Accounting Tutorial

CHAPTER 1: INTRODUCTION TO ACCOUNTING

1.1 What is Accounting?
 Accounting is famously known as the "language of business". Through the financial statements, the end-product reports in
accounting, it delivers information to different users.
 Accounting is a means through which information about a business entity is communicated.

Let's take a moment to illustrate that.

Meet Mr. Strauss

Mr. Strauss started a printing business. He invested $100,000 personal money to start the company's operations. After a month, he
wants to know how much the business made. He also wants to know if the money he invested is still there.

Without a way of recording the activities of the business, we will not be able to answer his questions. Surely we can tell him, "Mr.
Strauss, we made a lot this month!", but we need proof! And he needs the figures!

We can easily answer Mr. Strauss' questions if we kept track of the company's transactions. If we used $30,000 of the $100,000 we
had at the beginning to buy printers and pay the bills, then we'd have $70,000 cash left. If we collected $50,000 from our customers,
then we would have $120,000. Easy, right?

Okay, that's just a tiny bit of what accounting can do. What if we have thousands of transactions? Also, there's a lot more to
accounting than just recording. How much income did we make? How much do we owe our creditors? Is this a good investment?
Ask away. Accounting would confidently say, "I'll have the reports prepared." How cool is that?

Accounting Definition

Technical definitions of accounting have been published by different accounting bodies. The American Institute of Certified Public
Accountants (AICPA) defines accounting as:

the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are,
in part at least of financial character, and interpreting the results thereof.

Though I am not a fan of technical definitions, I believe that studying the statement above will give us a better understanding of
accounting.

1. Accounting is considered an art

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

Accounting is also considered a science because it is a body of knowledge. However, accounting is not an exact science since the
rules and principles are constantly changing (improved).

2. Accounting involves interconnected "phases"

Recording pertains to writing down or keeping records of business transactions. Classifying involves grouping similar items that have
been recorded. Once they are classified, information is summarized into reports which we call financial statements.

3. Concerned with transactions and events having financial character

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

4. Business transactions are expressed in terms of money

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They are assigned amounts when processed in an accounting system. Using one of the examples above, it is not enough to record
that the company paid salaries for April. It must include monetary figures – say for example, $20,000 salaries expense.

5. Interpreting the results

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

By studying the definition alone, we learned some important concepts in accounting. It also gave us an idea of what accountants do.

You may not notice but the simple things you do and encounter everyday can actually be related to some level of accounting. You
make budgets, count change and check the receipts from the supermarket. You may also have listed things you spent your money
with at one point in your life.

We are surrounded by business – from managing our own money to seeing profit statements of big corporations. And where there is
business, there sure is accounting.

1.2 Purpose of Accounting

In this article you will learn the purpose of accounting and the different types of financial information.

We learned that accounting is the language of business; a means of communicating information about an economic entity to
different users for decision-making.

An economic entity is a separately identifiable organization which makes use of resources to achieve its goals and objectives.

An economic entity may be a business entity operating primarily to generate profit, or a non-profit entity carrying out charitable and
not-for-profit operations.

This means that a "business entity or business organization" refers to the for-profit type of economic entity. Some authors use
"business entity" to refer to both for-profit and not-for-profit organizations. Nonetheless, all economic entities – whether business
or non-profit – rely on accounting in processing and providing financial information.

The Purpose of Accounting

From the illustration presented, and for a straightforward answer, it is clear that the ultimate purpose of accounting is to provide
information to different users. The users utilize the information in making economic decisions.

It can actually be depicted from some definitions made by accounting bodies. According to the American Institute of Certified Public
Accountants (AICPA):

Accounting is a service activity. Its function is to provide quantitative information, primarily financial in nature, about economic
entities that is intended to be useful in making economic decisions, in making reasoned choices among alternative courses of action.

And then, we have another definition – one which has been in use for a long time already – by the American Accounting Association
(AAA).

Accounting is the process of identifying, measuring and communicating economic information to permit informed judgment and
decision by users of the information.

Both of the above definitions and the very nature of accounting suggest its basic purpose – to provide information needed by users
in making economic decisions.

Accounting Information
Here's a list of the different types of information provided by accounting reports. These things will be clearer when you get to the
tutorials on Financial Statements. For now, it is sufficient (and good) to know what information we are talking about.

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 Results of operations. This pertains to the profit generated by the company for a certain span of time (for a year, for a quarter,
for a month, etc.). This is measured by deducting all expenses from all income. The resulting amount is called net income.
 Financial position. How much resources does the entity currently have? How much does the entity owe third parties? How
much is left for the owners after we pay all obligations using our resources? The first question refers to the entity's total assets;
the second to liabilities, and the third to capital.
 Solvency and liquidity. Solvency refers to the entity's ability to pay obligations when they become due. Liquidity pertains to its
ability to meet short-term obligations.
 Cash flows. The financial statements also show the inflows and outflows of cash in the different activities of the business
(operating, investing, and financing activities).
 Other information. The financial statements provide qualitative, quantitative, and financial information. One of the
characteristics of the financial statements is relevance. Any information that could affect the decisions of users should be
included in the financial reports.

1.3 Users of Financial Statements

The objective of accounting is to provide information to users for decision-making. But, who exactly are these "users of financial
statements"? What information do they need?

The users of accounting information include: the owners and investors, management, suppliers, lenders, employees, customers,
the government, and the general public.

1. Owners and investors

 Stockholders of corporations need financial information to help them make decisions on what to do with their investments
(shares of stock), i.e. hold, sell, or buy more.
 Prospective investors need information to assess the company's potential for success and profitability. In the same way,
small business owners need financial information to determine if the business is profitable and whether to continue,
improve or drop it.

2. Management

 In small businesses, management may include the owners. In huge organizations, however, management is usually made up
of hired professionals who are entrusted with the responsibility of operating the business or a part of the business. They act
as agents of the owners.
 The managers, whether owners or hired, regularly face economic decisions – How much supplies will we purchase? Do we
have enough cash? How much did we make last year? Did we meet our targets? All those, and many other questions and
business decisions, require analysis of accounting information.

3. Lenders

 Lenders of funds such as banks and other financial institutions are interested in the company’s ability to pay liabilities upon
maturity (solvency).

4. Trade creditors or suppliers

 Like lenders, trade creditors or suppliers are interested in the company’s ability to pay obligations when they become due.
They are nonetheless especially interested in the company's liquidity – its ability to pay short-term obligations.

5. Government

 Governing bodies of the state, especially the tax authorities, are interested in an entity's financial information for taxation
and regulatory purposes. Taxes are computed based on the results of operations and other tax bases. In general, the state
would like to know how much the taxpayer makes to determine the tax due thereon.

6. Employees

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 Employees are interested in the company’s profitability and stability. They are after the ability of the company to pay
salaries and provide employee benefits. They may also be interested in its financial position and performance to assess
company expansion possibilities and career development opportunities.

7. Customers

 When there is a long-term involvement or contract between the company and its customers, the customers become
interested in the company’s ability to continue its existence and maintain stability of operations. This need is also
heightened in cases where the customers depend upon the entity.
 For example, a distributor (reseller), the customer in this case, is dependent upon the manufacturing company from which
it purchases the items it resells.

8. General Public

 Anyone outside the company such as researchers, students, analysts and others are interested in the financial statements
of a company for some valid reason.

Internal and External Users

The users may be classified into internal and external users.

 Internal users refer to managers who use accounting information in making decisions related to the company's operations.
 External users, on the other hand, are not involved in the operations of the company but hold some financial interest. The
external users may be classified further into users with
 Direct financial interest – owners, investors, creditors; and users with;
 Indirect financial interest – government, employees, customers and the others.

Author's Notes: I'll leave you a question to help you better appreciate the purpose of and need for accounting.

Assume we are looking into two companies – Company A and Company B. Suppose you have $50,000 and are planning to invest
your money and receive annual returns from share in profits. In which company would you invest – Company A or B? Can't pick just
yet, right? Then you get the point.

1.4 Types of Accounting (Branches, Specializations)

As a result of economic, industrial, and technological developments, different specialized fields in accounting have emerged.

The famous branches or types of accounting include: financial accounting, managerial accounting, cost accounting, auditing,
taxation, AIS, fiduciary, and forensic accounting.

1. Financial Accounting

 Financial accounting involves recording and classifying business transactions, and preparing and presenting financial
statements to be used by internal and external users.
 In the preparation of financial statements, strict compliance with generally accepted accounting principles or GAAP is
observed. Financial accounting is primarily concerned in processing historical data.

2. Managerial Accounting

 Managerial or management accounting focuses on providing information for use by internal users, the management. This
branch deals with the needs of the management rather than strict compliance with generally accepted accounting principles.
 Managerial accounting involves financial analysis, budgeting and forecasting, cost analysis, evaluation of business decisions,
and similar areas.

3. Cost Accounting

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 Sometimes considered as a subset of management accounting, cost accounting refers to the recording, presentation, and
analysis of manufacturing costs. Cost accounting is very useful in manufacturing businesses since they have the most
complicated costing process.
 Cost accountants also analyze actual and standard costs to help managers determine future courses of action regarding the
company's operations.

4. Auditing

 External auditing refers to the examination of financial statements by an independent party with the purpose of expressing an
opinion as to fairness of presentation and compliance with GAAP. Internal auditing focuses on evaluating the adequacy of a
company's internal control structure by testing segregation of duties, policies and procedures, degrees of authorization, and
other controls implemented by management.

5. Tax Accounting

 Tax accounting helps clients follow rules set by tax authorities. It includes tax planning and preparation of tax returns. It also
involves determination of income tax and other taxes, tax advisory services such as ways to minimize taxes legally, evaluation
of the consequences of tax decisions, and other tax-related matters.

6. Accounting Information Systems

 Accounting information systems (AIS) involves the development, installation, implementation, and monitoring of accounting
procedures and systems used in the accounting process. It includes the employment of business forms, accounting personnel
direction, and software management.

7. Fiduciary Accounting

Fiduciary accounting involves handling of accounts managed by a person entrusted with the custody and management of property of
or for the benefit of another person. Examples of fiduciary accounting include trust accounting, receivership, and estate accounting.

8. Forensic Accounting

Forensic accounting involves court and litigation cases, fraud investigation, claims and dispute resolution, and other areas that
involve legal matters. This is one of the popular trends in accounting today.

Focusing on a Specialization

If you want to focus on a specialization, you may want to consider obtaining an accounting certification in your chosen field. It will
give you an edge over those who are uncertified. Due to the increasing population and demand for competitive professionals, you
need to step it up a little to get recognized.

Some of the most famous certifications include the Certified Public Accountant (CPA), Certified Management Accountant (CMA),
Certified Internal Auditor (CIA), Certified Financial Planner (CFP), and Certified Information Systems Auditor (CISA).

1.5 Areas of Accounting Practice

Accounting career opportunities may be divided into four broad areas or scope of practice.

1. Public Accounting

 Accountants in public practice are working in accounting firms or individually to provide audit and attestation, tax planning
and preparation, and advisory services to their clients.
 Accountants in public accounting serve clients on a project or contractual basis.

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 In CPA firms, new accountants start as accounting or audit staff and work their way up to the junior accountant, senior
accountant, supervisor, manager, and partner positions. After gaining enough experience, they may also start a public
accounting firm of their own.

2. Private Accounting

 In private accounting, also known as practice in commerce and industry, an accountant serves only one company. Accountants
in private accounting provide a staff function which supports the company by performing accounting-related tasks.
 Positions in private practice include entry-level jobs such as bookkeeper, accounting clerk, financial analyst, internal auditor,
and others. From there, new entrants can work their way up the organizational chart and get to key management positions
such as Chief Internal Auditor, Controller (Chief Management Accountant or Chief Accounting Officer), and Chief Financial
Officer (CFO).

3. Government Accounting

 Government agencies also need accountants. These agencies need accounting information to help them plan, budget,
forecast, and allocate government funds. State auditors are also employed by the government to ensure the proper use and
allocation of the said funds.

4. Accounting Education

 This area is made up of accountants who are into teaching, research, and training & development. Accountants can pursue a
career as a faculty member in a school, an author of an accounting book, a researcher, a trainer, or a reviewer.

Note that it is not unusual to work in more than one area. In fact, many accounting professionals engage in more than one scope of
practice. One may be providing public accounting services while having a part-time job in teaching. Another may be employed by a
multi-national company or by a government agency while also working as a bookkeeping consultant to the public.

1.6 Types of Business and Forms of Ownership

A business entity is an organization that uses economic resources or inputs to provide goods or services to customers in exchange
for money or other goods and services.

Business organizations come in different types and different forms of ownership.

3 Types of Business

There are three major types of businesses:

1. Service Business

 A service type of business provides intangible products (products with no physical form). Service type firms offer professional
skills, expertise, advice, and other similar products.
 Examples of service businesses are: schools, repair shops, hair salons, banks, accounting firms, and law firms.

2. Merchandising Business

 This type of business buys products at wholesale price and sells the same at retail price. They are known as "buy and sell"
businesses. They make profit by selling the products at prices higher than their purchase costs.
 A merchandising business sells a product without changing its form. Examples are: grocery stores, convenience stores,
distributors, and other resellers.

3. Manufacturing Business

 Unlike a merchandising business, a manufacturing business buys products with the intention of using them as materials in
making a new product. Thus, there is a transformation of the products purchased.
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 A manufacturing business combines raw materials, labor, and factory overhead in its production process. The manufactured
goods will then be sold to customers.

Hybrid Business

 Hybrid businesses are companies that may be classified in more than one type of business. A restaurant, for example,
combines ingredients in making a fine meal (manufacturing), sells a cold bottle of wine (merchandising), and fills customer
orders (service).
 Nonetheless, these companies may be classified according to their major business interest. In that case, restaurants are more
of the service type – they provide dining services.

Forms of Business Organization

These are the basic forms of business ownership:

1. Sole Proprietorship

 A sole proprietorship is a business owned by only one person. It is easy to set-up and is the least costly among all forms of
ownership.
 The owner faces unlimited liability; meaning, the creditors of the business may go after the personal assets of the owner if the
business cannot pay them.
 The sole proprietorship form is usually adopted by small business entities.

2. Partnership

 A partnership is a business owned by two or more persons who contribute resources into the entity. The partners divide the
profits of the business among themselves.
 In general partnerships, all partners have unlimited liability. In limited partnerships, creditors cannot go after the personal
assets of the limited partners.

3. Corporation

 A corporation is a business organization that has a separate legal personality from its owners. Ownership in a stock
corporation is represented by shares of stock.
 The owners (stockholders) enjoy limited liability but have limited involvement in the company's operations. The board of
directors, an elected group from the stockholders, controls the activities of the corporation.
 In addition to those basic forms of business ownership, these are some other types of organizations that are common today:

Limited Liability Company

 Limited liability companies (LLCs) in the USA, are hybrid forms of business that have characteristics of both a corporation and a
partnership. An LLC is not incorporated; hence, it is not considered a corporation.
 Nonetheless, the owners enjoy limited liability like in a corporation. An LLC may elect to be taxed as a sole proprietorship, a
partnership, or a corporation.

Cooperative

 A cooperative is a business organization owned by a group of individuals and is operated for their mutual benefit. The persons
making up the group are called members. Cooperatives may be incorporated or unincorporated.
 Some examples of cooperatives are: water and electricity (utility) cooperatives, cooperative banking, credit unions, and
housing cooperatives.

SUMMARY OF THE INTRODUCTION

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Introduction to Accounting: Summary

This is a summary of the topics covered in Chapter 1: Introduction to Accounting. You can always check the full lessons anytime.

What is Accounting?

Accounting is regarded as the language of business. It is a means through which business entities communicate information to different users.

The American Institute of Certified Public Accountants (AICPA) defined accounting as: "the art of recording, classifying, and summarizing in a significant manner and in
terms of money, transactions and events which are, in part at least of financial character, and interpreting the results thereof."

Purpose of Accounting

The AICPA also provided this definition: "Accounting is a service activity. Its function is to provide quantitative information, primarily financial in nature, about
economic entities that is intended to be useful in making economic decisions, in making reasoned choices among alternative courses of action."

The American Accounting Association (AAA) defined accounting as: "the process of identifying, measuring and communicating economic information to permit
informed judgment and decision by users of the information."

Based on the above definitions and the very nature of accounting as the language of business, it is evident that the basic purpose of accounting is to provide
information needed by users in making economic decisions.

These users include: current and potential investors, management, lenders, creditors, the government, employees, customers, and the general public. These users
have varied interests and therefore have different information needs.

Branches of Accounting and Areas of Practice

Accounting is one of the oldest business disciplines. It has never failed to provide opportunities to career-seekers. The high demand for accounting services makes it a
stable profession amidst economic fluctuations.

Different fields of specialization have evolved over the years. Today, holding a certification in a specific field gives the holder an edge over those who are uncertified.

The branches of accounting (fields of specialization) include: financial accounting, management accounting, cost accounting, auditing, tax accounting, accounting
information systems, fiduciary, and forensic accounting.

Accounting professionals work in at least one of the 4 major areas of accounting practice: public accounting, private accounting, government accounting, and
accounting education.

Accounting professionals in public accounting work in CPA firms or individually in providing accounting and auditing services to clients. An accountant in private
accounting is hired by a business to work as an employee of that entity. Government accountants work in the government and its agencies. Accounting education or
academe includes accountants who pursue careers as instructors, reviewers, researchers, and authors. See Full Tutorial

Types and Forms of Businesses

The three major types of businesses are: service business, merchandising business, and manufacturing business.

Service businesses offer intangible products to customers using their skills and expertise. Merchandising businesses buy goods and sell the same at higher prices.
Manufacturing businesses purchase goods and use them to make new products that are to be sold.

The basic forms of organization or business ownership include: sole proprietorship, partnership, and corporations.

A sole proprietorship is owned by only one person, known as sole proprietor, who bears an unlimited liability.

Partnership is owned by two or more persons called partners. A general partner has unlimited liability, whereas, limited partners are liable only up to the amount of
their investment.

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A corporation is owned by stockholders who enjoy limited liability. They are nonetheless not involved in the actual operations of the company. The board of directors
runs the company for the stockholders.

It is essential to learn about the types of businesses and forms of organizations in pursuing business studies. In accounting, it is important to be familiar with them
because of the differences in accounting practices.

CHAPTER 2: FUNDAMENTAL ACCOUNTING CONCEPT

2.1 Basic Accounting Principles
 Accounting principles serve as bases in preparing, presenting and interpreting financial statements.
 They provide a foundation to prevent misunderstandings between and among the preparers and users of financial statements.
 The Conceptual Framework of Accounting mentions the underlying assumption of going concern.
 In addition, the concepts of accrual, accounting entity, monetary unit, and time period are also important in preparing and
interpreting financial statements.

Going Concern Assumption

 The going concern principle, also known as continuing concern concept or continuity assumption, means that a business entity
will continue to operate indefinitely, or at least for another twelve months.
 Financial statements are prepared with the assumption that the entity will continue to exist in the future, unless otherwise
stated.
 The going concern assumption is the reason assets are generally presented in the balance sheet at cost rather that at fair market
value. Long-term assets are included in the books until they are fully utilized and retired.

