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Accounting Equation

The accounting system is an information system that uses


accounts to record and classify the financial effects of an entity'
transactions and events, summarize these effects, and report the
results in financial statements. Accounts ordinarily are classified in
accordance with the ff. equations:

Asset (ex. Prepaid Insurance)

xx

Unearned revenues (pre-collected or deferred revenues) - cash


received in advance by the company for the future sale of
inventory or services to be performed in the future. The
collection in advance is treated as a liability (using the liability
method) or as an income (using the income method), as
follows:

Assets = Liabilities + Equity


LIABILITY METHOD

INCOME METHOD

Equity = Contributed Capital + Retained Earnings


Retained Earnings = RE, Beginning of the period
+ Net income - Dividends +(-) Certain adjustments
Net income = Revenues - Expenses + Gains - Losses
Classification of Accounts
Permanent (real) accounts - asset, liability and equity accounts.
Temporary (nominal) accounts - revenues, expenses, gains,
losses, and dividends.
Key terms
Journal entries - record the financial effects of transactions and
events in the accounting system.
Adjusting entries - entries made as of the balance sheet date to
record the effects on periodic revenue and expense of
prepayments (prepaid expenses and unearned revenues) and
accruals (revenues earned but not yet received in cash and
expenses incurred but not yet paid in cash).
Types of Adjustments:
Accrued expenses - expenses already incurred but not yet paid.
Expense (e.g. Salaries & Wages Expense)
xxx
Liability (e.g. Salaries & Wages Payable)
xxx
Accrued revenues - income already earned but not yet collected.
Asset (e.g. Commission Receivable)
xxx
lncome (e.g. Commission Income)
xxx
Prepaid expenses - are items of goods or services purchased by
the company for use in its operations but not fully consumed or
used up by the entity at the end of the accounting period. When
goods or services are initially purchased, the cost is recorded
either as an asset (using the asset method) or as an expense
(using the expense method), as follows:
ASSET METHOD

EXPENSE METHOD

Journal entry upon payment for goods or services


Asset (ex. Prepaid Insurance) xx
Expense (ex. Insurance Expense) xx
Cash
xx
Cash
xx
Adjusting entry (end of the accounting period)
Expense (ex. Insurance Expense) xx
Asset (ex. Prepaid Insurance)
xx
Asset (ex. Prepaid Insurance)
xx
Expense (ex. Insurance Expense) xx
To take up the used portion of the item.
To take up the unused portion of the item
Reversing entry (beginning of the subsequent accounting period)
None
Expense (ex. Insurance Expense) xx

Journal entry upon cash collection in advance


Cash
xx
Cash
xx
Liability (ex. Unearned Rent)
xx
Income (ex. Rent Income)

xx

Adjusting entry (end of the accounting period)


Liability (ex. Unearned Rent)
xx
Income (ex. Rent Income)
xx
Income (ex. Rent Income)
xx
Liability (ex. Unearned Rent)
xx
To take up the earned portion of the item
To take up the unearned portion of item
Reversing entry (beginning of the subsequent accounting period)
Liability (ex. Unearned Rent)
None
Income (ex. Rent Income)

Depreciation/amortization of assets
Depreciation Expense
Accumulated Depreciation

xxx

Provision for uncollectible or doubtful accounts


Uncollectible Accounts Expense
Allowance for Uncollectible Accounts

xxx

xx
xx

xxx

xxx

Reasonably estimable and probable losses due to past events


(such as decline in value of investment in marketable securities
or those arising from pending lawsuits).
Estimated loss from pending lawsuit
xxx
Estimated liability from pending lawsuit
xxx
Provision for income taxes:
Income Tax Expense
Income Tax Payable

xxx
xxx

Inventory (if periodic inventory system is used):


Adjusting entry (end of the accounting period)
Cost of Goods Sold Method
(Adjusting Method)

Alternative Approach

Inventory, end
xx
Income summary
xx
Purchase returns and allowances xx
Beginning inventory
xx
Cost of goods sold
xx
Inventory, beginning
xx
Ending inventory
xx
Purchases
xx
Income summary
xx
Freight - In
xx
When perpetual inventory system is used, the ending inventory and the cost of goods
sold balances already appear in the ledger and therefore, no adjusting entry is
necessary unless there are discrepancies or errors (ex. shortage or overage) in the
inventory count vs. perpetual inventory records.

