operate in isolation.
It handles the financial operations of the business and also provides information and advice to
other departments. Business transactions are the economic activities of a business.
 Recording of historical events is a significant function of accounting.
 Accounts are produced to aid management in planning, control, and decision-making to
comply with regulations.

Classify and Summarize

By simply measuring and recording the transactions, the resulting information will be of limited
use.
 To be useful in making decisions, the recorded data must be classified and summarized.
 Classification reduces the effects of numerous transactions into useful groups or
categories.
 Summarization of financial data is achieved through the preparation of financial
statements.
 These summarize the effects of all business transactions that occurred during some
period.

Interpret
After going through the preceding phases, it is imperative that the result of the summarization
phase be interpreted or analyzed to evaluate the liquidity, solvency, and profitability of the
business. Accounting provides the decision makers with information to make reasoned choices
among alternative uses of scarce resources in the conduct of business and economic activities.
 BRANCHES OF ACCOUNTING
The main branches of accounting are the following:
 Auditing.
It is the accountancy profession’s most significant service to the public. An external audit is the
independent examination that ensures the fairness and reliability of the reports that management
submits to users outside the business entity. The result of the examination is embodied in the
independent auditor’s report. Once the required financial statements have been prepared by
management, they have to be evaluated in order to ensure that they do not present a distorted
picture.
External auditors are appointed from outside the organization. The external auditor’s job is to
protect the interest of the users of the financial statements. Also, the external auditors are likely
to go in for much selective testing.
In contrast, the internal auditors are employees of the company. They are appointed by, and
answer to the company’s management though they work independently of the accounting and
other departments. They ensure the accuracy of business records, uncover internal control
problems and identify operational difficulties. Further, internal auditors perform routine tasks
and undertake detailed checking of the company’s accounting procedures.
Nonetheless, they work closely together, although the distinction made between them still
remains important.
 Bookkeeping.
It is a mechanical task involving the collection of basic financial data. The data are first entered
in the accounting records or the books of accounts, and then extracted, classified and
summarized in the form of income statement, balance sheet, and cash flow statement. This
process normally takes place once a month. The bookkeeping procedures usually end when the
basic data have been entered in the books of accounts and the accuracy of each entry has been
tested. At that stage, the accounting function takes over.
 Cost Bookkeeping, and Cost Accounting.
Cost bookkeeping is the process that involves the recording of cost data in books of accounts. It
is therefore, similar to bookkeeping except that data are recorded in much greater detail.
Cost accounting makes use of those data once they have been extracted from the cost books in
providing information for managerial planning and control.
 Financial Accounting
Financial accounting is focused on the recording of business transactions and the periodic
preparation of reports on financial position and results of operations. Financial accountants
accord importance to generally accepted accounting principles.
 Financial Management
Financial management is a relatively new branch of accounting that has grown rapidly over the
last 30 years. Financial managers are responsible for setting financial objectives, making plans,
and generally safeguarding all the financial resources of the entity.
 Management Accounting
Management accounting incorporates cost accounting data and adapts them for specific decisions
which management may be called upon to make. A management accounting system incorporates
all types of financial and non-financial information from a wide range of sources.
 Taxation
Tax accounting includes the preparation of tax returns and the consideration of the tax
consequences of proposed business transactions or alternative courses of action. Accountants
involved in tax work are responsible for computing the amount of tax payable by both business
and individuals but their work is really more complex.
 Government Accounting
It is concerned with the identification of the sources and uses of resources consistent with the
provisions of city, municipal, provincial or national laws. The government collects and spends
huge amount of public funds annually, so it is necessary that there is proper custody and
disposition of these funds.

HISTORY AND CONTEMPORARY DEVELOPMENTS

The origins of accounting
Accounting arguably began before the use of abstract counting. Around 7,500 BC, the
Mesopotamians were using small clay objects as counters for keeping account of goods. Each
object represented particular quantities of different types of commodities, such as food, clothing,
and even labor. They became increasingly complex over centuries, bearing intricate markings,
and eventually, imprints of these markings onto parchment replaced the counters themselves.
According to many scholars, accounting and writing evolved side-by-side in this way.

Double entry bookkeeping

The double entry bookkeeping system we’re familiar with today was first properly described by
Luca Pacioli in 1494. Referred to as ‘the father of bookkeeping and accounting’, he defined
much modern day thinking about debits, credits, journals, and ledgers. The inventor of double-
entry bookkeeping was Amatino Manucci. He managed to construct a comprehensive and fully-
articulated set of double-entry records, with a regular balancing procedure on closure of the
General Ledger.
The Modern Accountant
With industrialization came a need for more advanced accounting methods. The large
corporations of the industrial revolution required cost accounting systems that addressed external
sources of finance like shareowners, and needed to be able to calculate and predict profits
accurately, basing their operations on real financial data. All of this called for dedicated
accounting professionals who had highly specialized knowledge, and could be trusted with great
financial responsibility.

Information age and the Fourth Industrial Revolution

Tremendous advances in information technology have revolutionized accounting in recent years.
Time-consuming tasks that used to be manually done can now be done with speed, consistency,
precision, and reliability by computers. There is an abundance of accounting applications and
modules to suit various business needs. With the advent of the Fourth Industrial Revolution, new
technologies such as artificial intelligence, block chain, and robotics are changing the business
and work landscape and impacting the field of accounting in fundamental ways. The challenge
for the contemporary accountant is how to adapt and be resilient in the face of accelerating
changes.

FUNDAMENTAL ACCOUNTING CONCEPTS

Several fundamental concepts underlie the accounting process. In recording business
transactions, accountants should consider the following:
 Entity
 Periodicity
 Stable Monetary Unit
 Going Concern
Entity
An accounting entity is an organization or a section of an organization that stands apart from
other organizations and individuals as a separate economic unit.
Simply put, the transactions of different entities should not be accounted for together.
Each entity should be evaluated separately.
Periodicity
An entity's life can be meaningfully subdivided into equal time periods for reporting purposes.
This concept allows the users to obtain timely information to serve as a basis on making
decisions about future activities.
For the purpose of reporting to outsiders, one year is the usual accounting period.
Stable Monetary Unit
The Philippine peso is a reasonable unit of measure and that its purchasing power is relatively
stable.
The peso amounts as though each peso has the same purchasing power as any other peso at any
time.
This is the basis for ignoring the effects of inflation in the accounting records.
Going Concern
Financial statements are normally prepared on the assumption that the reporting entity is a going
concern and will continue in operation for the foreseeable future.
Hence, it is assumed that the entity has neither the intention nor the need to enter liquidation or
to cease trading.
This assumption underlies the depreciation of assets over their useful life.