Accrual Basis of Accounting

 The accrual method of accounting means that "revenue or income is recognized when earned regardless of when received and
expenses are recognized when incurred regardless of when paid".
 Hence, income is not the same as cash collections and expense is different from cash payments. Under accrual basis, revenues
and expenses are recognized when they occur regardless of when the amounts are received or paid.
 For example, ABC Company rendered repair services to a client on December 9, 2016. The client paid after 30 days – January 8,
2017.
When should the income be recognized? – On the date it is considered earned (when the service has been rendered). Hence,
the income should be recognized in December 2016 even if it has not yet been collected as of that date.
Another example, suppose ABC Company received its electricity bill for March on April 5, 2016 and paid it on April 10. When
should the electricity expense be recorded?
Correct! – March. Why? Because, the electricity expense was for the month of March even if the bill has been received and paid
in April. In other words, the "electricity" was used/consumed in March.

Accounting Entity Concept

 The accounting entity concept recognizes a specific business enterprise as one accounting entity, separate and distinct from the
owners, managers, and employees of that business.
 In other words, it means that a company has its own identity set apart from its owners or anyone else. Personal transactions of
the owners, managers, and employees must not be mixed with transactions of the company.
 For example, if ABC Company buys a vehicle to be used as delivery equipment, then it is considered a transaction of the business
entity.
 However, if Mr. A, owner of ABC Company, buys a car for personal use using his own money, that transaction is not recorded in
the company's accounting system because it clearly is not a transaction of the company.

Time Period (Periodicity)

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 The time period assumption, also known as periodicity assumption, means that the indefinite life of an enterprise is subdivided
into time periods (accounting periods) which are usually of equal length for the purpose of preparing financial reports on
financial position, performance and cash flows.
 An accounting period is usually a 12-month period – either calendar or fiscal.
 A calendar year refers to a 12-month period ending December 31. A fiscal year is a 12-month period ending in any day
throughout the year, for example, April 1 to March 31 of the following year.
 The need for timely reports has led to the preparation of more frequent reports, such as monthly or quarterly statements.

Monetary Unit Assumption

 The monetary unit assumption has two characteristics – quantifiability and stability of the currency.
 Quantifiability means that records should be stated in terms of money, usually in the currency of the country where the
financial statements are prepared.
 Stability of the dollar (or euro, pound, peso, etc.), a.k.a. stable dollar concept means that the purchasing power of the said
currency is stable or constant and that any insignificant effect of inflation is ignored.
 It is to be noted however that financial statements of a company reporting in the currency of a hyperinflationary economy (an
economy with very high inflation rate) must be restated, in accordance with applicable accounting standards.

Other Principles Derived from the Above Concepts

Some of the other principles followed in accounting include:

Matching Principle – The matching concept means that expenses are recognized in the period the related income is earned, and
income is recognized in the period the related expenses are incurred. In essence, income is matched with expenses and vice versa.

Through the accrual basis of accounting, better matching of income and expenses is achieved.

Revenue Recognition Principle – In accrual basis accounting, revenue or income is recognized when earned regardless of when
received. It means that income is recorded when the service is fully performed or when sale occurs, even if the amount is not yet
collected.

Expense Recognition Principle – Also under accrual basis accounting, expenses are recognized when incurred regardless of when
they are paid. In other words, expenses are recorded when used (incurred), even if they are not yet paid.

Historical Cost Principle – Items in the balance sheet are generally presented at historical cost. Nonetheless, some accounts are
measured using other bases such as fair market value, current cost, and discounted amount. You will learn more about them in
intermediate accounting studies.

2.2 Accounting Elements: Assets, Liabilities, and Capital

The three major elements of accounting are: Assets, Liabilities, and Capital

These terms are used widely in accounting so it is necessary that we take a close look at each element. But before we go into them,
we need to understand what an "account" is first.

What is an Account?

The term "account" is used often in this tutorial. Thus, we need to understand what it is before we proceed. In accounting, an
account is a descriptive storage unit used to collect and store information of similar nature.

For example, "Cash".

Cash is an account that stores all transactions that involve cash receipts and cash payments. All cash receipts are recorded as
increases in "Cash" and all payments are recorded as deductions in the same account.

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Another example, "Building". Suppose a company acquires a building and pays in cash. That transaction would be recorded in the
"Building" account for the acquisition of the building and a reduction in the "Cash" account for the payment made.

Now, let's take a look at the accounting elements.

Assets

Assets refer to resources owned and controlled by the entity as a result of past transactions and events, from which future economic
benefits are expected to flow to the entity. In simple terms, assets are properties or rights owned by the business. They may be
classified as current or non-current.

A. Current assets – Assets are considered current if they are held for the purpose of being traded, expected to be realized or
consumed within twelve months after the end of the period or its normal operating cycle (whichever is longer), or if it is cash.
Examples of current asset accounts are:

 Cash and Cash Equivalents – bills, coins, funds for current purposes, checks, cash in bank, etc.
 Receivables – Accounts Receivable (receivable from customers), Notes Receivable (receivables supported by promissory notes),
Rent Receivable, Interest Receivable, Due from Employees (or Advances to Employees), and other claims
• Allowance for Doubtful Accounts – This is a valuation account which shows the estimated uncollectible amount of accounts
receivable. It is a contra-asset account and is presented as a deduction to the related asset – accounts receivable.
 Inventories – assets held for sale in the ordinary course of business
 Prepaid expenses – expenses paid in advance, such as, Prepaid Rent, Prepaid Insurance, Prepaid Advertising, and Office Supplies

B. Non-current assets – Assets that do not meet the criteria to be classified as current. Hence, they are long-term in nature – useful
for a period longer that 12 months or the company's normal operating cycle. Examples of non-current asset accounts include:

 Long-term investments – investments for long-term purposes such as investment in stocks, bonds, and properties; and funds
set up for long-term purposes
 Land – land area owned for business operations (not for sale)
 Building – such as office building, factory, warehouse, or store
 Equipment – Machinery, Furniture and Fixtures (shelves, tables, chairs, etc.), Office Equipment, Computer Equipment, Delivery
Equipment, and others
• Accumulated Depreciation – This is a valuation account which represents the decrease in value of a fixed asset due to
continued use, wear & tear, passage of time, and obsolescence. It is a contra-asset account and is presented as a deduction to
the related fixed asset.
 Intangibles – long-term assets with no physical substance, such as goodwill, patent, copyright, trademark, etc.
 Other long-term assets

Liabilities

Liabilities are economic obligations or payables of the business.

Company assets come from 2 major sources – borrowings from lenders or creditors, and contributions by the owners. The first refers
to liabilities; the second to capital.

Liabilities represent claims by other parties aside from the owners against the assets of a company.

Like assets, liabilities may be classified as either current or non-current.

A. Current liabilities – A liability is considered current if it is due within 12 months after the end of the balance sheet date. In other
words, they are expected to be paid in the next year.

If the company's normal operating cycle is longer than 12 months, a liability is considered current if it is due within the operating
cycle.

Current liabilities include:

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 Trade and other payables – such as Accounts Payable, Notes Payable, Interest Payable, Rent Payable, Accrued Expenses, etc.
 Current provisions – estimated short-term liabilities that are probable and can be measured reliably
 Short-term borrowings – financing arrangements, credit arrangements or loans that are short-term in nature
 Current-portion of a long-term liability – the portion of a long-term borrowing that is currently due.
Example: For long-term loans that are to be paid in annual installments, the portion to be paid next year is considered current
liability; the rest, non-current.
 Current tax liabilities – taxes for the period and are currently payable

B. Non-current liabilities – Liabilities are considered non-current if they are not currently payable, i.e. they are not due within the
next 12 months after the end of the accounting period or the company's normal operating cycle, whichever is shorter.

In other words, non-current liabilities are those that do not meet the criteria to be considered current. Hah! Make sense?
Non-current liabilities include:

 Long-term notes, bonds, and mortgage payables;

 Deferred tax liabilities; and
 Other long-term obligations

Capital

Also known as net assets or equity, capital refers to what is left to the owners after all liabilities are settled. Simply stated, capital is
equal to total assets minus total liabilities.

Capital is affected by the following:

 Initial and additional contributions of owner/s (investments),

 Withdrawals made by owner/s (dividends for corporations),
 Income, and
 Expenses.

Owner contributions and income increase capital. Withdrawals and expenses decrease it.

The terms used to refer to a company's capital portion varies according to the form of ownership.

 In a sole proprietorship business, the capital is called Owner's Equity or Owner's Capital;
 in partnerships, it is called Partners' Equity or Partners' Capital; and
 In corporations, Stockholders' Equity.

In addition to the three elements mentioned above, there are two items that are also considered as key elements in accounting.
They are income and expense. Nonetheless, these items are ultimately included as part of capital.

Income

Income refers to an increase in economic benefit during the accounting period in the form of an increase in asset or a decrease in
liability that results in increase in equity, other than contribution from owners.

Income encompasses revenues and gains.

Revenues refer to the amounts earned from the company’s ordinary course of business such as professional fees or service revenue
for service companies and sales for merchandising and manufacturing concerns.

Gains come from other activities, such as gain on sale of equipment, gain on sale of short-term investments, and other gains.

Income is measured every period and is ultimately included in the capital account.

Examples of income accounts are:

Service Revenue Interest Income

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Professional Fees
Rent Income Royalty Income
Commission Income Sales

Expense

Expenses are decreases in economic benefit during the accounting period in the form of a decrease in asset or an increase in liability
that result in decrease in equity, other than distribution to owners.

Expenses include ordinary expenses such as Cost of Sales, Advertising Expense, Rent Expense, Salaries Expense, Income Tax, Repairs
Expense, etc.; and losses such as Loss from Fire, Typhoon Loss, and Loss from Theft.

Like income, expenses are also measured every period and then closed as part of capital.

Net income refers to all income minus all expenses.

Conclusion

And we've come to the end of this lesson. We have covered all the elements of accounting. For a recap: assets are properties owned
by a business; liabilities are obligations to other parties; and, capital refers to the portion of the assets available to the owners of the
business after all liabilities are settled.

On the next page, you will find some exercises to test and solidify your knowledge of the accounting elements. Be sure to check it
out!

Try this: Accounting Elements Exercises

2.3 The Accounting Equation and How It Stays in Balance

The accounting equation is the unifying concept in accounting that shows the relationships between and among the accounting
elements: assets, liabilities, and capital.

Total assets is equal to total liabilities and capital.

In this lesson (and the next ones), you will learn about the basic accounting equation and how it stays in balance.

Before taking this lesson, be sure to be familiar with the accounting elements.

Basic Accounting Equation

The basic accounting equation is:

Assets = Liabilities + Capital

 When a business is put up, its resources (assets) come from two sources: contributions by owners (capital) and those acquired
from creditors or lenders (liabilities). In other words, all assets initially come from liabilities and owners' contributions.
 As business transactions take place, the values of the accounting elements change. The accounting equation nonetheless
always stays in balance.
 Every transaction has a two-fold effect. Meaning, at least two accounts are affected. Let's illustrate all of that through these
examples.

Assume the following transactions:

1. Mr. Alex invested $20,000 to start a printing business,

2. The company obtained a loan from a bank, $30,000,
3. The company purchased printers and paid a total of $1,000.
4. How will the transactions affect the accounting equation?

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Let us take a look at transaction #1:

Transaction Assets = Liabilities + Capital

1. Owner's investment

20,000.00 = - + 20,000.00

Again, every transaction has a two-fold effect. In the above transaction, Assets increased as a result of the increase in Cash. At the
same time, Capital increased due to the owner's contribution. Remember that capital is increased by contribution of owners and
income, and is decreased by withdrawals and expenses. No liability is affected hence, stays at zero.

Let's continue with transaction #2:

Transaction Assets = Liabilities + Capital

1. Owner's investment

20,000.00 = - + 20,000.00

2. Loan from bank

30,000.00 = 30,000.00 + -

In transaction #2, the company received cash. Thus, the value of total assets is increased. At the same time, it incurred in an
obligation to pay the bank. Therefore, liabilities are increased. The liability in this case is recorded as Loans Payable.

Notice that the accounting equation is still equal (balanced).

Let's add transaction #3:

Transaction Assets = Liabilities + Capital

1. Owner's investment

20,000.00 = - + 20,000.00

2. Loan from bank

30,000.00 = 30,000.00 + -

3. Purchased printers

1,000.00
(1,000.00) = - + -

The company acquired printers, hence, an increase in assets. However, the company used cash to pay for the printers. Thus, it also
results in a decrease in assets. Transaction #3 results in an increase in one asset (Service Equipment) and a decrease in another asset
(Cash).

For those who are new to accounting format: The parentheses "()" around the 1,000 amount above means "minus" or "less".

Liabilities and capital were not affected in transaction #3. Still, the equation in such transaction is equal. It resulted to a zero effect in
both sides.

At this point, the balance of total assets is $50,000. The combined balance of liabilities and capital is also at $50,000.

The accounting equation is (and should always be) in balance.

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2.4 Accounting Equation: More Examples

The accounting equation is a mathematical expression that shows the relationship among the different elements of accounting, i.e.
assets, liabilities, and capital (or "equity").

Assets = Liabilities + Capital

Because of the two-fold effect of transactions, the equation always stays in balance.

To help you better understand how the accounting equation works and stays in balance, here are more sample transactions and
their effects to the accounting equation.

In addition to transactions 1, 2 and 3 in the previous lesson, assume the following data:

1. Rendered services and received the full amount in cash, $500

2. Rendered services on account (receivable from customer), $750
3. Purchased office supplies on account (payable to supplier), $200
4. Had some equipment repaired for $400, to be paid after 15 days
5. Mr. Alex, the owner, withdrew $5,000 cash for personal use
6. Paid one-third of the loan obtained in transaction #2
7. Received customer payment from services in transaction #5

The transactions will result to the following effects:

Transaction Assets = Liabilities + Capital

1. Owner's investment

20,000.00 = + 20,000.00

2. Loan from bank

30,000.00 = 30,000.00 +

3. Purchased printers

1,000.00
(1,000.00) = +

4. Service revenue for cash

500.00 = + 500.00

5. Service revenue on account

750.00 = + 750.00

6. Supplies on account

200.00 = 200.00 +

7. Repair of equipment

= 400.00 + (400.00)

8. Owner's withdrawal

(5,000.00) = + (5,000.00)

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9. Payment of loan

(10,000.00) = (10,000.00) +

10. Collection of accounts

750.00
(750.00) = +

Balance

36,450.00 = 20,600.00 + 15,850.00

Examples Explained

The company received cash for services rendered. Cash increased thereby increasing assets. At the same time, capital is increased as
a result of the income (Service Revenue). As we've mentioned in the Accounting Elements lesson, income increases capital.

The company rendered services on account. The services have been rendered, hence, already earned. Thus, the $750 worth of
services rendered is considered income even if the amount has not yet been collected. Since the amount is still to be collected, it is
recorded as Accounts Receivable, an asset account.

Office supplies worth $200 were acquired. This increases the company's Office Supplies, part of the company's assets. The purchase
results in an obligation to pay the supplier; thus a $200 increase in liability (Accounts Payable).

The company incurred in $400 Repairs Expense. Expenses decrease capital. The amount has not yet been paid. Thus, it results in an
increase in total liabilities.

The owner withdrew $5,000 cash. Cash is decreased thereby decreasing total assets. Withdrawals or drawings decrease capital.

One-third of the $30,000 loan was paid. Therefore, Cash is decreased by $10,000 as a result of the payment. And, liabilities are
decreased because part of the obligation has been settled.

The $750 account in a previous transaction has been collected. Therefore, the Accounts Receivable account is decreased and Cash is
increased.

Notice that every transaction results in an equal effect to assets and liabilities plus capital. The beginning balances are equal. The
changes arising from the transactions are equal. Therefore, the ending balances would still be equal.

The balance of the total assets after considering all of the above transactions amounts to $36,450. It is equal to the combined
balance of total liabilities of $20,600 and capital of $15,850 (a total of $36,450).

Assets = Liabilities + Capital is a mathematical equation. Using algebra, the formula can be rewritten to get other versions of the
equation.

Liabilities = Assets - Capital

Capital = Assets - Liabilities

2.5 Expanded Accounting Equation

Like the basic accounting equation, the expanded accounting equation shows the relationships among the accounting elements.

What's the difference? In the expanded accounting equation, the "capital" portion is broken down into several components:
contributions, withdrawals, income, and expenses.

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We know that capital is affected by contributions, withdrawals, income, and expenses.

Contributions and income increase capital. Withdrawals and expenses decrease it.

The accounting equation for a sole proprietorship can be rewritten as:

Assets = Liabilities + Capital - Withdrawals + Income - Expenses

Owners' contributions are recorded directly into Capital. Hence, additional contributions are already included in "Capital".
Nevertheless, if you want to show all of the components, then you can rewrite the equation as:

Assets = Liabilities + (Capital, beginning + Additional Contributions - Withdrawals + Income - Expenses)

Example

Assume the following transactions:

1. Mr. Alex invested $20,000 to start a printing business

2. The company obtained a loan from a bank, $30,000
3. The company purchased printers and paid a total of $1,000
4. Rendered services and received cash, $500
5. Rendered services on account, $750
6. Purchased office supplies on account, $200
7. Had its equipment repaired for $400, to be paid after 15 days
8. Mr. Alex, the owner, withdrew $5,000 cash for personal use
9. Paid one-third of the loan obtained in transaction #2
10. Received customer payment from services in transaction #5.

The effects to the expanded accounting equation of the transactions are as follows:

NO. ASSETS = LIABILITIES + CAPITAL - WITHDRAWALS + INCOME - EXPENSES

1 $ 20,000 = + $ 20,000 - + -
2 $ 30,000 = $ 30,000 + - + -
3 $ 1,000 = + - + -
($ 1,000)
4 $ 500 = + - + $ 500 -
5 $ 750 = + - + $750 -
6 $ 200 = $ 200 + - + -
7 = $ 400 + - + - $ 400
8 ($ 5,000) = + - $5,000 + -
9 ($ 10,000) = ($ 10,000) + - + -
10 $ 750 = + - + -
($ 750)
BAL $ 36,450 = $ 20,600 + $ 20,000 - $ 5,000 + $ 1,250 - $ 400
Notice that the equation stays in balance. If you take the total of the right side of the equation (i.e. liabilities, capital, income,
expense, and withdrawals) you will get $36,450, which is equal to the total assets in the left side.

Study the examples above and try to determine what specific items were affected under each element and why they increased or
decreased. Do it one transaction at a time. If you find it difficult, refer to the explanations in the previous lesson. You will appreciate
it better if you do this yourself.

Conclusion

The accounting equation, whether in its basic form or its expanded version, shows the relationship between the left side (assets) and
the right side (liabilities plus capital). It also shows that resources held by the company are coupled with claims against them.

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There is a two-fold effect in every transaction. This results in the movement of at least two accounts in the accounting equation. The
amount of change in the left side is always equal to the amount of change in the right side, thus, keeping the accounting equation in
balance.

The accounting equation is very important. It will guide you in understanding related accounting principles and help you solve many
accounting problems.

2.6 Double Entry Accounting System

In this lesson, we are going to learn the double entry accounting system or double entry bookkeeping.

It is one of the basic foundations upon which the steps in the accounting cycle and other accounting principles are based.