Closing entries - transfer (close) temporary account balances to


retained earnings (assuming corporate business) as follows:
Revenues/Gains
xxx
Income Summary
xxx

Income Summary
xxx
Expenses/Losses
xxx
If net loss, that is, income summary has a credit balance:
Income Summary
xxx
Retained Earnings
xxx
If net loss, that is, income summary has a debit balance:
Retained Earnings
xxx
Income Summary
xxx
Retained Earnings
Dividends

xxx
xxx

Reversing entries - reverse the effects of adjusting entries to


simplify the future recording of revenue and expense
transactions related to adjusting entries. These entries are made
at the beginning of the subsequent period to dispose some
accrued and deferred items (assets and liabilities) that were
entered in the balance sheet accounts through adjusting entries.
But, not all adjusting entries are reversed; only those
adjustments that affect asset or liability accounts that are
normally used during an accounting period are reversed.
Preparation of reversing entries is optional.
ADJUSTING ENTRIES

REVERSING ENTRIES

Wages Expense
Wages Payable

Accrued expenses
xx
Wages Payable
xx
Wages Expense

xx

Interest Receivable
Interest Income

Accrued revenues
xx
Interest Income
xx
Interest Receivable

xx

Prepaid expenses (using Expense Method only)


Prepaid Insurance
xx
Insurance Expense
Insurance Expense
xx
Prepaid Insurance

xx

xx
xx
xx

Unearned revenues (using Income Method only)


Rent Income
xx
Unearned Rent
xx
Unearned Rent
xx
Rent Income
xx
Note: Adjusting, closing and reversing entries must affect at least one temporary
account and at least one real account.

T-Accounts showing typical transactions and balances of


selected accounts:

GUIDELINES IN RECONSTRUCTION OF ACCOUNTS


1. Reconstruction of journal entries from the ledger postings. Be
familiar with the nature of business transactions that are posted
to each ledger account. If you know the account(s) that are
debited, you should also know the account(s) that are credited.
2. Reconstruction of the adjusting entries from comparative trial
balance. Compare the unadjusted trial balance with the adjusted
trial balance, and note the changes in the account balance
before and after adjustments are considered.
3. Reconstruction of adjusting entries from the financial statements.
Remember that there are certain accounts that do not have a
balance during the accounting period. These accounts would
only begin to have a balance and appear in the records after
adjusting entries are prepared and posted. Examples are
accrued items, most of the deferred items, doubtful accounts,
depreciation/amortizations and many more. Hence, you may
assume that these items have previously "zero balance" and
only formed part of the financial statements after adjustments
have been prepared. (Note: Not all adjusting entries can easily
be reconstructed by scanning the financial statements. If the
company uses the asset method of recording prepaid items and
the liability method of recording revenue deferrals, then
reconstruction of the adjusting entries by just scanning the
financial statements will be difficult or impossible.)
4. Reconstruction of the reversing entries. Nominal accounts do not
have any balance at the very start of the subsequent accounting
period. So, if a nominal account shows a balance immediately
after the reversing entries are posted on the ledgers but even
before recording the regular transactions of the period, such
balance must be due to the prepared reversing entry, and
therefore, the prepared reversing entry can be reconstructed
based on this balance.
5. Locating the missing items.
a. Know thoroughly the typical transactions that are posted to
the debit and credit sides of each ledger account.
b. Remember that after temporarily placing the amount of the
ending balance of a real account on the opposite or wrong
side of the ledger account, the said real account becomes
temporarily zero balance. So, if after temporarily placing the
ending balance on the opposite side, the said real account
still reflects an open balance, it is an indication that there
is/are missing amount/amounts or posting/postings.

c.

d.