GENERALLY- ACCEPTED ACCOUNTING PRINCIPLES

Accounting practices follow certain guidelines. Generally-accepted accounting principles
(GAAP) encompass the conventions, rules and procedures necessary to define accepted
accounting practice at a particular time. The general acceptance of an accounting principle
usually depends on how well it meets three criteria:
 Relevance
 Objectivity
 Feasibility

Relevance. A principle is relevant to the extent that it results in information that is meaningful
and useful to the users of the accounting information.
Objectivity. A principle has objectivity to the extent that the resulting information is not
influenced by the personal bias or judgment of those who furnish it. Objectivity connotes
impartiality and trustworthiness. It also connotes verifiability, which means that there is some
way of finding out whether the information is correct.
Feasibility. A principle has feasibility to the extent that it can be implemented without undue
complexity or cost.
 THE ACCOUNTANCY PROFESSION
Characteristics
Accountancy qualifies as a profession because it possesses the following attributes:
 All members of the accountancy profession are Certified Public Accountants, which
means that they have earned a Bachelor of Science in Accountancy degree and have
passed the CPA Licensure Examinations.
 CPAs have their own body of language. They use terminology peculiar to the profession.
 CPAs adhere to a Code of Ethics. This code upholds the CPA’s responsibility to serve the
public with competence and integrity. The public, in return, expresses its confidence to
CPAs by relying on the financial statements they audit.
 Like other professions, CPAs are members of a national organization, the PICPA, whose
role is to ensure the continued improvement of the accountancy profession to meet the
demands of the times.

Career Opportunities
The accountant may be engaged in any of the following areas of competence:
Public Practice. Accountants who render services on a fee basis and staff accountants employed
by them are engaged in public practice. Public accountants, who practice individually or as
members of public accounting firms, should be Certified Public Accountants (CPAs). They offer
their services to the public. Their work includes auditing, taxation, and management advisory
services.
Commerce and industry. Accountants employed in this area vary widely in their scope of
activities and responsibilities. Sample entry-level jobs: Financial Accounting and Reporting
Staff, Management Accounting Staff, Tax Accounting Staff, Internal Audit Staff, Financial
Analyst, Budget Analyst, Credit Analyst, and Cost Accountant. Middle-level positions:
Comptroller, Senior Information Systems Auditor, Senior Fraud Examiner, and Senior Forensic
Auditor. Advanced positions: Chief Financial Officer, and Chief Information Officer.
Government Service. Accountants may be hired by the following: Congress of the Philippines,
Commission on Audit (COA), Bureau of Internal Revenue (BIR), Department of Finance (DoF),
Department of Budget and Management (DBM), Bangko Sentral ng Pilipinas (BSP), and the
local government units (e.g. provincial, city or municipality).
Education/Academe. This area guarantees he continued development of the profession by
endeavoring to clarify and address emerging issues through research and sharing the results
obtained with their colleagues. Considered as modern day heroes, they make others understand
the body of accounting knowledge. In addition, they painstakingly prepare candidates for the
tough CPA exam.

FUNDAMENTAL BUSINESS MODEL

Business activities follow a fundamental business model (illustrated above). The model
illustrates the way money flows in a business and provides the basis of accounting.
The business model is built on five (5) activities:
1. The investors provide the required capital for the business. The cash investment will then be
held in a bank account.
2. The cash in the business can be: converted unto another type of assets that will be used in
the business or sold; or spent on operating costs such as salaries, rental, and utilities.
3. The combination of business resources provides the basis for producing the products or
services.
4. The sale of a product or services generates an asset called a receivable. This asset once
collected will produce a cash inflow for the business.
5. If there’s an existing debt from banks, the cash inflow from collection will be used to
provide the debt providers with interest on their loans to the company. The rest of the cash can
be sent back to the cycle by being converted into other assets or spent in operating costs. In a
normal course of business, this whole process will earn profits in which tax will have to be paid.
Any profit after tax can continue to be reinvested in the cycle or paid out to the owners as a
return on their investments.
TYPES OF BUSINESS
Although the fundamental business model does not vary, there are infinite ways of applying it to
provide the range of products and services that make up the business world. These products and
services can be summarized in seven broad categories, as follows:

FORMS OF BUSINESS ORGANIZATION

Sole Proprietorship
 Has a single owner called the proprietor (who generally is the manager).
 Proprietorship tend to be small service-type businesses and retail establishments.
 The owner receives all profits, absorbs all losses and solely responsible for all debts of
the business.
 From the accounting view point, the sole proprietorship is distinct from its proprietor.
Thus, the accounting records of the sole proprietorship do not include the proprietor’s
personal financial record.
  Typical sole proprietorships are sari-sari stores and small businesses.

Partnership
 A business owned and operated by two or more persons,
 Who bind themselves to contribute money, property, or industry to a common fund
 With the intention of dividing profits among themselves.
 Accounting considers the partnership a separate organization, distinct from personal
affairs of each partner.
 Examples of partnerships are professionals banding together to provide services and
share common costs, such as accounting firms and legal offices.

Corporation
 Owned by its stockholders.
 An artificial being created by operation of law,
 Having the rights of succession and the powers,
 Attributes and properties expressly authorized by law or incident to its existence.
 Stockholders are not personally liable for corporation’s debts.
 It is a separate legal entity.
 Corporations run the gamut from small startups to medium-sized firms and large
multinationals in all kinds of industries.

THE ACCOUNTING EQUATION AND THE DOUBLE-ENTRY SYSTEM

The Financial Statements
The financial statements are the end products of the accounting cycle. They provide financial
information about an entity to meet the needs of various users. The financial statements include
the following:
 Income Statement
 Balance Sheet or Statement of Financial Position
 Statement of Changes in Equity/Capital
 Cash Flow Statement

The Income Statement shows the results of operations or operating performance of the entity
for a given time period (e.g., year or month)
The Balance Sheet or Statement of Financial Position reports the entity’s financial position as
of a given date (e.g., as of December 31, 2019).
The Statement of Changes in Equity/Capital shows changes in owner’s equity or capital for a
given time period.
The Cash Flow Statement summarizes sources and uses of cash for a given time period.

The Basic Elements of Financial Statements

The elements of financial statements as defined in the 2018 Conceptual Framework are:
 Assets, Liabilities and Equity (financial position)
 Income and Expenses (financial performance)

Financial Position
Assets are what the entity OWNS. They represent present economic resources controlled by the
entity as a result of past events. An economic resource is a right that has the potential to produce
economic benefits. Examples of assets are cash, amounts due from customers, and equipment
used in the business.
Liability are what the entity OWES. They are present obligations of the entity to transfer
economic resources as a result of past events. Examples of liabilities are amounts payable to
suppliers, banks, and utility companies.
Capital or Equity represents the OWNER’s claim on the entity’s assets. It is the residual
interest in the assets of the entity after deducting all its liabilities.

Financial Performance
Income represents increases in assets or decreases in liabilities that result in increases to in
equity. Other than those relating to contributions from holders of equity claims. Examples of
income are receipts from customers for services rendered and interest earned from bank deposits.
Expenses – are decreases in assets or increases in liabilities; that result in decreases in equity,
other than those relating to distributions to holders of equity claims.
Expenses are decreases in assets or increases in liabilities that result in decreases in
capital/equity, other than those relating to distributions to owners or holders of equity claims.
Examples of expenses are amounts paid for employee salaries, office supplies, and rent.

THE BASIC ACCOUNTING EQUATION

The basic accounting equation relates the elements of financial position:
Assets = Liabilities + Capital
At any point in time, an entity’s total assets must equal its total liabilities and equity.