 The double entry accounting system emerged as a result of the industrial revolution. Merchants in the olden times recorded
transactions in simple lists, similar to what we call today as single entry method.
 Through the ages, business became more and more complex, hence, the development of more effective ways to keep track
of business transactions. The first accounts of the double entry bookkeeping system was documented by Luca Pacioli, a
Franciscan monk and hailed as the Father of Modern Accounting.
 Under the double entry bookkeeping system, business transactions are recorded with the premise that each transaction has
a two-fold effect – a value received and a value given.

To better understand the double entry method, let us first take a look at the single entry system.

Single Entry Bookkeeping

The single entry bookkeeping system does not explicitly record the two-fold effect of transactions. Under this method, separate
books are maintained for the company's basic accounts such as cash, receivables, and payables. Therefore, the accounting records
are incomplete.

For example, consider the following transactions:

 On October 1, 2016, Mr. Briggs invested $30,000 to start a marketing consultancy business.
 On October 5, the company purchased a computer for the office, $1,000.
 On October 8, the company rendered services and received $500.

Under the single entry, the company may use a cashbook to record its cash receipts and disbursements. After recording the above
transactions, the cashbook will look this:

DATE PARTICULARS AMOUNT BALANCE

10-01-2016 Beginning Balance $ 0.00
10-01-2016 Investment of owner $ 30,000.00 $ 30,000
10-05-2016 Purchase of computer ($ 1,000.00) $ 29,000
10-08-2016 Cash from customer $ 500.00 $ 29,500

We can readily determine the cash balance using this recording method. However, it will be difficult to determine the balances of
other accounts such as revenues and expenses unless the company maintains separate books for them as well.

An important note to consider here is that a valid set of financial statements can still be prepared even if the accounting system is
incomplete. But, it will require additional work to reconstruct the accounts to conform to the double-entry method.

Double Entry Bookkeeping

Under the double entry method, every transaction is recorded in at least two accounts. Once all transactions are processed into the
accounting system, the balances of all accounts will be readily available.

All accounts have a debit and a credit side. Debit means left and credit means right.

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Because of the two-fold or duality effect of transactions, the total effect on the left will always be equal to total the effect on the
right. Hence, the famous line "debit equals credit".

Now, here is the rule:

 To increase an asset, you debit it.

 To decrease an asset, you credit it.
 The opposite applies to liabilities and capital.
 To increase a liability or a capital account, you credit it.
 To decrease a liability or capital account, you debit it.
 Expenses are debited when incurred
 Income is credited when earned.

Here's a table to summarize that:

Accounting Element To Increase To Decrease

1. Asset Debit Credit
2. Liability Credit Debit
3. Capital Investment Credit Debit
4. Capital Withdrawal Debit Credit
5. Income Credit Debit
6. Expense Debit Credit
Tip: If you are having a hard time remembering the table above, you actually only need to familiarize yourself with the "To Increase"
part. The action to decrease the accounts is simply the opposite of the action to increase them.

Transactions are recorded using journal entries in the journal. A journal entry is a record showing the date of the transaction, the
account/s debited, the account/s credited, their respective amounts, and an explanation to describe the transaction.

Using the transactions presented earlier,

 On October 1, 2016, Mr. Briggs invested $30,000 to start a marketing consultancy business.
 On October 5, the company purchased a computer for the office, $1,000.
 On October 8, the company rendered services and received $500.

The journal would look like this:

Date Particulars Debit Credit

10-01-2016 Cash $ 30,000
Mr. Briggs, Capital $ 30,000
To record initial investment.
10-05-2016 Office Computer $ 1,000
Cash $ 1,000
To record purchase of computer.
10-08-2016 Cash $500
Service Revenue $ 500
To record cash for services rendered.
As mentioned earlier, every transaction has a two-fold effect. Thus, each transaction is recorded in at least two accounts. Notice the
two-fold effects in the above examples.

You will learn how to prepare journal entries in another lesson. For a head start, let us take a look at how we came up with the
journal entry for the first transaction. In that transaction, Mr. Briggs invested $30,000 to start a marketing consultation business on
October 1, 2016.

Place the date of the transaction on the leftmost side of the journal.

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Determine the account to be debited and the amount. In this case, there is an increase in cash because of the contribution. To
increase cash, an asset account, we debit it. So, we would then record Cash and place the amount, 30,000 on the debit column.

Next, we determine the account credited. We are recording the owner's initial contribution. It increases the company's capital;
therefore we would credit the capital account – Mr. Briggs, Capital, and place the amount in the credit column. Credits are recorded
below the debits. Also, notice the indentions used.

Finally, provide a brief explanation at the end of the entry.

See if you can figure out the logic behind the other two journal entries.

After recoding the transactions, we now have a running record of all accounts, and hence a complete accounting system.

In addition to the journals, some companies maintain separate books for some of their important accounts for better control.

The preparation of journal entries through the double entry bookkeeping method, along with the other steps in the accounting
cycle, results in a more systematic accounting system. You will learn more about journal entries in detail, including how to prepare
them, and the rest of the steps of the process in later lessons.

2.7 The Accounting Cycle: 9-Step Accounting Process

 The accounting cycle, also commonly referred to as accounting process, is a series of procedures in the collection, processing,
and communication of financial information.
 As defined in earlier lessons, accounting involves recording, classifying, summarizing, and interpreting financial information.
 Financial information is presented in reports called financial statements. But before they can be prepared, accountants need
to gather information about business transactions, record and collate them to come up with the values to be presented in the
reports.
 The cycle does not end with the presentation of financial statements. Several steps are needed to be done to prepare the
accounting system for the next cycle.

Accounting Cycle Steps

1. Identifying and Analyzing Business Transactions

 The accounting process starts with identifying and analyzing business transactions and events. Not all transactions and events
are entered into the accounting system. Only those that pertain to the business entity are included in the process.
 For example, a personal loan made by the owner that does not have anything to do with the business entity is not accounted
for.
 The transactions identified are then analyzed to determine the accounts affected and the amounts to be recorded.
 The first step includes the preparation of business documents, or source documents. A business document serves as basis for
recording a transaction.

2. Recording in the Journals

 A journal is a book – paper or electronic – in which transactions are recorded. Business transactions are recorded using the
double-entry bookkeeping system. They are recorded in journal entries containing at least two accounts (one debited and one
credited).
 To simplify the recording process, special journals are often used for transactions that recur frequently such as sales,
purchases, cash receipts, and cash disbursements. A general journal is used to record those that cannot be entered in the
special books.
 Transactions are recorded in chronological order and as they occur.
 Journals are also known as Books of Original Entry.

3. Posting to the Ledger

 Also known as Books of Final Entry, the ledger is a collection of accounts that shows the changes made to each account as a
result of past transactions, and their current balances.

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 After the posting all transactions to the ledger, the balances of each account can now be determined.
 For example, all journal entry debits and credits made to Cash would be transferred into the Cash account in the ledger. We
will be able to calculate the increases and decreases in cash; thus, the ending balance of Cash can be determined.

4. Unadjusted Trial Balance

 A trial balance is prepared to test the equality of the debits and credits. All account balances are extracted from the ledger and
arranged in one report. Afterwards, all debit balances are added. All credit balances are also added. Total debits should be
equal to total credits.
 When errors are discovered, correcting entries are made to rectify them or reverse their effect. Take note however that the
purpose of a trial balance is only test the equality of total debits and total credits and not to determine the correctness of
accounting records.
 Some errors could exist even if debits are equal to credits, such as double posting or failure to record a transaction.

5. Adjusting Entries

 Adjusting entries are prepared as an application of the accrual basis of accounting. At the end of the accounting period, some
expenses may have been incurred but not yet recorded in the journals. Some income may have been earned but not entered
in the books.
 Adjusting entries are prepared to update the accounts before they are summarized in the financial statements.
 Adjusting entries are made for accrual of income, accrual of expenses, deferrals (income method or liability method),
prepayments (asset method or expense method), depreciation, and allowances.

6. Adjusted Trial Balance

 An adjusted trial balance may be prepared after adjusting entries are made and before the financial statements are prepared.
This is to test if the debits are equal to credits after adjusting entries are made.

7. Financial Statements

 When the accounts are already up-to-date and equality between the debits and credits have been tested, the financial
statements can now be prepared. The financial statements are the end-products of an accounting system.
 A complete set of financial statements is made up of: (1) Statement of Comprehensive Income (Income Statement and Other
Comprehensive Income), (2) Statement of Changes in Equity, (3) Statement of Financial Position or Balance Sheet, (4)
Statement of Cash Flows, and (5) Notes to Financial Statements.

8. Closing Entries

 Temporary or nominal accounts, i.e. income statement accounts, are closed to prepare the system for the next accounting
period. Temporary accounts include income, expense, and withdrawal accounts. These items are measured periodically.
 The accounts are closed to a summary account (usually, Income Summary) and then closed further to the appropriate capital
account. Take note that closing entries are made only for temporary accounts. Real or permanent accounts, i.e. balance sheet
accounts, are not closed.

9. Post-Closing Trial Balance

 In the accounting cycle, the last step is to prepare a post-closing trial balance. It is prepared to test the equality of debits and
credits after closing entries are made. Since temporary accounts are already closed at this point, the post-closing trial balance
contains real accounts only.

*10. Reversing Entries: Optional step at the beginning of the new accounting period

 Reversing entries are optional. They are prepared at the beginning of the new accounting period to facilitate a smoother and
more consistent recording process.
 In this step, the adjusting entries made for accrual of income, accrual of expenses, deferrals under the income method, and
prepayments under the expense method are simply reversed.

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Author's Notes: So there you have the nine steps in the accounting cycle. This is just an overview of the accounting process. Each
step will be illustrated one by one in later chapters.

SUMMARY OF FUNDAMENTAL ACCOUNTING CONCEPTS

This is a summary of the topics covered in Chapter 2: Fundamental Accounting Concepts. You can always check the full lessons out anytime.

A. Basic Accounting Principles

Accounting assumptions and principles provide the bases in preparing, presenting and interpreting general-purpose financial statements.

The basic principles that accountants follow include:

 Accrual – Income is recognized when earned regardless of when collected, and expenses are recognized when incurred regardless of
when paid.
 Going Concern – Also known as continuing concern concept or continuity assumption, it means that a business entity will continue to
operate indefinitely.
 Accounting Entity Concept – A specific business enterprise is treated as one accounting entity, separate and distinct from its owners.
 Time Period Assumption – The indefinite life of an enterprise is subdivided into time periods or accounting periods which are usually of
equal length for the purpose of preparing financial reports.
 Monetary Unit Assumption – Transactions are recorded in terms of money (quantifiability). The currency used has a stable purchasing
power (stability).

B. Elements of Accounting

The elements of accounting pertain to assets, liabilities, and capital. Assets are resources owned by a company; liabilities are obligations to
creditors and lenders; and capital refers to the interest of the owners in the business after deducting all liabilities from all assets (or, what is left for
the owners after all company obligations are paid).

Assets

Assets can be classified as current or non-current. An asset is considered current if it is for sale, if it can be realized within 12 month from the end of
the accounting period or within the company's normal operating cycle if it exceeds 12 months. In addition, cash is generally considered current
asset.

Current assets include: Cash and Cash Equivalents, Marketable Securities, Accounts Receivable, Inventories, and Prepaid Expenses. Assets that do
not meet the criteria to be classified as current are, by default, non-current assets. Examples of non-current assets are: Long-term Investments;
Property, Plant and Equipment; and Intangibles.

Liabilities

Liabilities can also be classified as current or non-current. A liability is considered current of they are payable within 12 months from the end of the
accounting period, or within the company's normal operating cycle if the cycle exceeds 12 months.

Current liabilities include: Accounts Payable, Short-term Notes Payable, Tax Payable, Accrued Expenses, and other short-term obligations. Non-
current liabilities include those that do not meet the above criteria. Examples of non-current liabilities are: Loans Payable and Bonds Payable which
are long-term in nature, and Deferred Tax Liabilities.

Capital

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Capital refers to the interest of the owner/s of the business. The owner's interest is the value of total assets left after all liabilities to creditors and
lenders are settled. Capital is increased by contributions by the owner/s and income. It is decreased by withdrawals by owners (dividends in
corporations) and expenses.

Income

Income refers to an increase in assets or decrease in liability, and an increase in capital other than that arising from contributions made by owner/s.
Examples of income accounts include: Sales, Service Revenue, Professional Fees, Interest Income, Rent Income, and others.

Expense

Expenses result in decrease in assets or increase in liabilities, and decrease in capital other than those arising from withdrawals of the owner/s.
Some examples are: Cost of Sales, Salaries Expense, Rent Expense, Utilities Expense, Delivery Expense, and others.

C. Accounting Equation

The accounting equation shows the relationships between the accounting elements: assets, liabilities and capital. The basic accounting equation is:

Assets = Liabilities + Capital

It shows that assets owned by a company are coupled with claims by creditors and lenders, and by the owners of the business.

When business transactions take place, the values of the elements in the accounting equation change. Nonetheless, the equation always stays in
balance. This is due to the two-fold effect of transactions. The total change on the left side is always equal to the total change on the right. Thus,
the resulting balances of both sides are equal.

The accounting equation may be rewritten as:

Liabilities = Assets - Capital, or Capital = Assets - Liabilities.

The capital element may also be spread-out into its components, and thus resulting into the expanded accounting equation:

Assets = Liabilities + Capital - Withdrawals + Income - Expenses

Or Assets = Liabilities + (Capital, beginning + Additional Contributions - Withdrawals + Income - Expenses)

D. Double Entry Accounting System

The double entry accounting system recognizes a two-fold effect in every transaction. Thus, business transactions are recorded in at least two
accounts.

Under the double entry accounting system, transactions are recorded through debits and credits. Debit means left. Credit means right. The effect of
recording in debit or credit depends upon the normal balance of the account debited or credited.

The general rules are: to increase an asset, you debit it; to decrease an asset, you credit it. The opposite applies to liabilities and capital: to increase
a liability or a capital account, you credit it; to decrease a liability or a capital account, you debit it. Expenses are debited when incurred, and
income is credited when earned. See Full Tutorial

E. The Accounting Cycle

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The accounting cycle is a sequence of steps in the collection, processing, and presentation of accounting information. It is made up of the following
steps:

 Identifying and analyzing business transactions and events

 Recording transactions in the journals
 Posting journal entries to the ledger
 Preparing an unadjusted trial balance
 Recording and posting adjusting entries
 Preparing an adjusted trial balance
 Preparing the financial statements
 Recording and posting closing entries
 Preparing a post-closing trial balance
 Reversing entries may be prepared at the beginning of the new accounting period to enable a smoother recording process. In this step,
some adjusting entries are simply reversed. Nevertheless, reversing entries are optional.

CHAPTER 3: THE FINANCIAL STATEMENTS

3.1. Financial Statements Introduction: An Overview
Financial statements refer to a specific set of reports produced in an entity's accounting system. The objective of these reports is to
provide information about the entity.

A complete set of financial statements includes 5 components.

1. Statement of Comprehensive Income

 The Income Statement, also known as Profit and Loss Statement (P&L Statement), shows the results of operations of an
entity over a particular period of time. The income statement presents the period's income and expenses and the resulting
net income or loss.
 Many large companies today prepare a Statement of Comprehensive Income. The Statement of Comprehensive Income
presents a company's results of operations (net income or loss) and its other comprehensive income (OCI). If the company
has no other comprehensive income, then the contents of the Income Statement and Statement of Comprehensive Income
would be the same.
 Other comprehensive income include gains and losses that cannot be reported in the Income Statement such as revaluation
surplus, translation adjustments, and unrealized gains, for a given period. Other comprehensive income is covered in higher
financial accounting studies. Income Statement

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2. Statement of Changes in Capital

 The Statement of Changes in Capital (or Statement of Changes in Equity) shows the balance of the capital account at the
beginning of the period, the changes that occurred during the period, and the ending balance as a result of such changes.
Capital is affected by contributions and withdrawals of owners, income, and expenses.
 The title used for this report varies depending upon the form of business ownership. It is called Statement of Owner's
Equity in sole proprietorships, Statement of Partners' Equity in partnerships and Statement of Stockholders' Equity in
corporations. Statement of Owner's Equity

3. Statement of Financial Position

 A Balance Sheet presents an entity's assets, liabilities, and capital as of a given point in time. This report shows the entity's
financial position and condition, hence, also called Statement of Financial Position.
 All asset amounts are added. All liability and capital accounts are also added. The total amount of assets should be equal to
the total amount of liabilities plus capital. Balance Sheet

4. Statement of Cash Flows

 The Statement of Cash Flows, or Cash Flow Statement, presents the beginning balance of cash, the changes that occurred
during the period, and the cash balance at the end of the period as a result of the changes.
 The cash flow statement shows the cash inflows and outflows from three activities: operating, investing, and financing.
 Operating activities pertain to transactions that are directly related to the company's main course of business. Investing
activities refer to "where the company puts its money". These activities include long-term investments, acquisition of
property, plant and equipment; and other transactions related to non-current assets. Financing activities include
transactions in which a company acquires its funds. These include loans from banks (long-term liabilities) and contributions
from owners. Cash Flow Statement

5. Notes to Financial Statements

 The Notes to Financial Statements, or Supplementary Notes, provide information in addition to those presented in the
Balance Sheet, Income Statement, Statement of Changes in Equity, and Cash Flow Statement. The notes contain disclosures
required by accounting standards, supporting computations, breakdown of line items in the face of the financial statements,
and other information that users may be interested in.

Relationship among the Financial Statements

 The financial statements contain interrelated information. This is the reason the financial statements are prepared in the
sequence presented above. In fact, some of the figures in one financial statement component are actually taken from
another component.
 The net income from the Income Statement is used in the Statement of Changes in Equity. Remember that income and
expenses affect capital.
 The ending balance of capital in the Statement of Owner's/Partners'/SH's Equity is forwarded to the Balance Sheet (under
Capital).
 The cash balance presented in the Balance Sheet is supported by the Statement of Cash Flows. The ending balance of cash in
the Statement of Cash Flows is the same amount presented in the Balance Sheet.
 The notes to financial statements show supporting computations of the amounts and additional information about the items
presented in the above reports.

3.2 Income Statement a.k.a. Profit and Loss Statement

The Income Statement, also referred to as Profit and Loss (P&L) Statement, shows an entity's results of operations for a particular
period.

It presents an entity's income and expenses, and the resulting net income or net loss.

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This lesson presents an Income Statement example and provides important points you need to know in preparing and understanding
the said report.

Income Statement Example

Here is a sample income statement of a service type sole proprietorship business. Let us name the company Strauss Printing
Services. All amounts are assumed and simplified for illustration purposes.

Strauss Printing Services

Income Statement/ Statement of Comprehensive Income
For the Year Ended December 31, 2016

Service Revenue $ 160,000

Less: Expenses
Salaries Expense $ 40,000
Supplies Expense $ 26,100
Rent Expense $ 20,500
Utilities Expense $ 11,300
Depreciation Expense $ 5,000 $ 102,900

Net Income $ 57,100

Explanation and Pointers

An income statement shows the net income or net loss of a business. This is achieved by deducting all expenses from all income.

A typical income statement starts with a heading which consists of three lines. The first line presents the name of the company; the
second describes the title of the report; and the third states the period covered in the report.