After posting the closing entries, a nominal account becomes


zero balance. So, if after posting the closing entries and yet
the nominal account still has an open balance, it is also an
indication that there is/are missing items or posting/postings
to said nominal account.
Use T-account in locating missing items. Post all known data
to a T-account and start working on the missing debit(s) or
credit(s).

6. Reconstruction of the transactions from the trial balance.


a. Know the typical debits and credits posted in each ledger
account and the relationship of accounts with one another.
b. Start with the easier accounts or the more obvious
transactions- those accounts with lesser or no alternative
corresponding debit or credit account. If there are alternatives
corresponding debit or credit accounts for certain
transactions, trial and error procedures will be used for the
meantime until some logical assumptions could be adopted or
until the missing items are found. Eliminating the closely

c.

d.
e.

related accounts and the easier transactions will narrow down


the analyses to fewer accounts.
Use T-accounts in your analysis. To prove the fairness of the
reconstructed entries and of the assumed completed
transactions that resulted to the trial balance, postings to Taccount may be prepared for each account included in the
said trial balance. These T-accounts will show the same debit
arid credit posting totals as those given in the trial balance of
totals.
Beginning balance of a real account is included in the total of
the debit or credit postings, as the case may be.
Trial and error procedure is used, if necessary, provided
logical assumptions are used at all times.

7. Computation for an unknown amount. Problems may require you to


solve for an unknown amount, for example, gross profit, bonus
to manager, cash discount, etc. So, be familiar with the formulas
to compute for unknown items.

(Problem 1) Leonor, a CPA practitioner, was called upon by three small entrepreneurs/proprietors Anna, Barbie, and Cindy to assist them in
analyzing their owner's equity transactions. From the records and documents, Leonor was able to extract the following information:
Anna
Barbie
Cindy

Beginning Capital
P240,000
P438,000
P264,000

Additional Investment
P160,000
P074,000
P000,00?

Required: Determine the unknown amounts.

Owners Withdrawals
P30,000
P56,000
P22,000

Ending Capital
P460,000
P000,00?
P638,000

Net Profit (Loss)


P000,00?
P300,000
P(18,000)

(Problem 3) Jologs Company maintains its accounting records


using the cash basis of accounting. During the current year, the
company collected P340,000 from various customers and paid
P154,000 in expenses. Upon examination of other documents, the
ff. information was obtained:
Accrued income
Unearned income
Accrued expenses
Prepaid expenses
Required:
1. What is the total revenue in the current year?
2. What is the total expense in the current year?

3. What is the net income in the current year?

January 1
P38,000
P02,000
P06,000
P30,000

(Problem 2) During the audit of BMP Car Wash Center, the


auditor was able to extract the following account balances:
Cash
Trade and other accounts
Supplies inventory
Trade and other payables
Bank loan payable

January 1
P020,000
P140,000
P070,000
P046,000
P000,000

(Problem 5) You were asked to reconstruct the account balances


of D. Balanse Trading Company. The ff. data were extracted from
the company's incomplete accounting records:

December 31
P056,000
P184,000
P118,000
P022,000
P100,000

Account balances from the general ledgers:


December 31, 2016

December 31, 2015

P10,185
P11,415
P15,870
P01,125
P14,325

P06,840
P08,910
P14,580
P00,900
P12,750

P10,485
P06,000
P00,840

P09,495
P07,500
P00,675

Assets
Cash
Accounts receivable
Inventory
Prepaid expenses
Store equipment, net
Liabilities
Accounts payable
Bank loan payable
Accrued expenses

During the year, the owner made an additional cash contribution


to the business of P70,000 and withdrawal of P24,000.
Required:
1. What is the owners equity at January 1?
2. What is the owner's equity at December 31?
3. What is the net profit for the year?