Variations of the basic equation are as follows:

Assets – Liabilities = Capital
Assets – Capital = Liabilities

Note that the assets are on the left side of the equation opposite the liabilities and owner’s equity.
This explains why increases and decreases in assets are recorded in the opposite manner (“mirror
image”) as liabilities and owner’s equity.

The equation also explains why liabilities and owner’s equity follow the same rules of debit and
credit.

The logic of debiting and crediting is related to the accounting equation, the equality must
always be maintained.

ACCOUNTING EVENTS AND TRANSACTIONS

 Accountants observe many events that they identify, and measure in financial terms.
 An accounting event is an economic occurrence that causes changes in an enterprise’s
assets, liabilities and/or equity.
 Accounting events may be internal actions, such as the use of equipment for the
production of goods or services. It can also be an external event, such as purchase of raw
materials from supplier.
 A transaction is a particular kind of event that involves the transfer of something of value
between two entities.
 Transactions include acquiring assets from owner/s, borrowing funds from creditors, and
purchasing or selling of goods or services.

The Account
The account is the basic summary device of accounting. A separate account is maintained for
each class of transactions affecting an element appearing in the balance sheet (assets, liabilities,
and capital/equity) and income statement (income and expenses). An account serves as a detailed
record of the increases, decreases, and balance of each class of transactions.
Examples of accounts are as follows:

Asset accounts:
Cash, accounts receivable, prepaid expenses, equipment
Liability accounts:
Accounts payable, notes payable
Capital/equity accounts:
Owner’s capital, drawing
Income accounts:
Professional fees, Rent income
Expense accounts:
Salaries expenses, Supplies expense

The simplest form of the account is the T account, so named since it looks like a letter “T”. It has
three parts, as follows:

Account Title (e.g., Cash)

 Left side or Debit side
 Right side or Credit side

TYPICAL ACCOUNT TITLES USED

STATEMENT OF FINANCIAL POSITION
ASSETS should be classified into two:
 Current Assets, and
 Non-current Assets

Current Assets
Cash is any medium of exchange that a bank will accept for deposit at face value. It includes
coins, currency, checks, money orders, bank deposits and drafts.
Cash Equivalents are short term, highly liquid investments that are readily convertible to known
amounts of cash and which are subject to an insignificant risk of changes in value.
Notes Receivable is a written pledge that the customer will pay the business a fixed amount of
money on a certain date,
Accounts Receivable are claims against customers arising from sale of services or good on credit.
This type of receivable offers less security than promissory note.
Inventories are assets which are (a) held for sale in the ordinary course of business; (b) in the
process of production for such sale; or (c) in the form of materials or supplies to be consumed in
the production process or in the rendering of services.
Prepaid Expenses are expenses paid for in advance by the business. It is an asset because the
business avoids having to pay cash in the future for a specific expense. These include insurance
and rent. These prepaid items (Insurance and rent) represent future economic benefits (asset),
until the time these start to contribute to the earning process, these then become expenses.
Non-current Assets
Property, Plant and Equipment are tangible assets that are held for use of the enterprise in the
production or supply of goods or services, or for rental to others, or for administrative purposes
and which are expected to be used during more than one period. Included are such items as land,
building, machinery and equipment, furniture and fixtures, motor vehicle and equipment.
Accumulated Depreciation is a contra account that contains the sum of the periodic depreciation
charges. The balance in this account is deducted from the cost of the related asset such as
building or equipment to obtain book value.
Intangible Asset are identifiable, nonmonetary assets without physical substance held for use in
the production or supply of goods or services, for rental to others, or for administrative purposes.
These include goodwill, patents, copyrights, licenses, franchises, brand names, secret processes,
subscription lists and non-competition agreements.

LIABILITIES should be classified into two:

 Current Liabilities, and
 Non-current Liabilities

Operating cycle is the time between the acquisition of assets for processing and their realization
in cash or cash equivalents. When the entity’s normal operating cycle is not clearly identifiable,
it is assumed to be twelve months.
Current Liabilities
Accounts Payable represents the reverse of account receivable. By accepting the goods or
services, the buyer agrees to pay for them in the near future.
Notes Payable is like note receivable but in a reverse sense. In the case of note payable, the
business entity is the maker of the note that is the business entity is the party who promises to
pay the other party a specified amount of money on a specified future date.
Accrued Liabilities are amounts owed for unpaid expenses.
Unearned Revenues are payments received by the entity in advance before providing its
customers with goods or services. The amounts received as advance payment from customers are
recorded in the unearned revenue account (liability method). When the goods or services are
provided to the customer, the unearned revenue account is reduced and income is recognized.
Current Portion of Long-Term Debt are portions of mortgage notes, bonds and other long-term
indebtedness which are to be paid within one year from the balance sheet date.
Non-current Liabilities
Mortgage Payable records long-term debt of the business entity for which the business entity has
pledge certain assets as security to the creditor. In the event that the debt payments are not made,
the creditor can foreclose or cause the mortgage asset to be sold to enable the entity to settle the
claim.
Bonds Payable is a contract between the issuer and the lender specifying the terms of repayment
and the interest to be charged. Business organizations often obtain substantial sums of money
from lender to finance the acquisition of machinery and other needed assets. They obtain these
funds by issuing bonds.

OWNER’S EQUITY
Capital is used to record the original and additional investments of the owner of the business
entity. It is increased by the amount of profit earned during the year or is decreased by a loss.
Cash or other assets that the owner withdraw from the business ultimately reduce it. This account
title bears the name of the owner.
Withdrawals is an account used to record drawings of the owner rather than directly reducing the
owner’s equity account.
Income Summary is a temporary account used at the end of the accounting period to close
income and expenses. This account shows the profit or loss for the period before closing to the
capital account.
 INCOME STATEMENT
INCOME
Service Income are revenues earned by performing services for a customer or client. Example,
accounting services by a CPA firm, legal services by a lawyer and laundry services by a laundry
shop.
Sales are revenues earned as a result of sale of merchandise. Example, sale of building materials
by a construction supplies firm.

EXPENSES
Cost of Sales are costs incurred to purchase or to produce the products sold to customers during
the period. It is also called Cost of Goods Sold. These include salaries or wages, 13th month pay,
cost of living allowance and other related benefits.
Salaries or Wages Expense includes all payments as a result of an employer-employee
relationship.
Telecommunications, Electricity, Fuel and Water Expenses are related to the use of
telecommunication facilities, consumption of electricity, fuel and water.
Rent Expense is for the use of space, equipment or other asset rentals.
Supplies Expense is the cost of supplies used in the conduct of daily business.
Insurance Expense is the portion of premiums paid on insurance coverage (on motor vehicle,
building, fire, typhoon or flood, health, or life) which has expired.
Depreciation Expense is the portion of the cost of tangible assets allocated or charged as expense
during the accounting period.
Uncollectible Accounts Expense is the amount of receivables estimated to be doubtful of
collection and charged as expense during an accounting period.
Interest Expense is an expense related to borrowed funds.