Notice that the third line is worded "For the Year Ended..." This means that the income statement presents information for a specific
span of time. In the above example, the period covers 1 year that ends on December 31, 2016. Hence, the amounts presented in the
report are income and expenses from January 1, 2016 to December 31, 2016.

Income accounts are presented before expenses. In the above statement, the income account is Service Revenue. Other income
accounts for service type businesses include Professional Fees, Rent Income, Tuition Fees, etc.

Expenses are presented after the income accounts. It is a good practice to arrange expenses according to amount (largest to
smallest). Some users who are interested in the company's expenses are concerned about the size of each expense. Arranging the
expenses from largest to smallest results in a more useful and organized report. Nonetheless, Miscellaneous Expense or Sundry
Expense is presented last.

If income exceeds expenses, there is a net income. If expenses exceed income, there is a net loss. Notice how computations are
presented. A single line is drawn every time an amount is computed. The resulting amount is double-ruled when it is no longer
followed by any operation. For example, $57,100 (the net income).

The income statement complies with the accrual basis of accounting. Income is recognized when earned regardless of when
collected. Expenses are recognized when incurred regardless of when paid.

This means that income and expenses presented in the income statement have been earned and incurred, respectively.
Nonetheless, it does not mean that they have all been collected or paid.

International accounting standards suggest that companies should present other comprehensive income in their financial
statements. A Statement of Comprehensive Income shows the contents of an income statement followed by a list of "other
comprehensive income".

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Other comprehensive income includes gains and losses that cannot be reported as profit and loss, such as unrealized gains and
losses, and revaluation surplus. This is taken up in higher financial accounting studies.

When the company does not have other comprehensive income, the contents of the income statement and the statement of
comprehensive income are the same. In any case, international accounting standards favor the use of the title "Statement of
Comprehensive Income".

Statement of Comprehensive Income

Here's a sample Statement of Comprehensive Income, which includes other comprehensive income. This topic is taken up in higher
accounting so you need not worry about it yet.

Strauss Printing and Publishing, Inc.

Statement of Comprehensive Income
For the Year Ended December 31, 2016

Service Revenue $ 160,000

Less: Expenses
Salaries Expense $ 40,000
Supplies Expense $ 26,100
Rent Expense $ 20,500
Utilities Expense $ 11,300
Depreciation Expense $ 5,000 ($ 102,900)
Net Income $ 57,100
Net Income $ 57,100
Other Comprehensive Income
Revaluation Surplus $ 20,000
Unrealized Translation Gain $10,200 $30,200
Total Comprehensive Income $ 87,300

3.3 Statement of Changes in Owner's Equity

This lesson presents the Statement of Owner's Equity (or Statement of Changes in Owner's Equity) along with important points you
need to know in preparing and understanding this report.

 A Statement of Owner's Equity shows the changes in the capital account due to contributions, withdrawals, and net income or
net loss.
 Capital is increased by owner contributions and income, and decreased by withdrawals and expenses.
 The Statement of Owner's Equity, which is prepared for the sole proprietorship type of business, shows the movement in capital
as a result of those four elements.

Statement of Owner's Equity Example

Here is a sample Statement of Owner's Equity of a service type sole proprietorship business, Strauss Printing Services. All amounts
are assumed and simplified for illustration purposes.

Assume that the company started the year 2016 with $100,000 capital. During the year, the owner made $10,000 additional
contributions and $20,000 total withdrawals. The Statement of Owner's Equity would look like this:

Strauss Printing and Publishing, Inc.

Statement of Owner’s Equity
For the Year Ended December 31, 2016

Strauss, Capital $ 100,000

Add: Additional Contributions $10,000
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Net Income $ 57,100

Subtotal $ 167,100
Less: Strauss, drawings $ 20,000
Strauss, Capital – December 31, 2016 $ 147,100

Explanation and Pointers

 A Statement of Owner's Equity (SOE) shows the owner's capital at the start of the period, the changes that affect capital, and
the resulting capital at the end of the period. It is also known as "Statement of Changes in Owner's Equity".
 A typical SOE starts with a heading which consists of three lines. The first line shows the name of the company; second the
title of the report; and third the period covered.
 The title of the report is Statement of Owner's Equity. This is used for sole proprietorships. For partnerships, the title used is
"Statement of Partners' Equity" and for corporations, "Statement of Stockholders' Equity".
 Notice that the third line is worded "For the Year Ended..." This means that the SOE presents information for a specific span of
time. In the above example, the period covers 1 year that ends on December 31, 2016. Hence, the amounts presented pertain
to changes to owner's equity from January 1, 2016 to December 31, 2016.
 The capital account used in the illustration is Strauss, Capital.
 Income increases capital. Expenses decrease it. Net income is equal to income minus expenses. Hence, net income would
increase the capital account. If expenses exceed income, there is a net loss. In such case, net loss will decrease the capital
account.
 Notice that the net income above, $ 57,100, is the bottom-line amount in the company's Income Statement.
 Strauss, Drawings represents the total withdrawals made by the owner during the period. The owner made $ 20,000 total
drawings. This amount is deducted to get the capital balance.
 The Statement of Owner's Equity example above shows that the company has $147,100 in capital as a result of the following:
$100,000 balance at the beginning of the year, plus $10,000 owner's contributions during the year, plus $57,100 net income,
and minus $20,000 withdrawals.
 Good accounting form suggests that a single line is drawn every time an amount is computed (it signifies that a mathematical
operation has been completed). The bottom-line amount is double-ruled, i.e. $ 147,100.

3.4 Balance Sheet a.k.a. Statement of Financial Position

 A balance sheet shows the financial position or condition of a company as of a certain date. It is also called Statement of
Financial Position.
 Financial position pertains to the resources owned and controlled by the company (assets), and the claims against them
(liabilities and capital).
 Hence, if you have a report that presents a company's assets, liabilities and capital, then you are probably looking at a
company's balance sheet.

This lesson shows what a Balance Sheet looks like and provides some points you need to know about this financial report.

Balance Sheet Example

Moving on from our previous illustrations, here is a sample balance sheet for Strauss Printing Services, a service type sole
proprietorship business. All amounts are assumed and simplified for illustration purposes.

Strauss Printing Services

Statement of Financial Position
As of December 31, 2016

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ASSETS
Current Assets:

Cash $ 21,000
Accounts Receivable $ 16,000
Prepaid Expenses $ 4,500 $ 41,500

Non-current Assets:

Property, Plant and Equipment 145,000

Total Assets $ 186,500

LIABILITIES AND OWNER'S EQUITY

Current Liabilities:

Accounts Payable $ 8,400

Rent Payable $ 8,000 $ 16,400

Non-current Liability:

Loans Payable $ 23,000

Strauss, Capital $ 147,100

Total Liabilities and Owner's Equity $ 186,500

Explanation and Pointers

 A Balance Sheet shows the financial position or condition of the company; thus, it is also called "Statement of Financial
Position".
 A typical balance sheet starts with a heading which consists of three lines. The first line presents the name of the company; the
second describes the title of the report; and the third states the date of the report.
 Notice that the third line is worded "As of..." Unlike the other components of the financial statements which cover a span of
time ("For the period ended.."), the balance sheet presents information as of a certain date (at a specific point in time). In the
above example, the contents of the balance sheet pertain to the financial condition of the company on December 31, 2016.
 A balance sheet summarizes the assets, liabilities, and capital of a company. Assets refer to properties owned and controlled by
the company. Liabilities are obligations to creditors, lenders, etc. And capital represents the portion left for the owners of the
business after all liabilities are paid. For detailed lessons about assets, liabilities and capital, check out the Elements of
Accounting.
 Assets and liabilities are classified as either current or non-current. Current assets are properties that will be converted into cash
within 12 months or within the operating cycle of the business. Current liabilities are due within 12 months or within the
operating cycle. Non-current assets and non-current liabilities are those that do not meet the above qualifications.
 "Total assets" and "total liabilities and capital" should always be equal.
 The capital amount, $147,100 for Strauss, Capital, was actually taken from the Statement of Owner's Equity.
 The balance sheet may be presented in two forms: account form and report form. In account form, assets are presented on the
left side while liabilities and capital are presented on the right. In report form, assets are presented first and then followed by
liabilities and capital. The example above is presented using the report form.
 Good accounting form suggests that a single line is drawn every time an amount is computed. It signifies that a mathematical
operation has been completed. The "total assets" and "total liabilities and capital" amounts are double-ruled.

3.5 Statement of Cash Flows

 A Statement of Cash Flows (or Cash Flow Statement) shows the movement in the Cash account of a company.
 It presents cash inflows (receipts) and outflows (payments) in the three activities of business: operating, investing, and
financing.

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 Accountants follow the accrual basis in measuring income and expenses. However, some users are particularly interested in
the cash transactions of the company; hence the need to present a Statement of Cash Flows.

This lesson takes a look at the Statement of Cash Flows and provides some important points in understanding it.

Statement of Cash Flows Example

Here is a sample cash flow statement for Strauss Printing Services, a service type sole proprietorship business. All amounts are
assumed and simplified.

Strauss Printing Services

Statement of Cash Flows
For the Year Ended December 31, 2016

Cash Flow from Operating Activities:

Cash received from customers $ 146,000

Cash paid for expenses ($ 81,000)
Cash paid to suppliers ($47,500) $ 17,500

Cash Flow from Investing Activities:

Cash paid to acquire additional equipment ($ 20,300)

Cash Flow from Financing Activities:

Cash received from investment of owner $ 10,000

Cash received from bank loan $ 50,000
Cash paid for bank loan – partial payment ($ 27,000)
Cash paid to owner – withdrawal ($ 20,000) $ 13,000

Net Increase (Decrease) in Cash for the Year $ 10,200

Add: Cash – January 1, 2016 $ 10,800
Cash – December 31, 2016 $ 21,000

Explanation and Pointers

 Statement of Cash Flows presents the inflows and outflows of cash in the different activities of the business, the net increase or
decrease in cash, and the resulting cash balance at the end of the period. Cash inflows refer to receipts of cash while cash
outflows to payments or disbursements.
 A typical cash flow statement starts with a heading which consists of three lines. The first line presents the name of the
company; the second describes the title of the report; and the third states the period covered in the report.
 Notice that the third line is worded "For the Year Ended..." This means that the information included in the report covers a span
of time. In the illustration above, the report presents inflows and outflows of cash for 1 year, i.e. from January 1 to December
31, 2016.
 Cash inflows and outflows are classified in three activities: operating, investing, and financing.
 Operating activities refer to the main operations of the company such as rendering of professional services, acquisition of
inventories and supplies, selling of inventories for merchandising and manufacturing concerns, collection of accounts, payment
of accounts to suppliers, and others. Generally, operating activities refer to those that involve current assets and current
liabilities.
 Investing activities may be summed up as: "where the company puts its money for long-term purposes", such as acquisition of
property, plant and equipment; and investment in long-term securities. Selling these properties are also considered investing
activities. In general, investing activities include transactions that involve non-current assets.
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 Financing activities refer to: "where the company gets its funds", such as investment of the owner/s, and cash proceeds from
bank loan and other long-term payables. The payment of such items (i.e. withdrawal of owner/s and payment of loans) are also
financing activities. Generally, financing activities include those that affect non-current liabilities and capital.
 All inflows are presented in positive figures while all outflows in negative (in parentheses).
 After inflows and outflows are presented, the net increase or decrease in cash is computed. Then it is added to the beginning
balance of cash to get the balance at the end. Easy, right? In simple sense, this report presents the cash balance at the beginning
of the period, the changes during the period, and the resulting balance at the end of the period.
 Notice that the cash balance at the end, $ 21,000, is the same as the cash balance presented in the company's Balance Sheet.
 Good accounting form suggests that a single line is drawn every time an amount is computed. It signifies that a mathematical
operation has been completed. The computed balance at the end of the report is double-ruled.

CHAPTER 4: ANALYZING, RECORDING AND CLASSIFYING

4.1 Understanding and Analyzing Business Transactions
 An accounting system must record all business transactions to ensure complete and reliable information when the financial
statements are prepared.
 What is a business transaction? A business transaction is an activity or event that can be measured in terms of money and which
affects the financial position or operations of the business entity.
 A business transaction has an effect on any of the accounting elements – assets, liabilities, capital, income, and expense.
 Transactions may be classified as exchange and non-exchange. Exchange transactions involve physical exchange such as
purchasing, selling, collection of receivables, and payment of accounts.
 Non-exchange transactions are events that do not involve physical exchanges but where changes in monetary values are
determinable, e.g. wear and tear of equipment, fire loss, typhoon loss, etc.

To qualify as an accountable/recordable business transaction, the activity or event must:

1. Be a transaction involving the business entity

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The separate entity concept or accounting entity assumption clearly establishes a distinction between transactions of the business
and those of its owner/s.

If Mr. Bright, owner of Bright Productions, buys a car for personal use using his own money, it will not be reflected in the books of
the company. Why? Because it does not have anything to do with the business. Now if the company purchases a delivery truck, then
that would be a business transaction of the company.

If Mr. Grim invests $20,000 into the company, would that be recorded in the books of the business? Ask this: Does it have anything
to do with the company? Yes. Then, that would be a recordable business transaction.

In any case, always remember that a business is treated as an individual entity, separate and distinct from its owners.

2. Be of a financial character (in a certain amount of money)

Transactions must involve monetary values, meaning a certain amount of money must be assigned to the elements or accounts
affected.

For example, Bright Productions renders video coverage services and expects to collect $10,000 after 10 days. In this case, it's
explicit. The income and receivable can be measured reliably at the $10,000.

Fire, typhoon and other losses may be estimated and assigned with monetary values.

The mere request (order) of a customer is not a recordable business transaction. There should be an actual sale or performance of
service first to give the company a right over the income or revenue.

3. Have a dual or "two-fold" effect on the accounting elements

Every transaction has a dual or two-fold effect. For every value received, there is a value given; or for every debit, there is a credit.
This is the concept of double-entry accounting.

For example, Bright Productions purchased tables and chairs for $6,000. The company received tables and chairs thereby increasing
its assets (increase in Office Equipment). In return, the company paid cash; thus, there is an equal decrease in assets (decrease in
Cash). For more illustration and examples, check out the lesson about the Accounting Equation here.

4. Be supported by a source document

As part of good accounting and internal control practice, business transactions must be supported by source documents. The source
documents serve as bases in recording transactions in the journal.

Examples of source documents are: Official Receipt issued whenever cash is received, Sales Invoice for sales transactions, Cash
Voucher for payment in cash, Statement of Account from suppliers, Vendor's Invoice, Promissory Notes, and other business
documents.

The first step in the accounting process is actually to prepare the source document and determine the effects of the business
transaction to the accounts of the company. After which, the accountant records the transaction through a journal entry.

Examples of business transactions will be given and explained in detail as you go through the lessons in this chapter. To see how
business transactions are actually analyzed, you may jump to Accounting Equation, Journal Entries, and More Journal Entry
Examples. The next lessons will discuss the rules of debit and credit, and chart of accounts first.

4.2. Rules of Debit and Credit: Left versus Right

In this article, you will learn the rules of debit and credit; when and how to use them.

Account

First, let us recall the definition of an "account". An account is a storage unit that stores similar items or transactions.

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Examples of accounts are: Cash, Accounts Receivable, Office Equipment, Accounts Payable, Service Income, Rent Expense, and so on.

Let's take Cash, for instance. The Cash account stores all transactions that involve cash, i.e. cash receipts and cash disbursements.

Debit and Credit

Second, let us define "debit" and "credit". Debit means left and credit means right. Do not associate any of them with plus or minus
yet. Debit simply means left and credit means right – that's just it! "Debit" is abbreviated as "Dr." and "credit", "Cr.".

The terms originated from the Latin terms "debere" or "debitum" which means "what is due", and "credere" or "creditum" which
means "something entrusted or loaned".

Normal Balance

And third, we define what we call "normal balance". Each account has a debit and a credit side. You could picture that as a big letter
T, hence the term "T-account". Again, debit is on the left side and credit on the right. Normal balance is the side where the balance
of the account is normally found.

Asset accounts normally have debit balances, while liabilities and capital normally have credit balances. Income has a normal credit
balance since it increases capital . On the other hand, expenses and withdrawals decrease capital, hence they normally have debit
balances.

Now what is the significance of the "normal balance"?

When you place an amount on the normal balance side, you are increasing the account. If you put an amount on the opposite side,
you are decreasing that account. Therefore, to increase an asset, you debit it. To decrease an asset, you credit it. To increase liability
and capital accounts, credit. To decrease them, debit.

Example

Let us take Cash. Cash is an asset account. Again, asset accounts normally have debit balances. Therefore, to increase Cash you debit
it. To decrease Cash, you credit it.

Another example – let's take Accounts Payable. It is a liability account. Liability accounts normally have credit balances. Thus, if you
want to increase Accounts Payable, you credit it. If you want to decrease Accounts Payable, you debit it.

The same rules apply to all asset, liability, and capital accounts.

To Sum It Up

Here's a table summarizing the normal balances of the accounting elements, and the actions to increase or decrease them. Notice
that the normal balance is the same as the action to increase the account.

Accounting Element Normal Balance To Increase To Decrease

1. Asset Debit Debit Credit
2. Liability Credit Credit Debit
3. Capital Investment Credit Credit Debit
4. Capital Withdrawal Debit Debit Credit
5. Income Credit Credit Debit
6. Expense Debit Debit Credit
Tip: You don't need to memorize the whole table. Just be familiar with the normal balance portion and you'll be okay. The normal
balance is the same as the action to increase the account. The action to decrease the account is simply the opposite of that.

Done? Now try these:

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1. To increase Office Equipment, debit or credit?

2. To increase Rent Payable.
3. To record/increase Rent Expense.
4. To decrease Accounts Payable.
5. To record/increase Service Revenue.
6. To decrease Cash.
7. To record/increase Loss from Fire.
8. To decrease Delivery Equipment.
9. To increase Accumulated Depreciation

Answers:

1. Debit; 2. Credit; 3. Debit; 4. Debit; 5. Credit; 6. Credit; 7. Debit; 8. Credit.

What about item #9? How do you increase Accumulated Depreciation?

Accumulated Depreciation is a contra-asset account (deducted from an asset account). For contra-asset accounts, the rule is simply
the opposite of the rule for assets. Therefore, to increase Accumulated Depreciation, you credit it.

We will apply these rules and practice some more when we get to the actual recording process.

4.3 The Chart of Accounts – Example and Explanation

 Before recording transactions into the journal, we should first know what accounts to use. This is where a chart of accounts
comes in handy.
 A chart of accounts is a list of all accounts used by a company in its accounting system. It makes the bookkeeper's work easier.
 The accounts included in the chart of accounts must be used consistently to prevent clerical or technical errors in the accounting
system.
 Take note, however, that the chart of accounts vary from company to company. The contents depend upon the needs and
preferences of the company using it.