Cashbook transactions during 2016 were as follows:


1.

2.

3.

4.

5.

6.

(Problem 4)
The accounts receivable at the beginning and at the end of the
period amounted to P150,000 and P127,500, respectively.
Uncollectible accounts written off during the period amounted
to P36,000. What would be the total sales for the period
assuming total cash received from customers amounted to
P1,126,500?
Accounts payable at the beginning of the period amounted to
P240,000. Payment on accounts payable (net of P15,000
discount) amounted to P735,000. What would be the balance
of accounts payable at the end of the period if total purchases
amounted to P915,000?
Assuming salaries payable at the beginning and at the end of the
period amounted to P34,000 and P56,000, respectively.
Salaries paid during the period totaled P368,000. How much
would be the salaries expense for the period?
If prepaid insurance amounted to P16,000 at the beginning of the
period and total insurance premium paid during the period
amounted to P56,000, what would be the ending balance of
prepaid insurance if insurance expense for the period
amounted to P28,000?
Assume all rent income are received in advance and accounted
for as unearned rent. Beginning and ending balances of
unearned rent are P42,000 and P63,000, respectively. If total
rent collections for the period amounted to P255,000, what
would be the amount of rent income for the period?
If beginning and ending interest receivable were P3,000 and
P5,500, respectively. Total interest collected for the period
amounted to P32,000, how much would be the interest
revenue for the period?

Cash receipts
From customer
From bank loan
Other income
Cash disbursements
To trade creditors/suppliers
To bank for bank loan
For expenses
To purchase new store equipment
To owner for drawings

P104,625
P006,000
P001,200
P080,490
P007,875
P014,115
P003,000
P003,000

Other information was as follows:


Sales returns during the year were P3,150. Bad debts written off
directly against accounts receivable were P1,620.
Purchase returns amounted to P1,950. Goods received from
supplier on December 28, 2016, P1,200, were not invoiced,
thus, not recorded by D. Balanse Company until January 3,
2017.
The only change in the store equipment was the purchase of a
new CCTV camera on June 30, 2016. Depreciation charges
were credited to the Store Equipment account from the month
following the purchase.

1.
2.
3.
4.
5.

Required: Calculate the adjusted balances of the following:


Net Sales
Net Purchases
Total Operating Expenses
Cost of Goods Sold
Net Income for 2016

(Problem 6) Maya Company had the following partial adjusted trial


balance as at December 31, 2016:

Supplies inventory
Prepaid insurance
Salaries payable
Unearned income
Supplies expense
Insurance expense
Salaries expense
Service income

1.

2.
3.
4.

MAYA COMPANY
Adjusted Trial Balance
December 31, 2016
Debit
P03,500
P12,000

(Problem 7) Ser Chief Company began operation in 2014. The


company is engaged in computer dealership. It purchases PCs,
laptops, notebook, and tablets from manufacturers and then sells
them to retail stores. During 2014, the accountant/bookkeeper
used a check register to record all cash receipts and cash
payments. No other journals were used. The following is a
summary of the cash receipts and payments made during the
year:

Credit
P04,000
P03,750

Cash receipts
Sale of share capital
Collections from customers
Borrowed from local bank on April 1, note signed
requiring principal and interest at 12% to be paid
on March 31, 2015
Total cash receipts
Cash payments
Purchase of merchandise
Payment of salaries
Purchase of equipment
Rental on building
Miscellaneous expenses
Total cash payments

P04,750
P02,000
P09,000
P10,000

Assuming that the new fiscal period begins December 1, 2016,


calculate the following:
If the amount in the Supplies Expense account is the December
31 adjusting entry, and that P4,250 of supplies were purchased
in December, what was the balance in the Supplies Inventory
on December 1?
If the amount in the Insurance Expense account represents the
December 31 adjusting entry, and that the original insurance
premium was for one year, what was the total premium?
If P12,500 of salaries was paid in December, what was the
balance in the Salaries Payable account on November 30,
2016?
If P8,000 was received in December for services performed in
December, what was the balance in Unearned Income account
on November 30, 2016?