THE DUAL EFFECTS OF TRANSACTION

The dual effect principle is the foundation or basic principle of accounting. It provides the very
basis for recording business transactions into the records of a business. This concept states that
every transaction has a dual or double effect and should therefore be recorded in two places.
This is the beginning of the double entry book keeping system.
 FINANCIAL TRANSACTON WORKSHEET
Every financial transaction can be analyzed or expressed in terms of its effects on the accounting
equation. The financial transactions will be analyzed by means of a financial transaction
worksheet which is a form used to analyzed increases and decreases in the assets, liabilities or
owner’s equity of a business entity.

THE DOUBLE-ENTRY SYSTEM

The logic of debiting and crediting is related to the accounting equation, the equality must
always be maintained. Accounting is based on a double-entry system which means that the dual
effect of business transaction is recorded. A debit side entry must have a corresponding credit
side entry. Each transaction affects at least two accounts. The total debits for a transaction must
always equal the total credits.
 An account is debited when an amount is entered on the left side of account.
 Credited when the amount is entered on the right side of the account.

The Rules of Debit and Credit

The account determines how increases or decreases in it are recorded.
The normal balance of any account refers to the side of the account, either debit or credit as to
where increases are recorded. Assets\, owner’s withdrawal and expense accounts normally have
debit balances; while liability, owner’s equity and income accounts normally have credit
balances.
THE DRAWING ACCOUNT
The drawing account is an accounting record used in a business organized as a sole
proprietorship or a partnership, in which is recorded all distributions made to the owners of the
business. They are, in effect, "drawing" funds from the business.

THE USE OF THE T-ACCOUNTS

Analyzing and recording transactions using the accounting equation is useful in conveying a
basic understanding of how transactions affect the business. However, it is not an efficient
approach once the number of accounts involved increases. Double-entry system provides a
formal system of classification and recording business transactions.
 ACCOUNTING CYCLE
The accounting cycle refers to a series of sequential steps or procedures performed to accomplish
the accounting process. The steps in the cycle and their aims follow:
Step 1. Identification of events to be recorded
Aim: To gather information about transactions or events generally through the source
documents.

Step 2. Transactions are recorded in the journal.

Aim: To record the economic impact of transactions on the firm in a journal, which is a form
that facilitates transfer to the accounts.
Step 3. Journal entries are posted to the ledger.
Aim: To transfer the information from the journal to the ledger for classification.

Step 4. Preparation of a Trial Balance.

Aim: To provide a listing to verify the equality of debits and credits in the ledger.

Step 5. Preparation of the Worksheet including adjusting entries.

Aim: To aid in the preparation of the financial statements.

Step 6. Preparation of the financial statements.

Aim: To provide useful information to decision-makers.

Step 7. Adjusting journal entries are journalized and posted.

Aim: To record the accruals, expiration of deferrals estimation and other events from the
worksheet.

Sept 8. Closing journal entries are journalized and posted.

Aim: To close temporary accounts and transfer profit to owner's equity.
Step 9. Preparation of a post-closing trial balance.
Aim: To check the equality of debits and credits after the closing entries.

Step 10. Reversing journal entries are journalized and posted.

Aim: To simplify the recording of certain regular transactions in the next accounting period.
This cycle is repeated each accounting period.

Step 1. TRANSACTION ANALYSIS

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

SOURCE DOCUMENTS
Transactions and events are the starting points in the accounting cycle.
 Source documents identify and describe transactions and events entering the accounting
process.
 Transactions and events are the starting points in the accounting cycle.
 Relying on source documents, transactions and events can be analyzed as to how they
will affect performance and financial position.
 Source documents identify and describe transactions and events entering the accounting
process.
These original written evidences contain information about the nature and the amounts of the
transactions. These are the bases for the journal entries; some of the more common source
documents are sales invoices, cash register tapes, official receipts, bank deposit slips, bank
statements, checks, purchase orders, time cards and statements of account.
 THE GENERAL JOURNAL AND GENERAL LEDGER
 Relying on source documents, transactions and events can be analyzed as to how they
will affect performance and financial position.
 Source documents identify and describe transactions and events entering the accounting
process.
These original written evidences contain information about the nature and the amounts of the
transactions. These are the bases for the journal entries; some of the more common source
documents are sales invoices, cash register tapes, official receipts, bank deposit slips, bank
statements, checks, purchase orders, time cards and statements of account.

THE JOURNAL
 A chronological record of the entity’s transactions.
 Shows all the effects of a business transaction in terms of debits and credits.
 Each transaction is initially recorded in a journal rather than directly in the ledger.
 A journal is called the book of original entry.
Format.
The standard contents of the general journal are as follows:

1. Date. The year and month are not rewritten for every entry unless the year or month
changes or a new page is needed.
2. Account Titles and Explanation. The account to be debited is entered at the extreme left
of the first line while the account to be credited is entered slightly indented on the next
line. A brief description of the transaction is usually made on the line below the credit.
Generally, skip a line after each entry.
3. Posting Reference (PR). This will be used when the entries are posted, that is, until the
amounts are transferred to the related ledger accounts.
4. Debit. The debit amount for each account is entered in this column.
5. Credit. The credit amount for each account is entered in this column.

SIMPLE AND COMPOUND ENTRY

In a simple entry, only two accounts are affected, one account is debited and the other accounted
is credited. An example of this is the entry to record the initial investment of Perez-Manalo.
However, some transactions require the use of more than two accounts. When there are three or
more accounts required in a journal entry, the entry is referred to as a compound entry.
STEP 2. TRANSACTIONS ARE JOURNALIZED
After the transaction or event has been identified and measured, it is recorded in the journal. The
process of recording a transaction is called journalizing. To understand the nature of the affected
accounts, the letter A (for asset), L (liability) OE (owner's equity) is inserted after each entry. In
addition, owner's equity is further classified into OE: I (income) and OE: E (expenses).

Note that the rules of double-entry system are observed in each transaction:
1. Two or more accounts are affected by each transaction.
2. The sum of the debits for every transaction equals the sum of the credits.
3. The equality of the accounting equation is always maintained.

THE LEDGER
 A grouping of the entity's accounts is referred to as a ledger.
 It is called the "reference book" of the accounting system and is
 It is used to classify and summarize transactions, and to prepare data for basic financial
statements.
The accounts in the general ledger are classified into two general groups:
1. Balance sheet or permanent accounts (assets, liabilities and owner's equity).
2. Income statement or temporary accounts (income and expenses). Temporary or nominal
accounts are used to gather information for a particular accounting period. At the end of
the period, the balances of these accounts are transferred to a permanent owner's equity
account.

Each account has its own record in the ledger. Every account in the ledger maintains the basic
format of the T-account but offers more information (e.g. the account number at the upper right
corner and the journal reference column). Compared to a journal, a ledger organizes information
by account.

CHART OF ACCOUNTS
 A listing of all the accounts and their account numbers in the ledger is known as the chart
of accounts.
 The chart is arranged in the financial statement order, that is, assets first, followed by
liabilities, owner's equity, income and expenses.
 The accounts should be numbered in a flexible manner to permit indexing and cross-
referencing.
When analyzing transactions, the accountant refers to the chart of accounts to identify the
pertinent accounts to be increased or decreased. If an appropriate account title is not listed in the
chart, an additional account may be added.