Accounts are classified into assets, liabilities, capital, income, and expenses; and each is given a unique account number. A coding
system is used to organize the accounts. Here's a sample chart of accounts for a small sole proprietorship business:

Charts of Accounts Example

Gray
1000Electronic
Cash Repair Services
Chart
1010Of Accounts
Accounts Receivable
ASSETS
1011 (1000-1999)
Allowance for Doubtful Accounts
1020 Notes Receivable
1030 Interest Receivable
1040 Service Supplies
1510 Leasehold Improvements
1521 Accumulated Depreciation-Furniture and Fixtures
1530 Service Equipment
1531 Accumulated Depreciation-Service Equipment
LIABILITIES (2000-2999)
2000 Accounts Payable
2010 Notes Payable
2020 Salaries Payable
2030 Rent Payable 34
2040 Interest Payable
2050 Unearned Revenue
2060 Loans Payable
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OWNER’S EQUITY (3000-3999)

3000 Mr. Gray, Capital
Additional accounts can be added as the need arises. For 3010 Mr. Gray, Drawing
bigger companies, the accounts may be divided into several REVENUES (4000-4999)
sub-accounts. 4000 Service Revenue
4010 Interest Income
For example, employee salaries may have various accounts 4020 Gain on Sale of Equipment
for different departments and be included in the chart of 4999 Income Summary
accounts as: EXPENSES (5000-5999)
 5011 Salaries Expense – Administrative, 5000 Rent Expense
 5012 Salaries Expense – Servicing, 5010 Salaries Expense
 5013 Salaries Expense – Marketing, etc. 5020 Supplies Expense
5030 Utilities Expense
Again, take note that the chart of accounts of one company 5040 Interest Expense
may not be suitable for another company. It all depends 5050 Taxes and Licenses
upon the company's needs. In any case, the chart of 5060 Depreciation Expense
accounts is a useful tool for bookkeepers in recording 5070 Doubtful Accounts Expense
business transactions.

4.4. Journal Entries: Recording Business Transactions

 After analyzing and preparing business documents, the transactions are then recorded in the books of the company. In double-
entry accounting, transactions are recorded in the journal through journal entries.
 A journal, also known as Books of Original Entry, keeps records of business transactions in a systematic order.

Transactions are recorded in the journal in chronological order, i.e. as they occur; one after the other.

A simple journal looks like this:

Date Particulars Debit Credit

mmm dd Account debited Amount
Account credited Amount
mmm dd Account debited Amount
Account credited Amount

A column for posting reference or folio may also be included to facilitate easier tracking and cross-referencing with the ledger. Also,
an explanation of the transaction may be included below the row for account credited. The journal would then look like this:

Date Particulars PR Debit Credit

mmm dd Account debited ref. Amount
Account credited ref. Amount
Short explanation or annotation
Illustration

Let's try to prepare the journal entry for this transaction: On June 3, 2016, our company purchased computer equipment for its main
office and paid $1,200.00 in cash.

When we analyze that transaction, it would show that the accounting effects would be an increase in an asset account (Computer
Equipment), and a decrease in another asset (Cash) since we paid for the equipment.

We would then increase Computer Equipment by debiting it and decrease Cash by crediting it. The journal entry would be:

Date Particulars Debit Credit

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June 03, 2016 Computer Equipment $ 1,200.00

Cash $ 1,200.00
To record purchase of computer.

If you are not yet familiar with the accounting elements and how each is affected, see our lesson about Fundamental Accounting
Concepts here.

You will have no trouble as long as you know how to use debits and credits and what accounts to record.

In the above example, computer equipment is an asset account. To increase an asset account, you debit it. Hence, we debited
Computer Equipment. Cash is also an asset account. However, there is a decrease in cash because we paid for the computer
equipment. And so, we credited Cash.

Compound Journal Entries

When there is only one account debited and one credited, it is called a simple journal entry. There are however instances when
more than one account is debited or credited. They are called compound journal entries.

Let's take the previous transaction and change it up a bit. Here's the new transaction: On June 3, 2016, our company purchased
computer equipment for $1,200.00. Our company paid $800.00 and the $400.00 balance will be paid after 30 days.

The journal entry would be:

Date Particulars Debit Credit

June 03, 2016 Computer Equipment $ 1,200.00
Cash $ 800.00
Accounts Payable $400.00
To record purchase of computer.
The journal entry shows that the company received computer equipment worth $1,200. Cash is decreased by $800, the amount
paid.

In addition, the company incurred in an obligation to pay $400 after 30 days. The liabilities of the company increased. When we
increase liabilities, we credit it. That is why we credited Accounts Payable (a liability account) in the above entry.

Notice that the total amount debited is equal to the total amount credited.

Great! On the next page we will present more examples of recording transactions using a comprehensive illustrative case.

4.5 More Journal Entry Examples

For additional practice and exposure in journalizing transactions, we will be showing more examples of business transactions and
their journal entries.

The transactions in this lesson pertain to Gray Electronic Repair Services, our imaginary small sole proprietorship business.

For account titles, we will be using the chart of accounts presented in an earlier lesson.

All transactions are assumed and simplified for illustration purposes.

Note: We will also be using this set of transactions and journal entries in later lessons when we discuss the other steps of the
accounting process.

Let's start.

Transaction #1: On December 1, 2016, Mr. Donald Gray started Gray Electronic Repair Services by investing $10,000. The journal
entry should increase the company's Cash, and increase (establish) the capital account of Mr. Gray; hence:

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Date Particulars Debit Credit

December 01, 2016 Cash $ 10,000.00
Mr. Gray, Capital $ 10,000.00

Transaction #2: On December 5, Gray Electronic Repair Services paid registration and licensing fees for the business, $370.

First, we will debit the expense (to increase an expense, you debit it); and then, credit Cash to record the decrease in cash as a result
of the payment.

Date Particulars Debit Credit

December 05, 2016 Taxes and Licenses $ 370
Cash $ 370

Transaction #3: On December 6, the company acquired tables, chairs, shelves, and other fixtures for a total of $3,000. The entire
amount was paid in cash.

There is an increase in an asset account (Furniture and Fixtures) in exchange for a decrease in another asset (Cash).

Date Particulars Debit Credit

December 06, 2016 Furniture and Fixtures $ 3,000
Cash $ 3,000

Transaction #4: On December 7, the company acquired service equipment for $16,000. The company paid a 50% down payment and
the balance will be paid after 60 days.

This will result in a compound journal entry. There is an increase in an asset account (debit Service Equipment, $16,000), a decrease
in another asset (credit Cash, $8,000, the amount paid), and an increase in a liability account (credit Accounts Payable, $8,000, the
balance to be paid after 60 days).

Date Particulars Debit Credit

December 07, 2016 Service Equipment $ 16,000
Cash $ 8,000
Accounts Payable $ 8,000

Transaction #5: Also on December 7, Gray Electronic Repair Services purchased service supplies on account amounting to $1,500.

The company received supplies thus we will record a debit to increase supplies. By the terms "on account", it means that the
amount has not yet been paid; and so, it is recorded as a liability of the company.

Date Particulars Debit Credit

December 07, 2016 Service Supplies $ 1,500
Accounts Payable $ 1,500

Transaction #6: On December 9, the company received $1,900 for services rendered. We will then record an increase in cash (debit
the cash account) and increase in income (credit the income account).

Date Particulars Debit Credit

December 09, 2016 Cash $ 1,900
Service Revenue $ 1,900

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Transaction #7: On December 12, the company rendered services on account, $4,250.00. As per agreement with the customer, the
amount is to be collected after 10 days. Under the accrual basis of accounting, income is recorded when earned.

In this transaction, the services have been fully rendered (meaning, we made an income; we just haven't collected it yet.) Hence, we
record an increase in income and an increase in a receivable account.

Date Particulars Debit Credit

December 12, 2016 Account Receivable $ 4,250
Service Revenue $ 4,250

Transaction #8: On December 14, Mr. Gray invested an additional $3,200.00 into the business. The entry would be similar to what
we did in transaction #1, i.e. increase cash and increase the capital account of the owner.

Date Particulars Debit Credit

December 14, 2016 Cash $ 3,200
Mr. Gray, Capital $ 3,200

Transaction #9: Rendered services to a big corporation on December 15. As per agreement, the $3,400 amount due will be collected
after 30 days.

Date Particulars Debit Credit

December 15, 2016 Accounts Receivable $ 3,400
Service Revenue $ 3,400

Transaction #10: On December 22, the company collected from the customer in transaction #7. We will record an increase in cash by
debiting it. Then, we will credit accounts receivable to decrease it. We are reducing the receivable since it has already been
collected.

Date Particulars Debit Credit

December 22, 2016 Cash $ 4,250
Accounts Receivable $ 4,250
Actually, we simply transferred the amount from receivable to cash in the above entry.

Transaction #11: On December 23, the company paid some of its liability in transaction #5 by issuing a check. The company paid
$500 of the $1,500 payable.

To record this transaction, we will debit Accounts Payable for $500 to decrease it by the said amount. Then, we will credit cash to
decrease it as a result of the payment. The entry would be:

Date Particulars Debit Credit

December 23, 2016 Accounts Payable $ 500
Cash $ 500
Accounts payable would now have a credit balance of $1,000 ($1,500 initial credit in transaction #5 less $500 debit in the above
transaction).

Transaction #12: On December 25, the owner withdrew cash due to an emergency need. Mr. Gray withdrew $7,000 from the
company.

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We will decrease Cash since the company paid Mr. Gray $7,000. And, we will record withdrawals by debiting the withdrawal account
– Mr. Gray, Drawings.

Date Particulars Debit Credit

December 25, 2016 Mr. Gray, Drawings $ 7,000
Cash $ 7,000

Transaction # 13: On December 29, the company paid rent for December, $ 1,500. Again, we will record the expense by debiting it
and decrease cash by crediting it.

Date Particulars Debit Credit

December 29, 2016 Rent Expense $ 1,500
Cash $ 1,500

Transaction #14: On December 30, the company acquired a $12,000 short-term bank loan; the entire amount plus a 10% interest is
payable after 1 year.

Again, the company received cash so we increase it by debiting Cash. The company now has a liability. We will record it by crediting
the liability account – Loans Payable.

Date Particulars Debit Credit

December 30, 2016 Cash $ 12,000
Accounts Payable $ 12,000

Transaction #15: On December 31, the company paid salaries to its employees, $3,500.

For this transaction, we will record/increase the expense account by debiting it and decrease cash by crediting it. (Note: This is a
simplified entry to present the payment of salaries. In actual practice, different payroll accounting methods are applied.)

Date Particulars Debit Credit

December 31, 2016 Salaries Expense $ 3,500
Cash $ 3,500
There you have it. You should be getting the hang of it by now. If not, then you can always go back to the examples above.
Remember that accounting skills require mastery of concepts and practice.

4.6 Posting to the Accounting Ledger

 After journal entries are made, the next step in the accounting cycle is to post the journal entries into the ledger.
 Posting refers to the process of transferring entries in the journal into the accounts in the ledger. Posting to the ledger is the
classifying phase of accounting.
 An accounting ledger refers to a book that consists of all accounts used by the company, the debits and credits under each
account, and the resulting balances.
 While the journal is referred to as Books of Original Entry, the ledger is known as Books of Final Entry.

Example: Posting Process

Let us illustrate how accounting ledgers and the posting process work using the transactions we had in the previous lesson. Click
here to see the journal entries we will be using.

Let's start. Take transaction #1 first.

Date Particulars Debit Credit

December 01, 2016 Cash $ 10,000.00

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Mr. Gray, Capital $ 10,000.00

Now, go to the ledger and find the accounts. Post the amounts debited and credited to the appropriate side. Debits go to the left
and credits to the right. After posting the amounts, the cash and capital account would look like:

Cash Mr, Gray, Capital

DR CR DR CR
10,000.00 10,000.00

Explanation: First, we posted the entry to Cash. Cash in the journal entry was debited so we placed the amount on the debit side (left
side) of the account in the ledger. For Mr. Gray, Capital, it was credited so the amount is placed on the credit side (right side) of the
account. And that's it. Posting is simply transferring the amounts from the journal to the respective accounts in the ledger.

Note: The ledger accounts (or T-accounts) can also have fields for account number, description or particulars, and posting reference.

Let's try to post the second transaction.

Date Particulars Debit Credit

December 05, 2016 Taxes and Licenses $ 370
Cash $ 370
After posting the above entry, the affected accounts in the ledger would look like these:

Cash Taxes and Licenses

DR CR DR CR
10,000.00 370.00 370.00
There was a debit to Taxes and Licenses so we posted that in the left side (debit side) of the account. Cash was credited so we
posted that on the right side of the account.

Notice that after posting transaction #2, we now can get a more updated balance for each account. Cash now has a balance of
$9,630 ($10,000 debit and 370 credit). Nice, right? Post all the other entries and we will be able to get the balances of all the
accounts.

General Ledger Example

A general ledger contains accounts that are broad in nature such as Cash, Accounts Receivable, Supplies, and so on. There is another
type of ledge which we call subsidiary ledger. It consists of accounts within accounts (i.e., specific accounts that make up a broad
account).

For example, Accounts Receivable may be made up of subsidiary accounts such as Accounts Receivable – Customer A, Accounts
Receivable – Customer B, Accounts Receivable – Customer C, etc.

Okay – let's go back to the general ledger. In the above discussion, we posted transactions #1 and #2 into the ledger. If we post all 15
transactions and get the balances of each account at the end of the month, the ledger would look like this:

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After all accounts are posted, we can now

derive the balances of each account. So how
much Cash do we have at the end of the
month? As shown in the ledger above, the
company has $7,480 at the end of December.

How about accounts receivable? Accounts

payable? You can find them all in the ledger.

Note: The above is a simplified and theoretical

example of a ledger. In reality, companies have
a lot more than 15 transactions! They may have
hundreds or even thousands of transactions in
one day. Imagine how lengthy the ledger would
be. Worse, imagine the work needed in posting
that many transactions manually.

Because of technological advancements

however, most accounting systems today
perform automated posting process.
Nonetheless, the above example shows how a
ledger works.

4.7 Trial Balance: Testing the Equality

of Debits and Credits
 After analyzing transactions, recording them in the journal, and posting into the ledger, we enter the fourth step in the
accounting process – preparing a trial balance.
 A trial balance simply shows a list of the ledger accounts and their balances. Its purpose is to test the equality between total
debits and total credits.
 It shows a summary of how much Cash, Accounts Receivable, Supplies, etc. the company has after the posting process.
 The account names are listed as arranged in the ledger and the balances are placed either on the debit or credit column.

Trial Balance Example: To illustrate, here's a trial balance example. Based on the ledger we prepared in the previous lesson, the trial
balance would look like this:

Gray Electronic Repair Services

Unadjusted Trial Balance
December 31, 2016

ACCOUNT TITLE DEBIT CREDIT

Cash $7,480
Account Receivable $3,400
Service Supplies $1,500
Furniture and Fixtures $3,000
Service Equipment $16,000
Accounts Payable $9,000
Loans Payable $12,000
Mr. Gray, Capital $13,200
Mr. Gray, Drawing $7,000
Service Revenue $9,550
Rent Expense $1,500
Salaries Expense $3,500
Taxes and Licenses $370
TOTALS $43,750 $43,750
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The purpose of the trial balance is to test the equality between total debits and total credits after the posting process. This trial
balance is called an unadjusted trial balance (since adjustments are not yet included).

There are two other types of trial balance: the adjusted trial balance which is prepared after adjusting entries are prepared and
posted, and the post-closing trial balance which is prepared after closing entries. These two are prepared in later steps of the
accounting process.

Equal Doesn't Always Mean Correct

 When the total debits and total credits are not equal, it is a clear indication that a mistake has been committed in the
journalizing and/or posting process. An amount must have been entered incorrectly; hence, must be corrected.
 However, the trial balance does not guarantee that the records are accurate even if the total debits and total credits are equal.
There are instances when this happens such as:
 when a transaction was not recorded or not posted (no debit and no credit),
 when a transaction was recorded or posted twice (total debits and total credits are both overstated by the same amount),
 when an account was recorded instead of another account of the same classification; for example, Supplies was debited instead
of Equipment (the total debits would still be correct since they are both asset accounts).

4.8 Correcting Entries for Errors Detected

 When an error is discovered in the accounting records, it should be corrected immediately to prevent the processing of wrong
data which results to unreliable financial statements.
 A correcting entry is a journal entry whose purpose is to rectify the effect of an incorrect entry previously made.

To illustrate how to prepare correcting entries, here are some examples.

On December 5, 2016, Gray Electronic Repair Services paid $370 registration and licensing fees for the business.

The correct entry is:

Date Particulars Debit Credit

December 05, 2016 Taxes and Licenses $ 370
Cash $ 370
Suppose the bookkeeper, for whatever reason, debited Transportation Expense instead of Taxes and Licenses.

The entry made was:

Date Particulars Debit Credit

December 05, 2016 Transportation Expense $ 370
Cash $ 370
Upon analysis, the Transportation Expense is overstated (higher than in should be) because the bookkeeper recorded transportation
expense but it was not really a transportation expense.

Also, Taxes and Licenses is understated (lower than it should be). The amount should have been recorded but was not recorded
under this account.

To correct these errors, we should make an entry to offset the effects. Transportation Expense is overstated therefore we should
decrease it; Taxes and Licenses is understated therefore we should increase it.

The Cash account was credited in the entry made. Was the entry made to Cash correct? Look at the correct entry. Is it proper to
have Cash credited? Yes. Therefore, we have no problem with the Cash account.

Now, to increase Taxes and Licenses, we credit it. To decrease Transportation Expense, we debit it. Remember that to
increase/record an expense, we debit it; to decrease an expense, we credit it. The correcting entry would then be:

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Date Particulars Debit Credit

December 31, 2016 Taxes and Licenses $ 370
Transportation Expense $ 370
Note: The correcting entry is dated when the error is discovered. In this case, we assumed that it was discovered and corrected on
December 31.

If an explanation or annotation is required, it would be something like: "To correct error made on taxes and licenses" or "To record
correction of error on entry made for taxes and licenses."

After making this entry, Transportation Expense will zero-out ($370 debit and $370 credit) and Taxes and Licenses will now have a
balance of $370.00, thus making our records correct.

Another Example

Let us assume the bookkeeper made another error.

On December 17, the company collected a receivable from a customer, $1,650.00. Suppose the bookkeeper recorded it at $1,560.00
instead of $1,650.00. This was the entry made:

Date Particulars Debit Credit

December 17, 2016 Cash $ 1,560
Accounts Receivable $ 1,560
What is the correct entry? The entry should have been:

Date Particulars Debit Credit

December 17, 2016 Cash $ 1,650
Accounts Receivable $ 1,650
How will we correct this? Cash is understated because the accountant recorded $1,560 instead of $1,650. Accounts Receivable is
also overstated because it was reduced by $1,560 only but should have been reduced by $1,650. We should then increase Cash and
reduce Accounts Receivable by $90.

The correcting entry would be:

Date Particulars Debit Credit

December 31, 2016 Cash $ 90
Accounts Receivable $ 90
Another way of doing it (and an easier one) is to look at the entry made and correct entry. Upon analysis, you will see that the
amount debited to Cash is less that what should have been debited. The same goes for the amount credited to Accounts Receivable.
Cash should then be debited by $90 more and Accounts Receivable should be credited by $90 more.

Recap: Steps in Making Correcting Entries

The steps in preparing correcting entries may be summed up as follows:

Determine the entry mad. – What was the erroneous/wrong entry made?

Determine the correct entry – What entry should have been made?

Analyze #1 and #2 to come up with the correcting entry.

Steps 1 and 2 may be interchanged. Nonetheless, you need to know the entry made and the correct entry (should-be entry) before
you can come up with the correcting entry.