1.
2.
3.
4.
5.
6.
7.
8.

P0,150,000
P0,960,000
P0,120,000
P1,230,000
P0,660,000
P0,240,000
P0,090,000
P0,042,000
P0,030,000
P1,062,000

You are called in to prepare the financial statements as at


December 31, 2014. The following additional information were
supplied to you:
Customers owed the company P66,000 at year end. Of this
amount, it was anticipated that P6,000 would probably not be
collected. There were no actual bad debt write-offs in 2014.
At year end, P90,000 was still due to suppliers of merchandise
purchased on credit.
At year-end, merchandise inventory costing P150,000 still
remained on hand.
Salaries owed to employees at year-end amounted to P15,000.
On December 1, P9,000 in rent was paid to the owner of the
building used by Ser Chief Company. This represented rent for
the months of December through February.
The equipment, which has a 10-year life and no salvage value,
was purchased on January 1, 2014. Straight-line depreciation
is used.
Required: Find the adjusted balances of the following:
Sales
Cost of Sales
Salaries expense
Rent expense
Total current assets
Total noncurrent assets
Total current liabilities
Total noncurrent liabilities

CORRECTION OF ERRORS
Types of Errors
1. Errors discovered currently in the course of normal
accounting procedures.
a. Examples include an addition error or posting to wrong
account
b. Usually detected during the regular process of summarizing
the accounting cycle, are easily fixed, and have no effect on
financial statements.
2. Errors limited to balance sheet accounts.
a. Examples include debiting Notes Receivable instead of
Accounts Receivable or crediting Accounts Payable instead
of Notes Payable.
b. Correct balances through a journal entry when discovered
and subsequently restated prior period balance sheet data
for comparative reporting purposes.
3. Errors limited to income statement accounts.
a. For example, Office Salaries debited instead of Sales
Salaries.
b. If discovered in a subsequent period, no journal entry is
necessary since the affected accounts have been closed;
however, similar to 2, prior period income statements should
be restated (obviously with no effect on net income) for
comparative purposes.
4. Errors affecting both income statement accounts and
balance sheet accounts.
Prior Period Errors - The company shall correct material prior
period errors retrospective in the first set of financial
statements authorized for issue after their discovery by
restating the net income and retained earnings of prior period.
2 Types of prior period errors: (1) Counterbalancing errors (2)
Non-counterbalancing errors.

a.

Errors in net income that, when not detected, are


automatically counterbalanced in the following fiscal period.
(Counterbalancing errors - errors affecting both net income
of the year when the error was committed and the
immediate year thereafter in opposite directions.)
1) Net income is successively misstated, but in offsetting
directions across the two periods.
2) Balance sheet accounts are misstated in the period of
error but are correctly stated by the end of the
succeeding period.
3) Omission of accrual and prepaid adjustments at year-end
and errors in ending inventory are examples of this type
of error:
Omission of accrued expenses
Omission of unearned income/advances from
customer
Omission of accounts payable/purchases
Overstatement of ending inventories
Omission of prepaid expenses
Omission of accrued income/accounts receivables
Understatement of ending inventories
b.

Errors in net income that, when not detected, are not


automatically counterbalanced in the following fiscal period.
(Non-counterbalancing errors- errors that affect only the net
income of the year the error was committed.)
1) Account balances on successive balance sheets will be
inaccurately stated until such time as entries are made
compensating for or correcting the errors.
2) Recognizing capital expenditures as expenses and
omitting charges for depreciation/amortization are errors
of this kind.