Step 3. POSTING

Posting means transferring the amounts from the journal to the appropriate accounts in the
ledger. Debits in the journal are posted as debits in the ledger, and credits in the journal as credits
in the ledger. The steps are as follows:
1. Transfer the date of the transaction from the journal to the ledger.
2. Transfer the page number from the journal to the journal reference (J.R.) column of the
ledger.
3. Post the debit figure from the journal as a debit figure in the ledger and the credit figure
from the journal as a credit figure in the ledger.
4. Enter the account number in the posting reference column of the journal once the figure
has been posted to the ledger.

LEDGER ACCOUNTS AFTER POSTING

At the end of an accounting period, the debit or credit balance of each account must be
determined to enable us to come up with a trial balance.
 Each account balance is determined by footing (adding) all the debits and credits.
 If the sum of an account's debits is greater than the sum of its credits, that account has a
debit balance.
 If the sum of its credits is greater, that account has a credit balance.

Step 4. TRIAL BALANCE

The trial balance is a list of all accounts with their respective debit or credit balances. It is
prepared to verify the equality of debits and credits in the ledger at the end of each accounting
period or at any time the postings are updated. The procedures in the preparation of a trial
balance follow:
1. List the account titles in numerical order.
2. Obtain the account balance of each account from the ledger and enter the debit balances
in the debit column and the credit balances in the credit column.
3. Add the debit and credit columns.
 4. Compare the totals.
The trial balance is a control device that helps minimize accounting errors. When the totals are
equal, the trial balance is in balance. This equality provides an interim proof of the accuracy of
the records but it does not signify the absence of errors. For example, if the bookkeeper failed to
record payment of rent, the trial balance columns are equal but in reality, the accounts are
incorrect since rent expense is understated and cash overstated.

LOCATING ERRORS
An inequality in the totals of the debits and credits would automatically signal the presence of an
error. These errors include:
1. Error in posting a transaction to the ledger:
a) An erroneous amount was posted to the account
b) A debit entry was posted as a credit or vice versa.
c) A debit or credit posting was omitted.

2. Error in determining the account balances:

a) A balance was incorrectly computed.
b) A balance was entered in the wrong balance column.

3. Error in preparing the trial balance:

a) One of the columns of the trial balance was incorrectly added.
b) The amount of an account balance was incorrectly recorded on the trial balance.
c) A debit balance was recorded on the trial balance as a credit or vice versa, or a
balance was omitted entirely.

What is the most efficient approach in locating an error?

The following procedures when done in sequence may save considerable time and effort in
locating errors:
1. Prove the addition of the trial balance columns by adding these columns in the opposite
direction.
2. If the error does not lie in addition, determine the exact amount by which the trial balance
is out of balance. The amount of the discrepancy is often a clue to the source of the error.
If the discrepancy is divisible by 9, this suggests either a transposition (reversing the
order of numbers) error or a slide (moving of the decimal point).
3. Compare the accounts and amounts in the trial balance with that in the ledger. Be certain
that no account is omitted.
4. Recompute the balance of each ledger account.
 5. Trace all postings from the journal to the ledger accounts. As this is done, place a check
mark in the journal and in the ledger after each figure is verified. When the operation is
completed, look through the journal and the ledger for unchecked amounts. In tracing
postings, be alert not only for errors in amount but also for debits entered as credits, or
vice versa.

It is also advisable to look over the transactions for an item of the exact amount of the
discrepancy. An error may have been made by recording the debit side of the transaction and
forgetting to enter the credit side.

Note that even when a trial balance is in balance, the accounting records may still contain
errors. A balanced trial balance simply proves that, as recorded, debits equal credits. The
following errors are not detected by a trial balance:

1. Failure to record or post a transaction.

2. Recording the same transaction more than once.
3. Recording an entry but with the same erroneous debit and credit amounts.
4. Posting a part of a transaction correctly as a debit or credit but to the wrong account.

TWO BASIC ACCOUNTING METHODS

1. ACCRUAL BASIS
 The effects of transactions and other events are recognized when they occur and not as
cash or its equivalent is received or paid.
 The financial statements, except for the cash flow statement, are prepared on the accrual
basis of accounting.
 Financial statements prepared on the accrual basis inform users not only of past
transactions involving the payment and receipt of cash, but also of obligations to pay cash
in the future, and of resources that represent cash to be received in the future.
 Generally accepted accounting principles require that a business use the accrual basis.

2. CASH BASIS
 Transactions are not recorded until cash is received or paid.
 Generally, cash receipts are treated as revenues and cash payments as expenses.
 PERIODICITY CONCEPT
Accounting information is valued when it is communicated early enough to be used for
economic decision-making. To provide timely information, the economic life of a business is
divided into artificial time period.
This assumption is referred to as the periodicity concept.
Accounting periods are generally a month, a quarter, or a year. The most basic accounting
period is one year.
Entities differ in their choice of the accounting year – fiscal, calendar or natural.
 A fiscal year is a period of any twelve consecutive months.
 A calendar year is an annual period ending on December 31.
 A natural business year is a twelve-month period that ends when business activities are at
their lowest level of the annual cycle.
 An interim period is less than a year.
Businesses need periodic reports to assess their financial condition and performance. The
periodicity concept ensures that accounting information is reported at regular intervals. It
interacts with the revenue recognition and expense recognition principles to underlie the use of
accruals. To measure profit in a fair manner, entities update the income and expense accounts
immediately before the end of the period.

REVENUE AND EXPENSE RECOGNITION PRINCIPLES

The process of measuring the performance of an entity requires that certain income and expense
transactions be allocated over several accounting periods. The adjustment process relies on the
revenue recognition and expense recognition principles.
Revenue is recognized when it is probable that economic benefits will flow to the enterprise
and these economic benefits can be measured reliably. It shall be measured at the fair value
of the consideration received or receivable. In most cases, revenue is earned in the accounting
period when the services are rendered or the goods are delivered.

Expense recognition principle is the basis for recording expenses. Expenses are recognized
in the income statement when it is probable that a decrease in future economic benefits related to
a decrease in an asset or an increase of a liability has arisen, and that the decrease in economic
benefits can be measured reliably.
RECOGNITION AND DERECOGNITION
Per 2018 Conceptual Framework, recognition is the process of capturing for inclusion in the
statement of financial position or the statement(s) of financial performance as item that meets the
definition of an asset, a liability, equity, income or expenses. The amount at which an asset, a
liability or equity is recognized in the statement of financial position is referred to as its
“carrying amount’.

The statement of financial position and statement(s) of financial performance depict an entity’s
recognized assets, liabilities, equity, income and expenses in structured summaries that are
designed to make financial information comparable and understandable.

Recognition links the elements, the statement of financial position and the statement(s) of
financial performance. The statements are linked because the recognition of one item (or a
change in its carrying amount) requires the recognition or derecognition of one or more other
items (or changes in the carrying amount of one or more other items). For example:

The recognition of income occurs at the same time as:

 The initial recognition of an asset, or an increase in the carrying amount of an asset; or
 The derecognition of a liability, or a decrease in the carrying amount of a liability.