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CHAPTER 5: ADJUSTING ENTRIES

5.1 Introduction to Adjusting Journal Entries
 Adjusting entries, or adjusting journal entries (AJE), are made to update the accounts and bring them to their correct balances.
 The preparation of adjusting entries is an application of the accrual concept of accounting and the matching principle.
 The accrual concept states that income is recognized when earned regardless of when collected and expense is recognized
when incurred regardless of when paid.
 The matching principle aims to align expenses with revenues. Expenses should be recognized in the period when the revenues
generated by such expenses are recognized.

Purpose of Adjusting Entries

 The main purpose of adjusting entries is to update the accounts to conform with the accrual concept. At the end of the
accounting period, some income and expenses may have not been recorded, taken up or updated; hence, there is a need to
update the accounts.
 If adjusting entries are not prepared, some income, expense, asset, and liability accounts may not reflect their true values when
reported in the financial statements. For this reason, adjusting entries are necessary.

Types of Adjusting Entries

Generally, there are 4 types of adjusting entries. Adjusting entries are prepared for the following:

1. Accrued Income – income earned but not yet received (you just performed the service) RECEIVABLES
Accrued revenues are used for transactions in which goods and services have been provided, but cash hasn't yet been received.
In many cases, these revenues are included in the accounts receivable listing, and accountants don't need to look for them or to
book them separately. A common accrued revenue situation is interest that has been earned but not yet received. The journal
entry is to debit or increase interest receivable, an asset account, and to credit or increase interest revenue, which is reported in
the income statement. When the interest is received, the entry is to debit cash, increasing it, and to credit interest receivable,
zeroing it out. The end result is to recognize the revenue in the income statement before the money is actually received.
2. Accrued Expense – expenses incurred but not yet paid.
3. Deferred Income – income received but not yet earned services
Deferred revenues reflect situations in which money has been received, but goods and services haven't been provided. These
revenues are also known as deposits, and they are not recognized as revenues in the income statement. Deferred revenues are
not "real revenues." They don't affect net income or loss at all.
Rather, they report on the balance sheet as liabilities. The journal entry to recognize a deferred revenue is to debit or increase
cash and credit or increase a deposit or another liability account. When services or goods are provided, the entry is to debit or
decrease the deposit account and credit or increase the revenue account – the "real" one, which reports in the income
statement and impacts net income or loss.
4. Prepaid Expense – expenses paid but not yet incurred. ADVANCES

Also, adjusting entries are made for:

 Depreciation
 Doubtful Accounts or Bad Debts, and other allowances

Composition of an Adjusting Entry

 Adjusting entries affect at least one nominal account and one real account.
 A nominal account is an account whose balance is measured from period to period. Nominal accounts include all accounts in the
Income Statement, plus owner's withdrawal. They are also called temporary accounts or income statement accounts.
 Examples of nominal accounts are: Service Revenue, Salaries Expense, Rent Expense, Utilities Expense, Mr. Gray Drawing, etc.

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 A real account has a balance that is measured cumulatively, rather than from period to period. Real accounts include all
accounts in the balance sheet. They are also called permanent accounts or balance sheet accounts.
 Real accounts include: Cash, Accounts Receivable, Rent Receivable, Accounts Payable, Mr. Gray Capital, and others.
 All adjusting entries include at least a nominal account and a real account.
 Note: "Adjusting entries" refer to the 6 entries mentioned above. However, in some branches of accounting (especially
auditing), the term adjusting entries could refer to any entry that aims to adjust incorrect account balances.
 As a result, there is little distinction between "adjusting entries" and "correcting entries" today. In the traditional sense,
however, adjusting entries are those made at the end of the period to take up accruals, deferrals, prepayments, depreciation
and allowances.
 In the next lessons, we will illustrate how to prepare adjusting entries for each type and provide examples as we go.

5.2 Adjusting Entry for Accrued Income

 Accrued income (or accrued revenue) refers to income already earned but has not yet been collected.
 At the end of every period, accountants should make sure that they are properly included as income, with a corresponding
receivable.
 When a company has performed services or sold goods to a customer, it should be recognized as income even if the amount is
still to be collected at a future date.
 If no journal entry was ever made for the above, then an adjusting entry is necessary.

Pro-Forma Entry

The adjusting entry to record an accrued revenue is:

mmm dd Receivable Account x,xxx.xx

Income Account x,xxx.xx
*Appropriate receivable account such as Accounts Receivable, Rent Receivable, Interest Receivable, etc.

**Income account such as Service Revenue, Rent Income, Interest Income, etc.

Here's an Example

In our previous set of transactions, assume this additional information:

On December 31, 2016, Gray Electronic Repair Services rendered $300 worth of services to a client. However, the amount has not
yet been collected. It was agreed that the customer will pay the amount on January 15, 2017. The transaction was never recorded in
the books of the company.

In this case, we should make an adjusting entry in 2016 to recognize the income since it has already been earned. The adjusting
entry would be:

Date Particulars Debit Credit

December 31, 2016 Accounts Receivable $ 300
Service Revenue $ 300
Here are some more illustrations.

More Examples: Adjusting Entries for Accrued Income

Example 1: Company ABC leases its building space to a tenant. The tenant agreed to pay monthly rental fees of $2,000 covering a
period from the 1st to the 30th or 31st of every month. On December 31, 2016, ABC Company did not receive the rental fee for
December yet and no record was made in the journal.

Under the accrual basis, the rent income above should already be recognized because it has already been earned even if it has not
yet been collected. The adjusting journal entry would be:

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Date Particulars Debit Credit

December 31, 2016 Rent Receivable $ 2,000
Rent Income $ 2,000

Example 2: ABC Company lent $9,000 at 10% interest on December 1, 2016. The amount will be collected after 1 year. At the end of
December, no entry was entered in the journal to take up the interest income.

Interest is earned through the passage of time. In the case above, the $9,000 principal plus a $900 interest will be collected by the
company after 1 year. The $900 interest pertains to 1 year.

However, 1 month has already passed. The company is already entitled to 1/12 of the interest, as prorated. Therefore the adjusting
entry would be to recognize $75 (i.e. $900 x 1/12 ) as interest income:

Date Particulars Debit Credit

December 31, 2016 Interest Receivable $ 75
Interest Income $ 75
The basic concept you need to remember is recognition of income. When is income recognized? Under the accrual concept of
accounting, income is recognized when earned regardless of when collected.

If the company has already earned the right to it and no entry has been made in the journal, then an adjusting entry to record the
income and a receivable is necessary.

5.3 Adjusting Entry for Accrued Expense

Accrued expenses refer to expenses that are already incurred but have not yet been paid.

At the end of period, accountants should make sure that they are properly recorded in the books of the company as an expense,
with a corresponding payable account.

Here's the rule. If a company incurred, used, or consumed all or part of an expense, that expense or part of it should be properly
recognized even if it has not yet been paid.

If such has not been recognized, then an adjusting entry is necessary.

Pro-Forma Entry

The pro-forma adjusting entry to record an accrued expense is:

mmm dd Expenses Account x,xxx.xx

Liability Account x,xxx.xx
*Appropriate expense account (such as Utilities Expense, Rent Expense, Interest Expense, etc.)
**Appropriate liability account (Utilities Payable, Rent Payable, Interest Payable, Accounts Payable, etc.)

For Example

For the month of December 2016, Gray Electronic Repair Services used a total of $1,800 worth of electricity and water. The company
received the bills on January 10, 2017. When should the expense be recorded, December 2016 or January 2017?

Answer – in December 2016. According to the accrual concept of accounting, expenses are recognized when incurred regardless of
when paid. The amount above pertains to utilities used in December. Therefore, if no entry was made for it in December then an
adjusting entry is necessary.

Date Particulars Debit Credit

December 31, 2016 Utilities Expense $ 1,800
Utilities Payable $ 1,800

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In the adjusting entry above, Utilities Expense is debited to recognize the expense and Utilities Payable to record a liability since the
amount is yet to be paid.

Here are some more examples.

More Examples: Adjusting Entries for Accrued Expense

Example 1: VIRON Company entered into a rental agreement to use the premises of DON's building. The agreement states that
VIRON will pay monthly rentals of $1,500. The lease started on December 1, 2016. On December 31, the rent for the month has not
yet been paid and no record for rent expense was made.

In this case, VIRON Company already incurred (consumed/used) the expense. Even if it has not yet been paid, it should be recorded
as an expense. The necessary adjusting entry would be:

Date Particulars Debit Credit

December 31, 2016 Rent Expense $ 1,500
Rent Payable $ 1,500

Example 2: VIRON Company borrowed $6,000 at 12% interest on August 1, 2016. The amount will be paid after 1 year. At the end of
December, the end of the accounting period, no entry was entered in the journal to take up the interest.

Let's analyze the above transaction.

VIRON will be paying $6,000 principal plus $720 interest after a year. The $720 interest covers 1 year. At the end of December, a part
of that is already incurred, i.e. $720 x 5/12 or $300. That pertains to interest for 5 months, from August 1 to December 31. The
adjusting entry would be:

Date Particulars Debit Credit

December 31, 2016 Interest Expense $ 300
Interest Payable $ 300
Expenses are recognized when incurred regardless of when paid. What you need to remember here is this: when it has been
consumed or used and no entry was made to record the expense, then there is a need for an adjusting entry.

5.4 Adjusting Entry for Unearned Income

 Unearned revenue (also known as deferred revenue or deferred income) represents revenue already collected but not yet
earned.
 Hence, they are also called "advances from customers".
 Following the accrual concept of accounting, unearned revenues are considered as are liabilities.
 It is to be noted that under the accrual concept, income is recognized when earned regardless of when collected.
 And so, unearned revenue should not be included as income yet; rather, it is recorded as a liability. This liability represents an
obligation of the company to render services or deliver goods in the future. It will be recognized as income only when the goods
or services have been delivered or rendered.
 At the end of the period, unearned revenues must be checked and adjusted if necessary. The adjusting entry for unearned
revenue depends upon the journal entry made when it was initially recorded.

There are two ways of recording unearned revenue: (1) the liability method, and (2) the income method.

Liability Method of Recording Unearned Revenue

Under the liability method, a liability account is recorded when the amount is collected. The common accounts used are: Unearned
Revenue, Deferred Income, Advances from Customers, etc. For this illustration, let us use Unearned Revenue.
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Suppose on January 10, 2016, ABC Company made $30,000 advanced collections from its customers. If the liability method is used,
the entry would be:

Date Particulars Debit Credit

January 10, 2016 Cash $ 30,000
Unearned Revenue $ 30,000
Take note that the amount has not yet been earned, thus it is proper to record it as a liability. Now, what if at the end of the month,
20% of the unearned revenue has been rendered? This will require an adjusting entry.

The adjusting entry will include: (1) recognition of $6,000 income, i.e. 20% of $30,000, and (2) decrease in liability (unearned
revenue) since some of it has already been rendered. The adjusting entry would be:

Date Particulars Debit Credit

January 31, 2016 Unearned Revenue $ 6,000
Service Income $ 6,000

We are simply separating the earned part from the unearned portion. Of the
$30,000 unearned revenue, $6,000 is recognized as income. In the entry
above, we removed $6,000 from the $30,000 liability. The balance of
unearned revenue is now at $24,000.

Income Method of Recording Unearned Revenue

Under the income method, the accountant records the entire collection under an income account. Using the same transaction
above, the initial entry for the collection would be:

Date Particulars Debit Credit

January 10, 2016 Cash $ 30,000
Service Income $ 30,000

If at the end of the year the company earned 20% of the entire $30,000, then the adjusting entry would be:

Date Particulars Debit Credit

January 31, 2016 Service Income $ 24,000
Unearned Income $ 24,000

By debiting Service Income for $24,000, we are decreasing the income initially recorded. The balance of Service Income is now
$6,000 ($30,000 - 24,000), which is actually the 20% portion already earned. By crediting Unearned Income, we are recording a
liability for $24,000.

Notice that the resulting balances of the accounts under the two methods are the same (Cash: $30,000; Service Income: $6,000; and
Unearned Income: $24,000).

Another Example
On December 1, 2016, DRG Company collected from TRM Corp. a total of $60,000 as rental fee for three months starting December
1.

Under the liability method, the initial entry would be:

Date Particulars Debit Credit

December 01, 2016 Cash $ 60,000

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Unearned Rent Income $ 60,000

On December 31, 2016, the end of the accounting period, 1/3 of the rent received has already been earned (prorated over 3
months).

We should then record the income through this adjusting entry:

Date Particulars Debit Credit

December 31, 2016 Unearned Rent Income $ 20,000
Rent Income $ 20,000

In effect, we are transferring $20,000, one-third of $60,000, from the Unearned Rent Income (a liability) to Rent Income (an income
account) since that portion has already been earned.

If the company made use of the income method, the initial entry would be:

Date Particulars Debit Credit

December 01, 2016 Cash $ 60,000
Rent Income $ 60,000

In this case, we must decrease Rent Income by $40,000 because that part has not yet been earned. The income account shall have a
balance of $20,000. The amount removed from income shall be transferred to liability (Unearned Rent Income). The adjusting entry
would be:

Date Particulars Debit Credit

December 31, 2016 Rent Income $ 40,000
Unearned Rent Income $ 40,000

Conclusion

If you have noticed, what we are actually doing here is making sure that the earned part is included in income and the unearned part
into liability. The adjusting entry will always depend upon the method used when the initial entry was made.

If you are having a hard time understanding this topic, I suggest you go over and study the lesson again. Sometimes, it really takes a
while to get the concept. Preparing adjusting entries is one of the most challenging (but important) topics for beginners.

5.5 Adjusting Entry for Prepaid Expense

 Prepaid expenses (a.k.a. prepayments) represent payments made for expenses which have not yet been incurred.
 In other words, these are "advanced payments" by a company for supplies, rent, utilities and others that are still to be
consumed. Hence, they are included in the company's assets.
 Expenses are recognized when they are incurred regardless of when paid. Expenses are considered incurred when they are
used, consumed, utilized or has expired.
 Because prepayments they are not yet incurred, they are not recorded as expenses. Rather, they are classified as current assets
since they are readily available for use.
 Prepaid expenses may need to be adjusted at the end of the accounting period. The adjusting entry for prepaid expense
depends upon the journal entry made when it was initially recorded.

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There are two ways of recording prepayments: (1) the asset method, and (2) the expense method.

Asset Method

Under the asset method, a prepaid expense account (an asset) is recorded when the amount is paid. Prepaid expense accounts
include: Office Supplies, Prepaid Rent, Prepaid Insurance, and others.

In one of our previous illustrations (if you have been following our comprehensive illustration for Gray Electronic Repair Services),
we made this entry to record the purchase of service supplies:

Date Particulars Debit Credit

December 07, 2016 Service Supplies $ 1,500
Rent Income $ 1,500

Take note that the amount has not yet been incurred, thus it is proper to record it as an asset.

Suppose at the end of the month, 60% of the supplies have been used. Thus, out of the $1,500, $900 worth of supplies have been
used and $600 remain unused. The $900 must then be recognized as expense since it has already been used.

In preparing the adjusting entry, our goal is to transfer the used part from the
asset initially recorded into expense – for us to arrive at the proper balances
shown in the illustration above.

The adjusting entry will include: (1) recognition of expense and (2) decrease in
the asset initially recorded (since some of it has already been used). The
adjusting entry would be:

Date Particulars Debit Credit

December 31, 2016 Service Supplies Expense $ 900
Service Supplies $ 900

The "Service Supplies Expense" is an expense account while "Service Supplies" is an asset. After making the entry, the balance of the
unused Service Supplies is now at $600 ($1,500 debit and $900 credit). Service Supplies Expense now has a balance of $900. Now,
we've achieved our goal.

Expense Method

Under the expense method, the accountant initially records the entire payment as expense. If the expense method was used, the
entry would have been:

Date Particulars Debit Credit

December 07, 2016 Service Supplies Expense $ 1,500
Cash $ 1,500

Take note that the entire amount was initially expensed. If 60% was used, then the adjusting entry at the end of the month would
be:

Date Particulars Debit Credit

December 31, 2016 Service Supplies $ 600
Service Supplies Expense $ 600

This time, Service Supplies is debited for $600 (the unused portion). And then, Service Supplies Expense is credited thus decreasing
its balance. Service Supplies Expense is now at $900 ($1,500 debit and $600 credit).

Notice that the resulting balances of the accounts under the two methods are the same (Cash paid: $1,500; Service Supplies
Expense: $900; and Service Supplies: $600).

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Another Example

GVG Company acquired a six-month insurance coverage for its properties on September 1, 2016 for a total of $6,000.

Under the asset method, the initial entry would be:

Date Particulars Debit Credit

September 01, 2016 Prepaid Insurance $ 6,000
Cash $ 6,000
On December 31, 2016, the end of the accounting period, part of the prepaid insurance already has expired (hence, expense is
incurred). The expired part is the insurance from September to December. Thus, we should make the following adjusting entry:

Date Particulars Debit Credit

December 31, 2016 Insurance Expense $ 4,000
Prepaid Insurance $ 4,000
Of the total six-month insurance amounting to $6,000 ($1,000 per month), the insurance for 4 months has already expired. In the
entry above, we are actually transferring $4,000 from the asset to the expense account (i.e., from Prepaid Insurance to Insurance
Expense).

If the company made use of the expense method, the initial entry would be:

Date Particulars Debit Credit

September 01, 2016 Insurance Expense $ 6,000
Cash $ 6,000
In this case, we must decrease Insurance Expense by $2,000 because that part has not yet been incurred (not used/not expired).
Insurance Expense shall then have a balance of $4,000. The amount removed from the expense shall be transferred to Prepaid
Insurance. The adjusting entry would be:

Date Particulars Debit Credit

December 31, 2016 Prepaid Insurance $ 2,000
Insurance Expense $ 2,000
Conclusion

What we are actually doing here is making sure that the incurred (used/expired) portion is included in expense and the unused part
into asset. The adjusting entry will always depend upon the method used when the initial entry was made.

If you are having a hard time understanding this topic, I suggest you go over and study the lesson again. Sometimes, it really takes a
while to get the concept. Preparing adjusting entries is one of the challenging (but important) topics for beginners.

5.6 Depreciation Expense

 When a fixed asset is acquired by a company, it is recorded at cost (generally, cost is equal to the purchase price of the asset).
This cost is recognized as an asset and not expense.
 The cost is to be allocated as expense to the periods in which the asset is used. This is done by recording depreciation expense.
 There are two types of depreciation – physical and functional depreciation.
 Physical depreciation results from wear and tear due to frequent use and/or exposure to elements like rain, sun and wind.

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 Functional or economic depreciation happens when an asset becomes inadequate for its purpose or becomes obsolete. In this
case, the asset decreases in value even without any physical deterioration.

Understanding the Concept of Depreciation

There are several methods in depreciating fixed assets. The most common and simplest is the straight-line depreciation method.

Under the straight line method, the cost of the fixed asset is distributed evenly over the life of the asset.

For example, ABC Company acquired a delivery van for $40,000 at the beginning of 2012. Assume that the van can be used for 5
years. The entire amount of $40,000 shall be distributed over five years, hence, a depreciation expense of $8,000 each year.