(Problem 1) During the audit of the records of Nicolo Company at the close of 2015, the following errors were discovered:
Income
2015
2016

Expense
2015
2016

Profit
2015

2016

Assets
2015
2016

Liabilities
2015
2016

2015

Equity
2016

Failure to record accrued


salaries at year- end
Failure to record sale of
merchandise on account
Failure to record
purchases of merchandise
on account
Omission of prepaid
insurance
Failure to take up accrued
interest on receivable
Failure to take up
unearned rent
Failure to record
depreciation of equipment
Failure to record collection
of accounts receivable

Required:
1. Indicate the effect of the foregoing errors on the accounts for 2015 and 2016 by writing O if overstated; U if understated; or NE if
no effect.
2. Classify the errors whether CB if counter-balancing error or NCB if non-counterbalancing.
(Problem 2) The first audit of the books of Nikki Company was made for the year ended December 31, 2015. In reviewing the books,
the auditor discovered that certain adjustments had either been overlooked or improperly recorded at the end of 2013, 2014, and
2015. Gross profit is 20% of sales. Errors are summarized below:

a.
b.
c.
d.
e.
f.
g.

Omission of accrued salaries expense


Omission of unearned rent income
Omission of accounts payable/ purchases
Overstatement of the ending inventory
Omission of prepaid insurance
Omission of accrued interest income
Understatement of the ending inventory as a result of
an error in the physical count of goods on hand.
h. Major expenditures had been recognized as repairs;
depreciation rate on such equipment is 20% per
year, but depreciation in the year of the expenditure
is at 10%.

2015
P02,000
P08,000
P14,000
P20,000
P26,000
P32,000

December 31
2014
P04,000
P10,000
P16,000
P22,000
P28,000
P34,000

2013
P06,000
P12,000
P18,000
P24,000
P30,000
P36,000

P38,000

P40,000

P42,000

P44,000

P46,000

P48,000

Required:
1. Prepare the audit adjustments assuming that the errors were discovered in you audit of the books for the period ended December 31,
2015.
2. Assume that the unadjusted net profit for the years 2015, 2014 and 2013 were P2,000,000; P4,000,000; and P6,000,000,
respectively, determine the adjusted net profit.
3. If the unadjusted retained earnings, end for the years 2015, 2014, and 2013 were P14,000,000; P16,000,000; and P18,000,000,
respectively, determine the adjusted retained earnings.
4. If unadjusted working capital, end for the years 2015, 2014, and 2013 were P8,000,000; P10,000,000, and P12,000,000,
respectively, determine the adjusted working capital.

(Problem 3) Luke Corporation reports net income for a 2-year period as follows: 2014, P3,000,000; and 2015, P3,200,000. In
auditing the accounts for 2015, you find that the following errors have been made in summarizing activities:
Omission of depreciation of equipment
Overstatement of inventory
Understatement of accrued advertising
Understatement of accrued interest income

2015
P100,000
P110,000
P030,000
P060,000

2014
P080,000
P130,000
P060,000
P040,000

Required:
1. Prepare the audit working paper summarizing corrections of net income for years 2014 and 2015.
2. Prepare the audit adjustments on December 31, 2015, assuming:
a. Books have not been closed.
b. Books have been closed.

(Problem 5) The December 31 year-end financial statements of Joma Corporation showed the following errors:
Ending inventory
Depreciation expense

December 31, 2014


48,000 understated
11,500 understated

December 31, 2015


40,500 overstated
0

An insurance premium of P330,000 was paid in advance in 2014 covering the years 2014, 2015, and 2016. The entire amount was
charged to expense in 2014.1n addition, on December 31, 2015, a fully depreciated machinery was sold for P75,000 cash, but the
sale was not recorded until 2016. There were no other errors during 2014 and 2015, and no corrections have been made for any of
the errors. Ignore income tax effects.
1. What is the total effect of the errors on Joma Corporation's 2015 net income?
2. What is the total effect of the errors on Joma's working capital at December 31, 2015?
3. What is the total effect of the errors on Joma's retained earnings at December 31, 2015?