The recognition of expenses occurs at the same time as:

 The initial recognition of a liability, or an increase in the carrying amount of a liability; or
 The derecognition of an asset, or a decrease in the carrying amount of an asset.

The initial recognition of assets or liabilities arising from transactions or other events may
result in the simultaneous recognition of both income and related expenses. For example:

 The sale of goods for cash results in the recognition of both income (from the recognition
of the one asset, the cash);
 An expense (from the derecognition of another asset, the goods sold).

The simultaneous recognition of income and related expenses is sometimes referred to as the
matching of costs with income.
Recognition is appropriate if it results in both relevant information about assets, liabilities,
equity, income and expenses and a faithful representation of those items, because the aim is to
provide information that is useful to investors, lenders and other creditors.

Derecognition is the removal of all or part of a recognized asset or liability from an entity’s
statement of financial position. Derecognition normally occurs when that item no longer meets
the definition of an asset or of a liability:
 For an asset, derecognition normally occurs when the entity loses control of all or part of
the recognized assets; and
 For a liability, derecognition normally occurs when the entity no longer has a present
obligations for all or part of the recognized liability.

NEED FOR ADJUSTMENTS

Adjusting entries are made to reflect in the accounts information on economic activities that have
occurred but have not yet been recorded. Adjusting entries assign revenues to the period in
which they are earned, and expenses to the period in which they are incurred. These entries are
needed to measure properly the profit for the period, and to bring related asset and liability
accounts to correct balances for the financial statements.

Adjustments are needed to ensure that revenue recognition and expense recognition principles
are followed thus resulting to financial statements reporting the effects of all transactions at the
end of the period.

Adjusting entries involve changing account balances at the end of the period from what is the
current balance of the account to what is the correct balance for proper financial reporting.
Without adjusting entries, financial statements may not fairly show the solvency of the entity in
the balance sheet and the profitability in the income statement.

DEFERRALS AND ACCRUALS

There are two general types of adjustments made at the end of the accounting period:
Deferrals is the postponement of the recognition of “an expense already paid but not yet
incurred”, or of “a revenue already collected but not yet earned”. This adjustment deals with an
amount already recorded in the balance sheet account; the entry in effect, decreases the balance
sheet account and increases an income statement account.
Deferrals would be needed in two cases:
1. Allocating assets to expense to reflect expenses incurred during the accounting period, e.
g. prepaid insurance, supplies,
2. Allocating revenues received in advance to revenue to reflect revenues earned during the
accounting period, e. g. subscriptions.

Accrual is the recognition of “an expense already incurred but unpaid”, or “revenue earned but
uncollected”. This adjustment deals with an amount unrecorded in any account; the entry, in
effect, increases both the balance sheet and an income statement account.

Accruals would be required in two cases:

1. Accruing expenses to reflect expenses incurred during the accounting period that are
unpaid and unrecorded.
2. Accruing revenues to reflect revenues earned during the accounting period that are
uncollected and unrecorded.

Step 5: ADJUSTMENTS FOR DEFERRALS

Allocating Assets to Expenses

Entities often make expenditures that benefit more than one period. These expenditures are
generally debited to an asset account. At the end of each accounting period, the estimated
amount that has expired during the period or that has benefited the period is transferred from the
asset account to an expense account. Two of the more important kinds of adjustments are
prepaid expenses, and depreciation of property and equipment.

Prepaid Expenses
Some expenses are customarily paid in advance. These expenditures include supplies, rent, and
insurance, and they are called prepaid expenses. Prepaid expenses are assets, not expenses. At
the end of the accounting period, a portion or all of these prepayments may have expired. The
portion of an asset that has expired becomes an expense. Prepaid expenses expire either with the
passage of time or through use and consumption.
If adjustments for prepaid expenses are not made at the end of the period, both the balance sheet
and the income statement will be misstated. First, the assets of the entity will be overstated;
second the expenses of the company will be understated. For this reason, the owner’s equity in
the balance sheet and profit in the income statement will both be overstated.
Depreciation of Property and Equipment
When an entity acquires long-lived assets such as buildings, service vehicles, computers or office
furniture, it is basically buying or prepaying for the usefulness of that asset. These assets help
generate profit for the entity. Therefore a portion of the cost of the assets should be reported as
expense in each accounting period. Proper accounting requires the allocation of the cost of asset
over its estimated useful life. The estimated amount allocated to any one accounting period is
called depreciation or depreciation expense.

Three factors are involved in computing depreciation expense:

1. Asset cost is the amount an entity paid to acquire the depreciable asset.
2. Estimated salvage value is the amount that the asset can probably be sold for at the end
of its estimated useful life.
3. Estimated useful life is the estimated number of periods that an entity can make use of
the asset. Useful life is an estimate, not an exact measurement.

Accountants estimate periodic depreciation. They have developed a number of methods for
estimating depreciation. The simplest procedure is the straight-line method. The formula for
determining the amount of depreciation expense for each period using this method is:

When recording depreciation expense, the asset account is not directly reduced. Instead, the
reduction is recorded in a contra account called accumulated depreciation. A contra account is
used to record reductions in a related account and its normal balance is opposite that of the
related account. Use of the contra account, accumulated depreciation allows the disclosure of the
original cost of the related asset in the balance sheet. The balance of the contra account is
deducted from the cost to obtain the book value of the property and equipment.

Allocating Revenues Received in Advance to Revenues

There are times when an entity receives cash for services or goods even before service is
rendered or goods are delivered. When such is received in advance, the entity has an obligation
to perform services or deliver goods. The liability referred to is unearned revenue.
For example, publishing companies usually receive payments for magazine subscriptions in
advance. These payments must be recorded in a liability account. If the company fails to deliver
the magazines for the subscription period, subscribers are entitled to a refund. As the company
delivers each issue of the magazine, it earns a part of the advance payment. This earned portion
must be transferred from the unearned subscription revenues account to the subscription
revenues account.

Step 5: ADJUSTMENTS FOR ACCRUALS

Accrued Expenses
An entity often incurs expenses before paying for them. Cash payments are usually made at
regular intervals of time such as weekly, monthly, quarterly or annually. If the accounting period
ends on a date that does not coincide with the scheduled cash payment date, an adjusting entry is
needed to reflect the expense incurred since the last payment. This adjustment helps the entity
avoid the impractical preparation of hourly or daily journal entries just to accrue expenses.
Salaries, interest, utilities, and taxes are examples of expenses that are incurred before payment
is made.

Note: In computing for length of time, usually exclude the day that loans occur and include the
day that loans are paid off.

Accrued Revenues
An entity may provide services during the period that are neither paid for by clients nor billed at
the end of the period. The value of these services represents revenue earned by the entity. Any
revenue that has been earned but not recorded during the accounting period calls for an adjusting
entry that debits an asset account and credits an income account.

ACCRUAL FOR UNCOLLECTIBLE ACCOUNTS

Entities often allow clients to purchase goods or avail of services on credit. Some of these
accounts will never be collected, hence, there is a need to reflect these as charges against
income. In practice, an expense is recognized for the estimated uncollectible accounts in the
current period, rather than when specific accounts actually become uncollectible. This practice
produces a better matching of income and expenses.
Estimates of uncollectible accounts may be based on:
 Credit sales for the period; or
 Accounts receivable balance.