Straight-line depreciation expense is computed using this formula:

Depreciable Cost (Acquisition Cost) – Residual Value/Estimated Useful Life

 Depreciable Cost: Historical or un-depreciated cost of the fixed asset

 Residual Value or Scrap Value: Estimated value of the fixed asset at the end of its useful life
 Useful Life: Amount of time the fixed asset can be used (in months or years)

In the above example, there is no residual value. Depreciation expense is computed as:

= $40,000 – $0 /5 years

= $8,000 / year

With Residual Value

What if the delivery van has an estimated residual value of $10,000? The depreciation expense then would be computed as:

= $40,000 – $10,000 /5 years

= $30,000 /5 years

= $6,000 / year

How to Record Depreciation Expense

Depreciation is recorded by debiting Depreciation Expense and crediting

Accumulated Depreciation. This is recorded at the end of the period (usually, at
the end of every month, quarter, or year).

The entry to record the $6,000 depreciation every year would be:

Date Particulars Debit Credit

December 31, 2012 Depreciation Expense $ 6,000
Accumulated Depreciation $ 6,000

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Depreciation Expense: An expense account; hence, it is presented in the income statement. It is measured from period to period. In
the illustration above, the depreciation expense is $6,000 for 2012, $6,000 for 2013, $6,000 for 2014, etc.

Accumulated Depreciation: A balance sheet account that represents the accumulated balance of depreciation. It is continually
measured; hence the accumulated depreciation balance is $6,000 at the end of 2012, $12,000 in 2013, $18,000 in 2014, $24,000 in
2015, and $30,000 in 2016.

Accumulated depreciation is a contra-asset account. It is presented in the balance sheet as a deduction to the related fixed asset.
Here's a table illustrating the computation of the carrying value of the delivery van.

2012 2013 2014 2015 2016

Delivery Van - $40,000 $40,000 $40,000 $40,000 $40,000
Historical Cost
Less: Accumulated 6,000 12,000 18,000 24,000 30,000
Depreciation
Delivery Van - $34,000 $28,000 $22,000 $16,000 $10,000
Carrying Value
Notice that at the end of the useful life of the asset, the carrying value is equal to the residual value.

Depreciation for Acquisitions Made Within the Period

The delivery van in the example above has been acquired at the beginning of 2012, i.e. January. Therefore, it is easy to calculate for
the annual straight-line depreciation. But what if the delivery van was acquired on April 1, 2012?

In this case we cannot apply the entire annual depreciation in the year 2012 because the van has been used only for 9 months (April
to December). We need to prorate.

For 2012, the depreciation expense would be: $6,000 x 9/12 = $4,500

Years 2013 to 2016 will have $6,000 annual depreciation expense. [(2013-6k)(2014-6k)(2014-6k)(2015-6k)(2016-6k) All in all, in that
4 years-24k]

In 2017, the van will be used for 3 months only (January to March) since it has a useful life of 5 years (i.e. April 1, 2012 to March 31,
2017). [2012 has 9 months, so 3 months is required to 2017 to complete a year]

The depreciation expense for 2017 would be: $6,000 x 3/12 = $1,500, and thus completing the accumulated depreciation of $30,000.

2012 (April to December) $ 4,500

2013 (entire year) 6,000
2014 (entire year) 6,000
2015 (entire year) 6,000
2016 (entire year) 6,000
2017 (January to March) 1,500
Total for 5 years $ 30,000

5.7. Bad Debts Expense

 Companies provide services or sell goods for cash or on credit. Allowing credit tends to encourage more sales.
 However, businesses that allow credit are faced with the risk that their receivables may not be collected.
 Accounts receivable should be presented in the balance sheet at net realizable value, i.e. the most probable amount that the
company will be able to collect.

Net realizable value for accounts receivable is computed like this:

Accounts Receivable - Gross Amount $ 100,000

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Less: Allowance for Bad Debts 3,000

Accounts Receivable - Net Realizable Value $ 97,000
Allowance for Bad Debts (also often called Allowance for Doubtful Accounts) represents the estimated portion of the Accounts
Receivable that the company will not be able to collect.

Take note that this amount is an estimate. There are several methods in estimating doubtful accounts. The estimates are often
based on the company's past experiences.

To recognize doubtful accounts or bad debts, an adjusting entry must be made at the end of the period. The adjusting entry for bad
debts looks like this:

Dec 31 Bad Debts Expense xxx.xx

Allowance for Bad Debts xxx.xx
Bad Debts Expense a.k.a. Doubtful Accounts Expense: An expense account; hence, it is presented in the income statement. It
represents the estimated uncollectible amount for credit sales/revenues made during the period.

Allowance for Bad Debts a.k.a. Allowance for Doubtful Accounts: A balance sheet account that represents the total estimated
amount that the company will not be able to collect from its total Accounts Receivable.

What is the difference between Bad Debts Expense and Allowance for Bad Debts?

Bad Debts Expense is an income statement account while the latter is a balance sheet account. Bad Debts Expense represents the
uncollectible amount for credit sales made during the period. Allowance for Bad Debts, on the other hand, is the uncollectible
portion of the entire Accounts Receivable.

You can also use Doubtful Accounts Expense and Allowance for Doubtful Accounts in lieu of Bad Debts Expense and Allowance for
Bad Debts. However, it is a good practice to use a uniform pair. Some say that Bad Debts have a higher degree of uncollectibility that
Doubtful Accounts. In actual practice, however, the distinction is not really significant.

Here's an Example

Gray Electronic Repair Services estimates that $100.00 of its credit revenue for the period will not be collected. The entry at the end
of the period would be:

Dec 31 Bad Debts Expense 100.00

Allowance for Bad Debts 100.00
Again, you may use Doubtful Accounts. Just be sure to use a logical (and uniform) pair every time. For example:

Dec 31 Doubtful Accounts Expense 100.00

Allowance for Doubtful Accounts 100.00
If the company's Accounts Receivable amounts to $3,400 and its Allowance for Bad Debts is $100, then the Accounts Receivable shall
be presented in the balance sheet at $3,300 – the net realizable value.

Accounts Receivable (Gross Amount) $ 3,400

Less: Allowance for Bad Debts 100
Accounts Receivable - Net Realizable Value $ 3,300

5.8. Adjusted Trial Balance

 An adjusted trial balance is prepared after adjusting entries are made and posted to the ledger.
 This is the second trial balance prepared in the accounting cycle. Its purpose is to test the equality between debits and
credits after adjusting entries are entered into the books of the company.

To illustrate how it works, here is a sample unadjusted trial balance:

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Gray Electronic Repair Services

Unadjusted Trial Balance
December 31, 2016

Account Title Debit Credit

Cash $ 7,480.00
Accounts Receivable 3,400.00
Service Supplies 1,500.00
Furniture and Fixtures 3,000.00
Service Equipment 16,000.00
Accounts Payable $ 9,000.00
Loans Payable 12,000.00
Mr. Gray, Capital 13,200.00
Mr. Gray, Drawing 7,000.00
Service Revenue 9,550.00
Rent Expense 1,500.00
Salaries Expense 3,500.00
Taxes and Licenses 370.00
Totals $ 43,750.00 $ 43,750.00

At the end of the period, the following adjusting entries were made:

Dec 31, 2016 Accounts Receivable 300.00

Service Revenue 300.00

Dec 31, 2016 Utilities Expense 1,800.00

Utilities Payable 1,800.00

Dec 31, 2016 Service Supplies Expense 900.00

Service Supplies 900.00

Dec 31, 2016 Depreciation Expense 720.00

Accumulated Depreciation 720.00
After posting the above entries, the values of some of the items in the unadjusted trial balance will change. Take the first adjusting
entry. Accounts Receivable is debited hence is increased by $300. Service Revenue is credited for $300.

The balance of Accounts Receivable is increased to $3,700, i.e. $3,400 unadjusted balance plus $300 adjustment. Service Revenue
will now be $9,850 from the unadjusted balance of $9,550.

Next entry. Utilities Expense and Utilities Payable did not have any balance in the unadjusted trial balance. After posting the above
entries, they will now appear in the adjusted trial balance.

Third. Service Supplies Expense is debited for $900. Service Supplies is credited for $900. The Service Supplies account had a debit
balance of $1,500. After incorporating the $900 credit adjustment, the balance will now be $600 (debit).

And fourth. There were no Depreciation Expense and Accumulated Depreciation in the unadjusted trial balance. Because of the
adjusting entry, they will now have a balance of $720 in the adjusted trial balance. (Was not discussed $720)

Adjusted Trial Balance Example

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After incorporating the adjustments above, the adjusted trial balance would look like this. Just like in the unadjusted trial balance,
total debits and total credits should be equal.

Gray Electronic Repair Services

Adjusted Trial Balance
December 31, 2016

Account Title Debit Credit

Cash $ 7,480.00
Accounts Receivable 3,700.00
Service Supplies 600.00
Furniture and Fixtures 3,000.00
Service Equipment 16,000.00
Accumulated Depreciation- Service Equipment $ 720.00
Accounts Payable 9,000.00
Utilities Payable 1,800.00
Loans Payable 12,000.00
Mr. Gray, Capital 13,200.00
Mr. Gray, Drawing 7,000.00
Service Revenue 9,850.00
Rent Expense 1,500.00
Salaries Expense 3,500.00
Taxes and Licenses 370.00
Utilities Expense 1,800.00
Service Supplies Expense 900.00
Depreciation Expense 720.00
Totals $ 46,570.00 $ 46,570.00

CHAPTER 6: HOW TO PREPARE FINANCIAL STATEMENT

6.1 How to Prepare an Income Statement
 An income statement contains information about a company's revenues and expenses and the resulting net income.
 Net income is computed by deducting all expenses from all revenues. It is the primary measure of the company's ability to make
money.
 In this tutorial, we will prepare an income statement of a sole proprietorship service-type business using information from
previous lessons. We will be using the adjusted trial balance from this lesson: Adjusted Trial Balance. If you want, you may take
a look at how an income statement looks like here before we proceed.

When you're ready, let's begin.

Step 1: Gather the necessary information

In an accounting system, the best tool to take information from would be the "adjusted trial balance". This is the most updated trial
balance (i.e. prepared after considering adjustments to several accounts). In any case, any report that shows a complete listing of
company accounts can be used.

Let's take the adjusted trial balance of Gray Electronic Repair Services.

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Gray Electronic Repair Services

Adjusted Trial Balance
December 31, 2016

Account Title Debit Credit

Cash $ 7,480.00
Accounts Receivable 3,700.00
Service Supplies 600.00
Furniture and Fixtures 3,000.00
Service Equipment 16,000.00
Accumulated Depreciation- Service Equipment $ 720.00
Accounts Payable 9,000.00
Utilities Payable 1,800.00
Loans Payable 12,000.00
Mr. Gray, Capital 13,200.00
Mr. Gray, Drawing 7,000.00
Service Revenue 9,850.00
Rent Expense 1,500.00
Salaries Expense 3,500.00
Taxes and Licenses 370.00
Utilities Expense 1,800.00
Service Supplies Expense 900.00
Depreciation Expense 720.00
Totals $ 46,570.00 $ 46,570.00

Step 2: Start by making the heading

The heading of a financial statement is made up of three lines. The first line contains the name of the company (Gray Electronic
Repair Services). The second line shows the title of the report (Income Statement). And the third line indicates the period reported.

For income statements, we use For the Year Ended..., For the Quarter Ended..., For the Month Ended..., etc., depending on the
period covered in the report. Nonetheless, some annual income statements omit the "For the Year Ended" phrase.

Gray Electronic Repair Services

Income Statement/Comprehensive Income Statement
For the Year Ended December 31, 2016

Step 3: Report all revenue accounts

From the trial balance, we will look for and report all income or revenue accounts. You will need to be familiar with different income
accounts such as Service Revenue, Sales, Professional Fees, Interest Income, etc. If you need a review on that topic, you may visit
this lesson: Elements of Accounting.

In the adjusted trial balance above, there is only one revenue account - Service Revenue.

Gray Electronic Repair Services

Income Statement/Comprehensive Income Statement
For the Year Ended December 31, 2016

Service Revenue $ 9,850

Note: If there are multiple revenue accounts, you need to list them down and take the sum total of all revenues.

Step 4: Report all expense accounts

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From the adjusted trial balance again, we will take all expenses and include them in the report. Once they are all listed, we will get
the sum of all the expenses.

Gray Electronic Repair Services

Income Statement/Comprehensive Income Statement
For the Year Ended December 31, 2016

Service Revenue $ 9,850

Less: Operating Expenses

Salaries Expense $ 3,500

Utilities Expense 1,800
Rent Expense 1,500
Service Supplies Expense 900
Depreciation Expense 720
Taxes and Licenses 370 8,790

It is a good practice to list the expenses from highest to lowest whenever possible. This allows better analysis of company expenses.

Drawing a horizontal line means that a mathematical operation has been performed. The line after 370 indicates that we took the
sum of all expenses which amounts to 8,790. The total amount of expenses is aligned with the total amount of revenues.

Step 5: Compute for the net income

Net income is equal to total revenues minus total expenses.

Gray Electronic Repair Services

Income Statement/Comprehensive Income Statement
For the Year Ended December 31, 2016

Service Revenue $ 9,850

Less: Operating Expenses

Salaries Expense $ 3,500

Utilities Expense 1,800
Rent Expense 1,500
Service Supplies Expense 900
Depreciation Expense 720
Taxes and Licenses 370 8,790

Net Income $ 1,060

Again, we drew a single line under 8,790 to indicate that a mathematical operation was made. Two horizontal lines are drawn under
the final amount (1,060 net income). This is known as "double-rule" and is similar to enclosing the final answers in a box or circle in
your math test.

So there you go. The preparation is somewhat easy – you just need to be familiar with the different revenue and expense accounts.

Some Important Notes

This is a simplified illustration of preparing an income statement. Income tax expense was not considered in the above example. The
treatment of income taxes depends upon the applicable laws of the state or country. Nonetheless, if the company is subject to
income tax, the income tax expense should be deducted to get the net income. Since income tax expense is based on income, we
need to get the income before tax first.

Total Revenues - Total Operating Expenses = Income Before Tax

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Income Before Tax - Income Tax Expense = Net Income

Also, the income statements of merchandising and manufacturing businesses will look a little different from the above example.
Gross Profit is computed before deducting the operating expenses. Gross profit is equal to Sales minus Cost of Sales.

6.2 How to Prepare a Statement of Owner's Equity

The "Statement of Owner's Equity", or "Statement of Changes in Owner's Equity", summarizes the items affecting the capital
account of a sole proprietorship business.

A sole proprietorship's capital is affected by four items: owner's contributions, owner's withdrawals, income, and expenses.

In this tutorial, we will prepare a statement of changes in owner's equity using information from previous lessons. We will be using
the adjusted trial balance from this lesson: Adjusted Trial Balance. You may also want to take a look at an example here before
proceeding.

Step 1: Gather the needed information

The Statement of Changes in Owner's Equity is prepared second to the Income Statement. We will still be using the same source of
information. Again, the most appropriate source would be the adjusted trial balance. Nonetheless, any report with a complete list of
updated accounts may be used. We will also be using the Income Statement later in the process.

Gray Electronic Repair Services

Adjusted Trial Balance
December 31, 2016

Account Title Debit Credit

Cash $ 7,480.00
Accounts Receivable 3,700.00
Service Supplies 600.00
Furniture and Fixtures 3,000.00
Service Equipment 16,000.00
Accumulated Depreciation- Service Equipment $ 720.00
Accounts Payable 9,000.00
Utilities Payable 1,800.00
Loans Payable 12,000.00
Mr. Gray, Capital 13,200.00
Mr. Gray, Drawing 7,000.00
Service Revenue 9,850.00
Rent Expense 1,500.00
Salaries Expense 3,500.00
Taxes and Licenses 370.00
Utilities Expense 1,800.00
Service Supplies Expense 900.00
Depreciation Expense 720.00
Totals $ 46,570.00 $ 46,570.00

Step 2: Prepare the heading

Like any financial statement, the heading is made up of three lines. The first line contains the name of the company. The second line
shows the title of the report. In this case, it would be Statement of Changes in Owner's Equity, Statement of Owner's Equity, or
simply Statement of Changes in Equity. Any of the three would be okay.

The third line shows the period covered. The report covers a span of time, hence we use For the Year Ended, For the Quarter Ended,
For the Month Ended, etc. Some annual financial statements omit the "For the Year Ended" phrase.

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Gray Electronic Repair Services

Statement of Changes in Owner's Equity
For the Year Ended December 31, 2016

Step 3: Capital at the beginning of the period

Report the capital balance at the beginning of the period reported – or the amount at the end of the previous period. Remember
that the ending balance of the last period is the beginning balance of the current period.

Gray Electronic Repair Services

Statement of Changes in Owner's Equity
For the Year Ended December 31, 2016

Gray, Capital - beginning $ 0

Note: Since the company started in December 1, 2016, the beginning balance of the capital account is zero. In the second year of
operations, an amount would already be shown in the capital's beginning balance.

Step 4: Add additional contributions

Contributions from the owner increases capital, hence added to the capital balance.

Gray Electronic Repair Services

Statement of Changes in Owner's Equity
For the Year Ended December 31, 2016

Gray, Capital - beginning $ 0

Add: Additional Contributions 13,200

Tip: You may need to refer to the journal to find out how much contributions were made by the owner. Other sources of information
may also be used such as a log of owner's capital contributions.

Step 5: Add net income

Net income increases capital hence it is added to the beginning capital balance. Net income is equal to all revenues minus all
expenses. We can also refer to the income statement we previously prepared for the amount.

Gray Electronic Repair Services

Statement of Changes in Owner's Equity
For the Year Ended December 31, 2016

Gray, Capital - beginning $ 0

Add: Additional Contributions 13,200

Net Income 1,060

Step 6: Deduct owner's withdrawals

Withdrawals made by the owner is recorded separately from contributions. You can easily find it in the adjusted trial balance as
"Owner, Drawings", "Owner, Withdrawals", or any other appropriate account. Withdrawals decrease capital, hence are deducted.

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Gray Electronic Repair Services

Statement of Changes in Owner's Equity
For the Year Ended December 31, 2016

Gray, Capital - beginning $ 0

Add: Additional Contributions 13,200

Net Income 1,060

Step 7: Compute for the ending capital balance

Compute for the balance of the capital account at the end of the period and draw the lines. One horizontal line means that a
mathematical operation has been performed. Two horizontal lines (double-rule) are drawn below the final amount.

Gray Electronic Repair Services

Statement of Changes in Owner's Equity
For the Year Ended December 31, 2016

Gray, Capital – beginning $0

Add: Additional Contributions 13,200

Net Income 1,060

Less: Gray, Drawings 7,000

Gray, Capital - ending $ 7,260

Conclusion

So there you have the preparation of a Statement of Changes in Owner's Equity. It is a report that shows the items that affect the
capital or equity account. Simply, we are just presenting this formula in a formal report:

Capital, ending = Capital, beg. + Additional Contributions + Net Income - Withdrawals

where: Net Income = Income - Expenses

6.3 How to Make a Balance Sheet

The "Balance Sheet", also known as "Statement of Financial Position", shows a company's financial condition as of a certain date.

Financial condition is presented by reporting how much assets the company owns, how much liabilities it owes to others, and its
equity or capital (assets minus liabilities).