EFFECTS OF OMITTING ADJUSTMENTS

When proper adjusting entries are not made, the resulting financial statements will not accurately
reflect the financial position and the performance of the entity. Inaccuracies in one accounting
period can cause further inaccuracies in the statements of subsequent periods.

ANALYSIS USING T-ACCOUNTS

To recapitulate, each adjusting entry affects a balance sheet account (an asset or a liability
account) and an income statement account (an income or an expense account). Almost every
revenue or expense account on the income statement has one or more related accounts on the
statement of financial position. For instance, rent expense is related to prepaid rent, supplies
expense to supplies, service revenue to unearned service revenue and salaries expense to salaries
payable.

Having been apprised of these relationships, transactions affecting particular accounts can now
be analyzed using T-accounts. This learning with be of use in reconstructing accounts to derive
details like cash inflow, cash outflows, revenue recognized for the period or expenses charged
for the period.

ALTERNATIVE METHODS OF RECORDING DEFERRALS

All transactions that required adjustments are initially recorded in the balance sheet accounts. A
prepaid expense is initially recorded in a prepaid asset account. Likewise, revenue received in
advance is initially recorded in a liability account, unearned revenues. In the case of a prepaid
expense, an adjusting entry is made at the end of the period to transfer the portion of the expired
asset to an expense account. Similarly, an adjusting entry is made to transfer earned revenues
from the liability account to an income account.
 THE WORKSHEET
It is multi-column document which provides an efficient way to summarize the data for financial
statements preparation.

Importance of the Worksheet

 It aids in the transfer of data from the unadjusted trial balance to the financial statement.
 It simplifies the adjusting and closing process.
 It reveals errors.
 It is a summary device that ease the work of the accountant in the preparation of the
financial statements.

Step 5. PREPARING THE WORKSHEET

The steps in the preparation of a worksheet are:
1. Enter the account and balances in the unadjusted trial balance columns and total the amounts.
a. The account numbers, titles and balances are lifted from the general ledger to the
unadjusted trial balance.
b. The accounts are listed in the worksheet in the order in the general ledger.
c. Accounts with zero balances are also presented.
d. Total debits and total credits must equal.

2. Enter the adjusting entries in the adjustments columns and total the amounts.
3. Compute each account’s adjusted balance by combining the unadjusted trial balance and the
adjustment figures. Enter the adjusted amounts in the adjusted trial balance.The adjusted trial
balance is prepared by combining horizontally, line by line, the amount of each account in the
unadjusted trial balance columns with the corresponding amounts in the adjustment columns.
The procedure is called cross-footing.
4. Extend the asset, liability and owner’s equity amounts from the adjusted trial balance columns
to the balance sheet columns. Extend the income and expense amounts to the income statement
columns. Total the columns.
Every account is either a balance sheet account or an income statement account. Asset, liability,
capital, and withdrawal accounts are extended to the balance sheet columns. Income and expense
accounts are moved to the income statement columns. Debits in the adjusted trial balance remain
as debits in the statement columns, while credits as credits. Each account’s adjusted balance
should appear in only one statement column. At this stage, the initial totals of the income
statement and balance sheet columns are not equal.

Compute for profit or loss as the difference between total revenues and total expenses in the
income statement. Enter profit or loss as a balancing amount in the income statement, and in the
balance sheet, and compute the final column totals. Profit or loss is equal to the difference
between the debit and credit columns of the income statement.

The profit or loss should always be the amount by which the debit and credit columns for income
statement, and the debit and credit columns for the balance sheet differ. The profit figure is
entered in debit column of the income statement and credit column of the balance sheet. After
completion, total debits and total credits in the income statement and balance sheet columns must
equal. The profit figure is extended to the credit column of the balance sheet because profit
increases owner’s equity and increases in owner’s equity are recorded as credits. Profit must be
added and withdrawals subtracted to arrive at the ending capital balance; this is done when the
statement of changes in equity is prepared.

ESSENCE OF FINANCIAL STATEMENTS

 It is the means by which the information accumulated and processed in financial
accounting is periodically communicated to the users.
 Sound economic decisions are based from the accounting information embodied in the
financial statement.
 It provides information about the financial position, financial performance, and cash
flows of an entity.

COMPLETE SET OF FINANCIAL STATEMENTS

Per revised Philippine Accounting Standards (PAS) No. 1, a complete set of financial statements
comprises:
1. Statement of financial position as at the end of the period;
2. Statement of comprehensive income for the period;
3. Statement of changes in equity for the period;
4. Statement of cash flows for the period;
5. Notes, comprising a summary of significant accounting policies and other explanatory
information; and
6. Statement of financial position as at the beginning of the earlier comparative period when
an entity applies an accounting policy retrospective restatement of items in its financial
statements or when it reclassifies items in its financial statements.
In a nutshell,
 Statement of Financial Position (or Balance Sheet) lists all the assets, liabilities and
equity of an entity as at a specific date.
 Statement of Financial Performance (or Income Statement) presents a summary of
revenues and expenses of an entity for a specific period.
 Statement of Changes in Equity presents a summary of the changes in capital such as
investments, profit or loss, and withdrawals.
 Statement of Cash Flows reports the amount cash received and disbursed during the
period.
 Notes to Financial Statements provide narrative descriptions or disaggregation of items
presented in the statement and information about them that do not qualify for recognition
in the statements.

Step 6. PREPARING THE FINANCIAL STATEMENTS

Statement of Financial Performance
An entity can present all items of income and expenses recognized in a period:
 In a single statement of comprehensive income, or
 In two statements:
o A statement displaying components of profit or loss (separate income statemen),
and
o A second statement beginning with profit or loss and displaying components of
other comprehensive income.

The 2018 Conceptual Framework does not specify whether the statement(s) of financial
performance comprise(s) a single statement or two statements. The discussion will zero in on the
separate income statement portion because the other line items comprising the statement of
comprehensive income will be tackled in higher accounting because of their complexity. The
income statement is a formal statement showing the performance of the enterprise for a given
period of time. It summarizes the revenues earned and expenses incurred for that period of time.

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

assess potential changes in the economic resources that is likely to be controlled in the future. It
is also useful in predicting the capacity of the enterprise to generate cash flows from its existing
resource base.
Statement of Changes in Equity
The statement of changes in equity summarizes the changes that occurred in owner’s equity. This
statement is now a required statement (per revised Philippine Accounting Standards (PAS) No.
1). Changes in an enterprise’s equity between two balance sheet dates reflect the increase or
decrease in its net assets during the period.

In the case of sole proprietorships, increases in owner’s equity arise from

 Additional investments by the owner, and
 Profit during the period.

While decreases in owner’s equity result from:

 Withdrawals of the owner, and
 Loss for the period.
The beginning balance and additional investments are taken from the owner’s capital account in
the general ledger. The profit or loss figure comes directly from the income statement while
withdrawals from the balance sheet columns in the worksheet.