In this tutorial, we will continue the illustration from previous lessons and prepare a balance sheet. Like the other financial
statements we have prepared, we will use this adjusted trial balance: Adjusted Trial Balance. If you wish, you may take a look at a
balance sheet example here before we proceed.

Let's begin.

Step 1: Gather the needed information

Like in any other financial statement, we need to gather information to be used in preparing a balance sheet. Any source that shows
updated account balances can be used. The most appropriate tool for this, however, would be the adjusted trial balance.

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Gray Electronic Repair Services

Adjusted Trial Balance
December 31, 2016

Account Title Debit Credit

Cash $ 7,480.00
Accounts Receivable 3,700.00
Service Supplies 600.00
Furniture and Fixtures 3,000.00
Service Equipment 16,000.00
Accumulated Depreciation- Service Equipment $ 720.00
Accounts Payable 9,000.00
Utilities Payable 1,800.00
Loans Payable 12,000.00
Mr. Gray, Capital 13,200.00
Mr. Gray, Drawing 7,000.00
Service Revenue 9,850.00
Rent Expense 1,500.00
Salaries Expense 3,500.00
Taxes and Licenses 370.00
Utilities Expense 1,800.00
Service Supplies Expense 900.00
Depreciation Expense 720.00
Totals $ 46,570.00 $ 46,570.00
Step 2: Prepare the heading

The first line contains the name of the company. The second line shows the title of the report. We can use either "Balance Sheet" or
"Statement of Financial Position". The third line indicates the date of the report.

The income statement, statement of changes in equity, and statement of cash flows use For the Year Ended, For the Month Ended,
For the Quarter Ended, etc. However, we cannot use any of those phrases in a balance sheet since we are not reporting information
for a period of time, but rather, information as of a certain date.

Therefore, we shall use "As of...". Though, some balance sheets omit the phrase.

Gray Electronic Repair Services

Balance Sheet/ Statement of Financial Position
As of December 31, 2016

Step 3: Report all company assets

From the trial balance, we take all assets and report them in the balance sheet. Current assets are normally reported first before
non-current assets. After which, we will compute for total current assets, total non-current assets, and total assets. A single line is
drawn every time a mathematical operation is made. The amount of total assets is double-ruled.

Gray Electronic Repair Services

Balance Sheet/ Statement of Financial Position
As of December 31, 2016

ASSETS

Current Assets:

Cash $ 7,480
Accounts Receivable 3,700

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Service Supplies 600

Total Current Assets 11,780

Non-Current Assets:

Furniture and Fixtures $ 3,000

Service Equipment 16,000
Less: Accumulated Depreciation 720
Total Non-Current Assets 18,280

TOTAL ASSETS $ 30,060

Note: The above step requires you to be familiar with assets accounts. The next steps will require knowledge of liability and capital
accounts. If you need a review of different accounts, you may visit this lesson: Elements of Accounting.

Step 4: Report all liabilities

After the "assets" portion, we will now present "liabilities and capital". We will start by presenting current liabilities, followed by
non-current liabilities. After that, we will take the totals of each as well as the amount of total liabilities – just like what we did for
assets.

Gray Electronic Repair Services

Balance Sheet/ Statement of Financial Position
As of December 31, 2016

ASSETS

Current Assets:
Cash $ 7,480
Accounts Receivable 3,700
Service Supplies 600
Total Current Assets 11,780

Non-Current Assets:
Furniture and Fixtures $ 3,000
Service Equipment 16,000
Less: Accumulated Depreciation 720
Total Non-Current Assets 18,280

TOTAL ASSETS $ 30,060

LIABILITIES AND CAPITAL

Current Liabilities:
Accounts Payable 9,000
Utilities Payable 1,800
Total Current Liabilities 10,800

Non-Current Liabilities:
Loans Payable 12,000
Total Non-Current Liabilities 12,000

TOTAL LIABILITIES $ 22,800

Step 5: Report the ending balance of capital after total liabilities

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The trial balance above does not show the ending balance of capital. The ending balance of capital can be taken from the Statement
of Changes in Equity. If you have been following our tutorials, we prepared it before preparing this balance sheet. In any case, any
source may be used as long as it gives you the ending balance of capital.

After including capital, we will take the total amount of "liabilities and capital". That amount is double-ruled.

Gray Electronic Repair Services

Balance Sheet/ Statement of Financial Position
As of December 31, 2016

ASSETS

Current Assets:
Cash $ 7,480
Accounts Receivable 3,700
Service Supplies 600
Total Current Assets 11,780

Non-Current Assets:
Furniture and Fixtures $ 3,000
Service Equipment 16,000
Less: Accumulated Depreciation 720
Total Non-Current Assets 18,280

TOTAL ASSETS $ 30,060

LIABILITIES AND CAPITAL

Current Liabilities:
Accounts Payable 9,000
Utilities Payable 1,800
Total Current Liabilities 10,800

Non-Current Liabilities:
Loans Payable 12,000
Total Non-Current Liabilities 12,000

TOTAL LIABILITIES $ 22,800

Gray, Capital - ending $ 7,260

TOTAL LIABILITIES AND CAPITAL $ 30,060

Total assets should be equal to total liabilities and capital. If they are not, then something must have gone wrong during the process.

There you have it. The balance sheet we have just prepared is for a sole proprietorship business. In a partnership, several capital
accounts will have to be presented – one for each partner. In a corporation, the capital portion is known as stockholders' equity and
is made up of capital stock, reserves, and ending balance of retained earnings.

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CHAPTER 7: CLOSING ENTRIES

 Closing journal entries are made at year-end to prepare temporary accounts for the next accounting period.
 Temporary or nominal accounts, (also called income statement accounts), are measured periodically.
 The amounts in one accounting period should be closed or brought to zero so that they won't be mixed with those of the next
period.
 Temporary accounts consist of all revenue and expense accounts, and also withdrawal accounts of owner/s in the case of sole
proprietorships and partnerships.
 Take note that closing entries are prepared only for temporary accounts. Permanent accounts are never closed.

Four Steps in Preparing Closing Entries

1. Close all income accounts to Income Summary

2. Close all expense accounts to Income Summary
3. Close Income Summary to the appropriate capital account
4. Close withdrawals to the capital account/s (this step is for sole proprietorship and partnership only)

Closing Entries: Example

Prepare the closing entries using the following information:

Gray Electronic Repair Services

Adjusted Trial Balance
December 31, 2016

Account Title Debit Credit

Cash $ 7,480.00
Accounts Receivable 3,700.00
Service Supplies 600.00
Furniture and Fixtures 3,000.00
Service Equipment 16,000.00
Accumulated Depreciation- Service Equipment $ 720.00
Accounts Payable 9,000.00
Utilities Payable 1,800.00
Loans Payable 12,000.00
Mr. Gray, Capital 13,200.00
Mr. Gray, Drawing 7,000.00
Service Revenue 9,850.00
Rent Expense 1,500.00
Salaries Expense 3,500.00
Taxes and Licenses 370.00
Utilities Expense 1,800.00
Service Supplies Expense 900.00
Depreciation Expense 720.00
Totals $ 46,570.00 $ 46,570.00
Step 1: Close all income accounts to Income Summary

Date Particulars Debit Credit

Dec 31, 2016 Service Revenue 9,850
Income Summary 9,850
In the given data, there is only 1 income account, i.e. Service Revenue. It has a credit balance of $9,850. To close that, we debit
Service Revenue for the full amount and credit Income Summary for the same.
The Income Summary account is temporary. It is used to close income and expenses. As you will see later, Income Summary is
eventually closed to capital.

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Step 2: Close all expense accounts to Income Summary

Dec 31 Income Summary 8,790.00

Rent Expense 1,500.00
Salaries Expense 3,500.00
Taxes and Licenses 370.00
Utilities Expense 1,800.00
Service Supplies Expense 900.00
Depreciation Expense 720.00
To close expenses, we credit the expense accounts and debit Income Summary.

Now for the next step, we need to get the balance of the Income Summary account. In step 1, we credited it for $9,850 and debited
it in step 2 for $8,790. It would then have a credit balance of $1,060. (net income)

Notice that the balance of the Income Summary account is actually the net income for the period. Remember that net income is
equal to all income minus all expenses.

Step 3: Close Income Summary to the appropriate capital account

The Income Summary balance is ultimately closed to the capital account.

31 Income Summary 1,060.00

Mr. Gray, Capital 1,060.00
Step 4: Close withdrawals to the capital account

Note: This step is applicable only to sole proprietorships and partnerships.

In a sole proprietorship, a drawing account is maintained to record all withdrawals made by the owner. In a partnership, a drawing
account is maintained for each partner. Drawing accounts are closed to capital at the end of the accounting period.

Our example is a sole proprietorship business. Mr. Gray's withdrawals are recorded in Mr. Gray, Drawing. To close the drawing
account to the capital account, we credit the drawing account and debit the capital account. Notice that drawings decrease capital.

31 Mr. Gray, Capital 7,000.00

Mr. Gray, Drawing 7,000.00
Conclusion

The purpose of closing entries is to prepare the temporary accounts for the next accounting period. In other words, the income
and expense accounts are "restarted".

After preparing the closing entries above, Service Revenue will now be zero. The expense accounts and withdrawal accounts will
now also be zero. The balances of these accounts have been absorbed by the capital account – Mr. Gray, Capital, which now has a
balance of $7,260 ($13,200 beginning balance + $1,060 in step #3 - $7,000 in step #4).

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CHAPTER 8: POST CLOSING TRIAL BALANCE

The last step in the accounting cycle is to prepare a post-closing trial balance.

A post-closing trial balance is prepared after closing entries are made and posted to the ledger.

It is the third (and last) trial balance prepared in the accounting cycle.

For a recap, we have three types of trial balance. They all have the same purpose (i.e. to test the equality between debits and
credits) although they are prepared at different stages in the accounting cycle.

1. Unadjusted trial balance - This is prepared after journalizing transactions and posting them to the ledger. Its purpose is to test the
equality between debits and credits after the recording phase.

2. Adjusted trial balance - This is prepared after adjusting entries are made and posted. Its purpose is to test the equality between
debits and credits after adjusting entries are prepared. It is also the basis in preparing the financial statements.

An adjusted trial balance contains nominal and real accounts. Nominal accounts are those that are found in the income statement,
and withdrawals. Real accounts are those found in the balance sheet.

3. Post-closing trial balance - This is prepared after closing entries are made. Its purpose is to test the equality between debits and
credits after closing entries are prepared and posted. The post-closing trial balance contains real accounts only since all nominal
accounts have already been closed at this stage.

Example

To illustrate, here is a sample adjusted trial balance:

Gray Electronic Repair Services

Adjusted Trial Balance
December 31, 2016

Account Title Debit Credit

Cash $ 7,480.00
Accounts Receivable 3,700.00
Service Supplies 600.00
Furniture and Fixtures 3,000.00
Service Equipment 16,000.00
Accumulated Depreciation- Service Equipment $ 720.00
Accounts Payable 9,000.00
Utilities Payable 1,800.00
Loans Payable 12,000.00
Mr. Gray, Capital 13,200.00
Mr. Gray, Drawing 7,000.00
Service Revenue 9,850.00
Rent Expense 1,500.00
Salaries Expense 3,500.00
Taxes and Licenses 370.00
Utilities Expense 1,800.00
Service Supplies Expense 900.00
Depreciation Expense 720.00
Totals $ 46,570.00 $ 46,570.00

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At the end of the period, the following closing entries were made:

Dec 31 Service Revenue 9,850.00

Income Summary 9,850.00
31 Income Summary 8,790.00
Rent Expense 1,500.00
Salaries Expense 3,500.00
Taxes and Licenses 370.00
Utilities Expense 1,800.00
Service Supplies Expense 900.00
Depreciation Expense 720.00
31 Income Summary 1,060.00
Mr. Gray, Capital 1,060.00
31 Mr. Gray, Capital 7,000.00
Mr. Gray, Drawing 7,000.00
After posting the above entries, all the nominal accounts would zero-out, hence the term "closing entries". Let's take a look.

In the first closing entry, Service Revenue was debited. Before that, it had a credit balance of 9,850 as seen in the adjusted trial
balance above. Now its balance would be zero.

Second entry. All expenses were credited. Before that, they had debit balances for the same amounts. They would now have zero
balances.

In the first and second closing entries, the balances of Service Revenue and the various expense accounts were actually transferred
to Income Summary, which is a temporary account. The Income Summary account would have a credit balance of 1,060 (9,850 credit
in the first entry and 8,790 debit in the second).

Income Summary is then closed to the capital account as shown in the third closing entry.

And finally, in the fourth entry the drawing account is closed to the capital account. At this point, the balance of the capital account
would be 7,260 (13,200 credit balance, plus 1,060 credited in the third closing entry, and minus 7,000 debited in the fourth entry).

Post-Closing Trial Balance Example

After incorporating the closing entries above, the post-closing trial balance would look like this:

Gray Electronic Repair Services

Post-Closing Trial Balance
December 31, 2016

Account Title Debit Credit

Cash 7,480
Accounts Receivable 3,700
Service Supplies 600
Furniture and Fixtures 3,000
Service Equipment 16,000
Accumulated Depreciation- Service Equipment 720
Accounts Payable 9,000
Utilities Payable 1,800
Loans Payable 12,000
Mr. Gray, Capital 7,260
TOTALS $ 30,780 $30,780

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The balances of the nominal accounts (income, expense, and withdrawal accounts) have been absorbed by the capital account – Mr.
Gray, Capital. Hence, you will not see any nominal account in the post-closing trial balance. And just like any other trial balance, total
debits and total credits should be equal.

CHAPTER 9: Reversing Entries

 Reversing entries are made at the beginning of the new accounting period to enable a smoother accounting process.
 This step is optional and is especially useful to companies that use the cash basis method.
 In this step, adjusting entries made at the end of the previous accounting period are simply reversed, hence the term
"reversing entries".
 However, not all adjusting entries qualify for this step.

The following are the only types that can be reversed:

1. Adjusting entry for accrued income,

2. Adjusting entry for accrued expense,
3. Adjusting entry for unearned revenue(deferred income) using the income method, and
4. Adjusting entry for prepaid expense using the expense method.

Adjusting entries for unearned revenue under the liability method and for prepaid expense under the asset method are never
reversed. Adjusting entries for depreciation, bad debts and other allowances are also never reversed.

Let us illustrate each of the above types.

Reversing Entry for Accrued Income

Example: ABC Company is to receive $3,000 interest income at the end of February 2017. It covers 3 months starting December 1,
2016. At the end of 2016, the accountant properly makes an adjusting entry for one month's worth of accrued income.

Date Particulars Debit Credit

Dec 31, 2016 Interest Receivable 1,000
Interest Income 1,000
At the beginning of 2017, the accountant can prepare this reversing entry:

Date Particulars Debit Credit

Jan 1, 2017 Interest Income 1,000
Interest Receivable 1,000
The adjusting entry is simply reversed. Debit what was credited and credit what was debited.

When the ABC Company receives the interest income at the end of February, the accountant will then prepare this journal entry:

Feb 28, 2017 Cash 3,000.00

Interest Income 3,000.00
Notice that Interest Income is credited for 3,000. Now you might be asking this: Under the concept of accrual, the interest income to
be recognized in 2017 should be $2,000. Then why credit $3,000 Interest Income?

Very good. Well, in the reversing entry at the beginning of the period, Interest Income was already debited for $1,000. So if we
combine them ($1,000 debit and 3,000 credit), then we'll end up with $2,000 Interest Income which is the correct amount to be
recognized in 2017.

We said that reversing entries are optional. If the accountant did not make a reversing entry at the beginning of the year, the
accountant will have this entry upon collection of the income.

Feb 28, 2017 Cash 3,000.00

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Interest Receivable 1,000.00

Interest Income 2,000.00
Note: Actually, if you combine the reversing entry and journal entry for collection. You'll come up with the journal entry above.

Reversing Entry for Accrued Expense

Example: Suppose that ABC Company and its lessor agrees that ABC will pay rent at the end of January 2017, covering a 3-month
period starting November 1, 2016. The entire amount is $6,000.

At the end of December 2016, the accountant properly prepares this adjusting entry for two months worth of rent expense (Nov 1 to
Dec 31):

Date Particulars Debit Credit

Dec 31, 2016 Rent Expense 4,000
Rent Payable 4,000
At the beginning of 2017, the accountant can prepare this reversing entry:

Date Particulars Debit Credit

Dec 31, 2016 Rent Payable 4,000
Rent Expense 4,000
Again, notice that the adjusting entry is simply reversed.

When the company pays the entire rent, the accountant will then prepare this journal entry:

Jan 31, 2017 Rent Expense 6,000.00

Cash 6,000.00
In effect, Rent Expense for 2017 is $2,000 even if the accountant debits $6,000 upon payment. This is because of the reversing entry
which includes a credit to Rent Expense for $4,000.

If the accountant did not make a reversing entry at the beginning of the year, the accountant will have this entry upon payment of
the rent.

Jan 31, 2017 Rent Payable 4,000.00

Rent Expense 2,000.00
Cash 6,000.00
There you have the first two types of adjusting entries that can be reversed. If you are having trouble understanding the process,
don't worry. It requires some time and a little effort for the concepts to sink in. In part 2, we'll take a look at the other two types.

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Reversing Entry for Unearned Income-(Deferred)

If the income method is used in recording unearned income, reversing entries can be prepared. Take note that adjusting entries for
unearned income recorded using the liability method are never reversed.

Example: ABC Company recorded customer advances amounting to $5,000 in December 1, 2016. The company uses the income
method in recording unearned income.

Date Particulars Debit Credit

December 1, 2016 Cash 5,000
Service Revenue 5,000

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At the end of 2016, the company rendered $2,000 worth of services. We need to set-up the unearned income of $3,000 and bring
Service Revenue to its correct balance ($2,000). The adjusting entry would be:

Dec 1 Service Revenue 3,000.00

Unearned Revenue 3,000.00

At the beginning of 2017, the following reversing entry can be prepared:

Date Particulars Debit Credit

Jan 1, 2017 Unearned Revenue 3,000.00
Service Revenue 3,000.00
Notice that the adjusting entry is simple reversed.

At the end of 2017, Service Revenue will again be checked to see if there is any unearned portion and if an adjusting entry is
necessary.

Reversing Entry for Prepaid Expense

If the expense method is used in recording prepaid expense, reversing entries can be prepared. Adjusting entries for prepaid
expense under the asset method are not reversed.

Example: On December 1, 2016, ABC Company paid $7,500 of rent for 3 months starting December 1. The expense method was used
in recording this transaction.

Date Particulars Debit Credit

Dec 1, 2016 Rent Expense 7,500.00
Cash 7,500.00
At the end of 2016, 1 month worth of rent has already expired. Prepaid Rent should be set-up for the remaining 2 months. The
adjusting entry would be:

Dec 31 Prepaid Rent 5,000.00

Rent Expense 5,000.00
At the beginning of 2017, the following reversing entry can be prepared:

Date Particulars Debit Credit

Jan 01, 2017 Rent Expense 5,000.00
Prepaid Rent 5,000.00
Again, notice that the adjusting entry is simple reversed.

At the end of February, the entire rent paid has already expired. We do not need to make an entry here since we already prepared a
reversing entry.

Nonetheless, Rent Expense will be reviewed at the end of the year. Rent Expense and all other expenses will be checked to see if
there are any unexpired portions which will require adjusting entries.

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