Statement of Financial Position

The statement of financial position is a statement that shows the financial position or condition
of an entity by listing the assets, liabilities and owner’s equity as at a specific date. The
information needed for the balance sheet items are the net balances at the end of the period,
rather than the total for the period as in the income statement. This statement is also called the
balance sheet.
Users of financial statements analyze the balance sheet to evaluate an entity’s liquidity, its
financial flexibility, and its ability to generate profits, and its solvency.
 Liquidity refers to the availability of cash in the near future after taking into account the
financial commitments over this period.
 Financial flexibility is the ability to take effective actions to alter the amounts and
timings of cash flows so that it can respond to unexpected needs and opportunities. This
includes the ability to raise new capital or tap into unused lines of credit.
 Solvency refers to the availability of cash over the longer terms to meet financial
commitments as they fall due.
In preparing the balance sheet, it may be necessary to make further analysis of the data. The
needed data ae the balances of asset, liability, and owner’s equity accounts, are available from
the balance sheet columns of the worksheet. However, the interim balance for owner’s equity
must be revised to include profit or loss and owner’s withdrawals for the accounting period. The
adjusted amount for ending owner’s equity is shown in the statement of changes in equity.

Format
The balance sheet can be presented in either of the following:
 Report format simply lists the assets, followed by the liabilities then by the owner’s
equity in vertical sequence.
 Account format lists the assets on the left and the liabilities and owner’s equity on the
right.
Note: Either balance sheet format is acceptable.

Classification
The revised PAS No. 1 does not prescribe the order or format in which an entity presents items
in the statement of financial position; what is required is the current and non-current distinction
for assets and liabilities. Assets can be presented current then non-current or vice versa.
Liabilities and equity can be presented current then non-current liabilities then equity, or vice-
versa.

It is proper to present a classified balance sheet: that is, the assets and liabilities are separated
into various categories. Assets are sub-classified as current assets and non-current assets; while
liabilities as current liabilities and non-current liabilities. At this point, it is advisable to review
the definitions of the foregoing (refer to Module 2). Classifying a balance sheet aids in the
analysis of financial statements data.

When presentation based on liquidity provides accounting information that is reliable and more
relevant to decision-makers then an entity shall present all assets and liabilities in order of
liquidity. For example,
 Assets are classified and presented in decreasing order of liquidity. Cash is the most
liquid. Assets that are least likely to be converted to cash are listed last.
 Liabilities are generally classified and presented based on time of maturity such that
obligations which are currently due are listed first.
Statement of Cash Flows
The statement of cash flows provides information about the cash receipts and cash payments of
an entity during a period. It is a formal statement that classifies cash receipts (inflows) and cash
payments (outflows) into operating, investing and financing activities. This statement shows the
net increase or decrease in cash during the period and the cash balance at the end of the period; it
also helps project the future net cash flows of the entity. Statement of Changes in Equity will be
discussed in higher accounting.

RELATIONSHIPS AMONG THE FINANCIAL STATEMENTS

The financial statements are based on the same underlying data and are fundamentally related.
The following shows the basic interrelationships among financial statements:

1. The income statement reports all income and expenses during the period. The profit or
loss is the final figure in this statement.
2. The statement of changes in equity considers the profit or loss figure from the income
statement as one of the determining factors that explain the changes in owner’s equity.
3. The statement of financial position reports the ending owner’s equity, taken directly from
the statement of changes in equity.
4. The statement of cash flows reports the net increase or decrease in cash during the period
and ends with the cash balance reported in the balance sheet. This statement is prepared
on information from the income statement and the balance sheet.
Step 7. ADJUSTMENTS ARE JOURNALIZED AND POSTED
The adjustment process is a key element of accrual basis accounting. The worksheet helps in the
identification of the accounts that need adjustments. The adjusting entries are directly entered in
the worksheet. Most accountant prepare the financial statements immediately after completing
the worksheet. The adjustments are journalized and posted as the closing entries are made. This
step in the accounting cycle brings, the ledger into agreement with the data reported in the
financial statements.

Step 8. CLOSING ENTRIES ARE JOURNALIZED AND POSTED

Income, expense and withdrawal accounts are temporary accounts that accumulate information
related to a specific accounting period. These temporary accounts facilitate income statement
preparation. At the end of each year, the balances of these temporary accounts are transferred to
the capital account. Thus, the balance of the owner’s capital account represents the cumulative
net result of income, expense and withdrawal transactions. This phase of the cycle is called the
closing procedure.

1. Close the income accounts

Income accounts have credit balances before the closing entries are posted. For this reason, an
entry debiting each revenue account in the amount of:

2. Close the expense accounts

Expense accounts have debit balances before the closing entries are posted. For this reason, a
compound entry is needed crediting each expense account for its balance and debiting the
income summary for the total. These data can be found in the debit side of the income statement
columns of the worksheet.
 3. Close the income summary account
After posting the closing entries involving income and expense accounts, the balance of the
income summary account will be equal to the profit or loss for the period. A profit is indicated
by a credit balance and a loss by the debit balance. The income summary account, regardless of
the nature of its balance, must be closed to the capital account.

4. Close the withdrawal account

The withdrawal account shows the amount by which capital is reduced during the period by
withdrawals of cash or other assets of the business by the owner for personal use. For this reason,
the debit balance of the withdrawal account must be closed to the capital account as follows:

Step 9. PREPARATION OF THE POST-CLOSING TRIAL BALANCE

It is possible to commit an error in posting the adjustments and closing entries to the ledger
accounts; thus, it is necessary to test the equality of the accounts by preparing a new trial
balance. This final trial balance is called a post-closing trial balance.
 The post-closing trial balance verifies that all the debits equal the credits in the trial
balance.
 The trial balance contains only balance sheet items such as assets, liabilities, and ending
capital because all income and expense accounts, as well as withdrawal account, have
zero balances.
Notice that only the balance sheet accounts have balances because at this point, all the income
statement accounts have been closed.
Step 10. REVERSING ENTRIES
Preparing the post-closing trial balance may not be the last step in the accounting cycle. Some
entities elect to reverse certain end-of-period adjustments on the first day of the new period. A
reversing entry is a journal entry which is the exact opposite of a related adjusting entry made at
the end of the period. It is basically a bookkeeping technique made to simplify the recording of
regular transactions in the next accounting period.

It should be emphasized that reversing entries are optional. Also, the act of reversing a
previously recorded adjusting entry should not lead us to the conclusion that the entries reversed
are unnecessary or inaccurate.

Even when an entity follows the policy of making reversing entries, not all adjusting entries
should be reversed. Generally, a reversing entry should be made for any adjusting entry that
increased an asset or a liability account. Therefore, all accruals are reversed but only deferrals
initially recorded in income statement, income or expenses accounts are reversed.

After analyzing the rest of the adjusting entries, the adjustments that can be reversed are as
follows: prepaid expenses (expense method), unearned revenues (income method), accrued
expenses and accrued expenses.

This step may appear easy in this simple case, but think of the problems that may ariseif the
company has many employees, especially if some of them are paid on different time schedules
such as weekly or monthly. A reversing entry is an accounting procedure that helps to solve this
difficult problem. As noted above, a reversing entry is exactly what its name implies. It is a
reversal of the adjusting entry made.